«Research commissioned by the Intellectual Property Office, and carried out by: Martin Brassell, Kelvin King This is an independent report ...»
• The high costs of due diligence, combined with the importance of making a return on capital employed that is material in absolute as well as percentage terms, have combined with reducing risk appetite to push many private equity firms towards the pursuit of increasingly large deals. This perfectly understandable and rational behaviour has exacerbated the funding gap facing SMEs wishing to grow and prepared to sacrifice equity to achieve it, because less new funding has reached the market in its place. The location of this gap is examined in Chapter 6
• Two other factors are tending to limit venture capital appetite: the absence of profitable exits during the recession (because many companies are choosing to conserve cash and repay debt, as numerous banking industry statistics have shown) and the difficulty in raising new funds because of concerns over macro-economic prospects 59 It should be noted that these represent UK investments by UK members: the EVCA, covering Europe, has information on fund investments in UK companies from Europe-wide funds.
94 The role of intellectual property and intangible assets in facilitating business finance
There is a considerable amount of regulatory activity around crowdfunding. At the time of writing, there are three FCA-regulated crowdfunding platforms companies can use to raise money on the internet; Crowdcube, Seedrs and Abundance. The largest and longest established of these is Crowdcube, which has now helped companies raise over £12m: it has over 45,000 investors now registered.
The models and emphasis of all three are slightly different. Abundance60 specialises in enabling individuals to invest in UK renewable energy projects and is essentially debt-based in outlook.
Seedrs61 (as its name suggests) is particularly directed at helping start-up companies to find seed capital. It also holds the shares that are issued as a nominee for investors, meeting that the company only deals with one organisation rather than a plethora of individuals with small shareholdings.
Crowdcube62, founded by Darren Westlake, offered its first investments in February 2011:
It adopts a different approach to the equity dissemination problem, which is to restrict voting ‘A’ shares to individuals who invest more than a set amount or percentage of the funding round requirement. Most investors receive ‘B’ shares, which provide a share of the business but do not have voting or pre-emption rights attached to them.
Experiences in dealing with IP
Westlake characterises the types of business which benefit from the platform as follows:
People like to invest in things that have a bit of traction. Only 20% of our companies are pre-revenue – the remainder are either generating turnover or have obtained some sort of foothold in the market. Our average fundraise now is about £175,000.
Overall, the split is around 75/25 between business-to-consumer and business-tobusiness propositions. Businesses that people can understand relatively quickly tend to do best on our platform. We have had a lot of success with food and drink companies and consumer-related technology.
In the past businesses that have been very scientific or high-tech-orientated haven’t done as well, but this is starting to change – for example, we successfully funded a biotech company last month. As the crowd grows, it becomes possible to fund an increasingly diverse range of businesses.
Whilst relatively few companies that have come through the platform have been “IP-type businesses”, there have still been some notable instances where IP issues have come to light.
Westlake cites two examples:
Quite early on, we funded an alcoholic drinks manufacturer. One of the prospective investors pointed out that there could be an issue with a German branded drink with a similar name. That’s one instance where the wisdom of the crowd helped the company address the situation before they spent lots of money building the brand.
Another instance has been a marine security device where there was a great deal of discussion over who owned the IP for the device, without which the business was not as investable.
We’ve currently got a medical device called Zovolt being funded through the platform, and another business called AlgaeCytes which sustainably farms algae. IP is likely to be quite an important element for both of them.
Both Seedrs and Crowdcube have a simple rule that if the target sum is not achieved, then no investment is made. Usually it is the first 20-30% of the funding being sought that is the most difficult to obtain; Westlake explains that this is a key point in client discussions, with companies encouraged to plan how they can mobilise friends and family and others who have expressed interest in supporting their business at an early stage. If a round goes particularly well, a company can opt to set an overfunding target; this conversation typically happens when 70-80% of the total has been achieved.
It is often observed that the benefits of angel investment include attracting talented and experienced individuals who can help the business to grow. There are similar benefits for
businesses that choose crowdfunding, according to Westlake:
96 The role of intellectual property and intangible assets in facilitating business finance
Crowdcube does not make or offer any judgement on whether it thinks a business is likely to be successful or not. There is an obligation on the company to make sure that information is fair, clear and not misleading, and Crowdcube ensures that the documentation made available for investor presentation addresses the key questions they will ask. Background checks are conducted into directors and the company, including for money laundering, as required by regulators.
Since 2009 there has been considerable network consolidation within England as well as a wide range of new groupings emerging. This is partly due to the disappearance of regional development agencies, many of which used to fund regional angel network operations. This change has compelled these networks to take a more commercial approach in line with other privately managed networks and groups, which can only come from successful deals (to quote Jenny Tooth, CEO of UKBAA: “because entrepreneurs can’t afford to pay much at the front end”).
Angel investors play a particularly important role for new and early stage businesses whose financing requirements exceed their founder’s resources, but which are too small and too high risk to be accommodated by venture capital investors, particularly given their requirements for due diligence and oversight. This in turn is important because of the important role high growth start up businesses play in the wider economy (referenced in other chapters of this report).
This profile is borne out by Nesta’s 2009 research, which found that the average company valuation was £875,000 (median) or £1.7m (mean) and 51% were at seed or start-up capital stage with a further 36% as early growth.
In terms of individual deals: when acting in syndicates, angels can bring anything from £100k to £1.5m depending on the quality of the IP and the opportunity, demonstrating (in Jenny Tooth’s
Angels now have the capacity to bring quite significant firepower to the table… there is a blurring of lines between angels and VCs.
Sandy Finlayson, referenced in Chapter 2, says the Scottish angel groups have proved remarkably resilient throughout the recession. He cites the example of Edinburgh-based Archangels65, the largest of all the syndicates, now established for over 20 years, and which has consistently invested £10m each year throughout the last four-year period. In total, the Archangels website references £55m invested in 60 businesses, with follow-on funding provided in a number of cases. “They are now big enough to operate without support and have five full-time people on the payroll”.
Whilst the most likely outcome to any investment is failure, Nesta’s research found that overall, angel investing delivered a 22% internal rate of return, despite the fact that 56% of exits did not return the capital invested.
The 44% overall which were positive delivered a larger multiple than the unsuccessful exits, leading to a 2.2 times return on capital invested. Interestingly, the top 9% of deals provided more than a 10 times return, and accounted for nearly 80% of the positive cash flows. The Nesta survey’s findings were in line with previous US studies which found an average IRR of 27% and that 10% of exits produced 90% of cash.
Looking at returns, Finlayson says it is “absolutely not scientific. The best I have seen is a 125 times return. I have also seen a 90 times return, but then again, I have seen £800,000 pissed up against the wall in three months. Some individual angels manage to generate returns in the 40-50% range.” Because of the high failure rate, angels generally look to assemble portfolios to spread risk and these can be built more quickly by working together. Nesta’s research found an average of six people co-invest in each company, though 17% of ventures get their funding from a single
individual. Jenny Tooth provides a perspective on this:
An individual’s £10-£25k won’t do much but working with others makes a real difference. Angels have the capacity to do more through syndication and work with a business through several phases... investors generally like to invest together with people they know.
65 See www.archangelsonline.com 98 The role of intellectual property and intangible assets in facilitating business finance Due to its business model, Angels Den tends to attract a different investor profile from other networks, but even though many of its angels act independently, co-investment behaviour (when it happens) appears similar. Founder Bill Morrow explains:
Scottish angel investment syndicates tend to be more formally organised than their English equivalents, but since each investor must make their own decisions for regulatory reasons, syndicates are not run as funds. However, syndicates such as Par Fund Management66, an FSA-regulated company, operates an EIS fund as well as an angel syndicate (and is also launching a “Par Innovation Fund’ to invest between £500k and £2.5m). This EIS fund operates as a ‘sidecar’ fund that invests alongside syndicated deals, helping to make additional use of the due diligence already conducted and bring more money into businesses with growth potential.
Another example is Kelvin Capital67, with a core group of investors meeting regularly to review opportunities. Kelvin Capital summarises its target market as being “start up and young businesses which have a novel technology that can deliver something useful in the market place and for which there is a genuine long-term market and demand from users.” Its portfolio includes a number of medical device companies as well as new products aimed at consumer markets.
Bill Morrow of Angels Den adds:
When we started out, we thought we were offering a service for entrepreneurs, but we now know that the primary audience is the angels, because we find what they want and we save them time. We have 400 of them on our website a day.
The demand for angel investment is indicated in the fact that Angels Den now receives 150 approaches a day from entrepreneurs. The dilemma of the investor is illustrated by what happens
Most companies will simply never have what it takes to attract angel investment. Of that 150 per day, we’ll need to put 100 out of their misery, and 20 will decide for themselves that they don’t want to continue. However, there will be 30 that are potentially trainable and worth working with, for example, on why it is important for them to protect their IP. Just one of the plans we see each day will be exciting, and we’ll want to take it on and make it ‘shiny’.
Angel network and syndicate views on IP
Due diligence procedures were shown in Nesta’s report to reduce angel investment risk of a bad exit. The evidence shows that due diligence is important in making better returns, with a positive correlation between investors spending 20 or more hours on due diligence compared with those who spent less time checking the business. Jenny Tooth observes that “syndicates allow you to be more efficient with due diligence, and to get different views; groups will naturally tend to be more enquiring”.
If a syndicate is seeking to take advantage of the Angel Co-Fund, referenced in Chapter 2, it is also notable that this fund (recently ‘topped up’ to a total of £100m) does no due diligence of its own; to qualify for this support, a syndicate has to have done it and pass it on to them. Tooth believes that “this is driving more due diligence in general, and has acted as a catalyst
towards best practice”. She continues:
When you’re looking for better overall financial performance, diligence lies at the heart of it - commercial, financial, technical, market and IP.
Concerns are around infringement, how well protected a technology is, and whether there is anyone else out there doing something similar. Syndicates have a lot of strength; you will usually be able to find someone who knows something about the opportunity that is helpful… Having some initial validation of the IP is important. Patents or patents applied for are one particular area of enquiry. The more a company has prepared itself around IP and its potential, the more likely they are to immediately attract investment.
100 The role of intellectual property and intangible assets in facilitating business finance
In Morrow’s experience, angels are good at sharing the due diligence workload between them, and will tend to have a salesperson, lawyer and accountant as part of the investor group who
are sufficiently trusted to get comfortable with the main points. However: