«Research commissioned by the Intellectual Property Office, and carried out by: Martin Brassell, Kelvin King This is an independent report ...»
Even if a company has been trading for several years, there is a limited amount that you can derive from their accounts. Angels are not going to spend weeks pouring over spreadsheets, and balance sheets are a bit pointless at this early stage; most of the assets will be intangible, especially IP, and the company’s accountant will have no idea what to do with it.
Serial investors’ personal views on IP
For the purposes of this report, five “serial investors” (business angels who regularly invest in early stage growth companies) were provided with IP questionnaires. All were active in networks based in the South and South-East of England, East of England, West Midlands and Wales, though the amount of investments identified through their networks as a proportion of their portfolio varied quite considerably, ranging from 30% to 90%.
Their views are set out in order below marked A-E (not all answered every question). They are intentionally unattributed, so as not to be interpreted as a reflection on particular current investments. These provide an informative picture of how a selection of high net worth individuals and sophisticated investors feel about IP.
When assessing a prospective investment, investors were asked to identify the main things they
looked for and where IP featured amongst them:
It’s the first three that determine whether you have a business and the last three that are relevant in determining the value of the business. If you answer those questions, simply and clearly, you have the best chance of starting the conversation that is the investment process.
B: Quality of management team, unique and defensible selling proposition, market size, scalability, competitive situation. IP plays a key role in establishing a defensible USP by providing innovation and entry barriers.
102 The role of intellectual property and intangible assets in facilitating business finance
None of those interviewed were impressed with the quality of information that they received from prospective investee businesses. Three were particularly critical: A stated that IP awareness was “shockingly bad amongst almost all levels of business”; C pointed out that there was “no generally accepted framework” for presenting IP: and E stated that “no more than half the investments I see have a quality approach to this area and even then it is often riddled with amateurish thinking and execution.”
A: At least 70%, but when really early it’s everything.
B: Apart from the management team the key consideration is a unique, scalable and defensible selling proposition in an attractive space that offers global market potential.
C: Valuation of all companies is an inexact science. When it comes to early stage companies the problem is particularly acute. There are usually no profits to multiply so a multiple of turnover is often used as a poor proxy. Amount of time, energy and money invested to date, quality of the management team, size of the market, barriers to entry are all important considerations. At an early stage, IP can represent as much as 75% of a company’s value.
E: Generally speaking, and especially with pre-revenue or very early stage businesses, the IP is the only thing you have to value with anything approaching an objective framework. Too often valuation is gut-feel based and approached from the owners as ‘how little can I get away with giving away to investors whilst still raising the money I need?’ They always overlook the fact that experienced investors will evaluate an investment as requiring at least 200% of what they invest on day 1.
The investors responded as follows when asked about the key risks and dangers they associate
with companies that are ‘IP rich’ (and whether these are any different from other businesses):
A: Valuation and delusion.
B: IP is very people-dependent and often concentrated, sometimes in just one individual. IP-rich companies tend to operate in a fast-changing environment where new competitors or technologies/products can destroy your business almost overnight.
Life cycles are short and IP-rich companies need to be able to continuously reinvent themselves in order to prosper over longer periods.
C: The IP isn’t held by the vehicle one is investing in, there are others who claim the same IP but are much bigger and therefore have deeper pockets to pay for lawyers, the IP is technically sound but has little or no commercial application.
E: Even when IP is of good quality and has been well protected through a considered IP protection strategy, it is of little value if the company cannot answer the question, ‘How will you respond when you come under attack from ‘Megacorp’s’ IP lawyers? which will happen if the techno is disruptive and generating real revenue in established markets, because the losers in these situations always seek to fight back in some way. There a host of good answers to this question, but the way in which a management team answers them is a key bellwether of their quality and intellectual horsepower; it also reveals clearly what experience they actually have of fighting in an IP-driven world, because too often such opportunities are advanced by well-intentioned boffins who do not have enough commercial DNA, which is another area in which angel investors can always help.
104 The role of intellectual property and intangible assets in facilitating business finance
Venture capital and private equity Industry view Mark Florman is the Strategic Adviser and Industry Ambassador for the BVCA. He also happens to have a specific interest in IP, both as an investor and as an advisor to the African IP Trust. He
provided the following commentary on the latest investment figures:
There are indications that investment activity is beginning to pick up: sentiment started to improve from mid-2012, due in part to AIFMD being substantially settled. It is not advisable to read too much into quarterly and half-yearly trends, which can be distorted by large individual deals. In addition, the fundraising cycle can easily take 18 months or more to complete, and has been difficult of late, especially for Euro-denominated funds.
Arranging an exit, whether through the stock market, a trade sale or to a new PE owner has been difficult for the past three years due to general uncertainty. Investors are now prepared to accept a little more risk, however.
Florman also provided some specific comments in relation to intellectual property in the private
equity context, firstly on the subject of IP management:
One of the key value enhancement opportunities for private equity is to invest in R&D.
If you are buying quite a well-established business, and you want to add value, then new IP is one way to do it. Many company boards are not as strong as they might be on that aspect, because they have never really thought about R&D in such a way.
Investor IP strategies can be about the management of downside risk, or making sure you can reap the rewards. In one previous investment of mine, LM Wind Power (a Danish company), we found a number of patentable inventions which had not been registered – the company went from about 5 to 20 patent applications within a couple of years. One of these was a lightning conductor device which provided a significant competitive advantage but which had never been protected.
As a result of attending to IP, you may find there is more value on your balance sheet than you realised, because you may not recognise assets that have been there for a while. In a recession, awareness of IP is more important because you are looking for everything that could represent additional value. In boom times, everything can be going well and you are not looking hard enough!
He also offered some thoughts on the part played by IP in due diligence exercises:
IP is not always very high up on the checklist. It should be on there, but its importance will depend on the type of company in which the investment is being made. Fixed assets are more likely to be obvious, but equally, it might also be obvious that certain brands have significant value, and that strategies need to be in place to protect it.
106 The role of intellectual property and intangible assets in facilitating business finance
Nick Goddard’s breadth of experience is unusual, having worked as both a scientist (a physicist and chartered engineer) and a corporate financier with BNP Paribas and ABN Amro. His experiences working on both sides of the funding ‘fence’ have led him to some particular views
on where IP ranks in the list of priorities from an equity funding perspective:
Industry initiatives: the Business Growth Fund In July 2010, the Chief Executives of some of the largest UK banks along with the British Bankers Association set up a Business Finance Taskforce to consider what more could be done to help the UL return to sustainable growth. In October 2010 the Business Finance Taskforce committed to a new source of growth equity for SMEs. BGF (Business Growth Fund) was launched in May 2011 funded by five of the largest UK banks (HSBC, RBS, Standard Chartered, Barclays and Lloyds TSB) with £2.5bn of committed capital.
BGF’s first investment was made that October and by the end of 2012 nearly £100m of new capital had been introduced into growing British businesses.
The capital provided by BGF (usually ordinary shares, warrants/options and unsecured loan notes) combines with alternative non-bank providers of mezzanine and junior debt and traditional bank lending of asset-backed debt, senior debt and working capital facilities.
Whilst funded by banks, BGF confirms that equity and debt positions require different investment skill sets, and that the skills necessary to identify and perform due diligence on good investment prospects are often too expensive to be compatible with the typical low margin debt present in conventional banking. BGF’s processes involve identifying businesses requiring growth capital that have passed through the early funding stage and demonstrate that they have a sustainable competitive advantage and an appropriately experienced management team.
A meeting with Alistair Brew, Investment Director, Mark Nunny, Senior Investment Manager and John Rhodes, Director of Marketing and Communications provided insight and a summary as to how BGF operates and its investment attitude.
However sophisticated a business plan may be, the deal team at BGF always prepares its own summary case for investment which is then taken to an investment committee for consideration.
BGF typically invests £2 - £10m of growth capital for a minority stake (10 - 40%) and a board seat and backs privately owned, profitable companies typically within a turnover of £5m to £100m. BGF also has the ability to make co-investments alongside other growth capital providers.
As minority shareholders, BGF is set up to work in partnership with incumbent management teams, rather than inserting their own team. However, they will assist in introducing nonexecutives and other senior management to complete the team, for example a finance director.
BGF only has one vote at the Board meetings and no day-to-day management control, unlike more mainstream private equity.
BGF offers long term funding of up to 10 years and seeks to develop a partnership with shared goals and objectives from the outset. Most business sectors with the exception of regulated financial services and property development are considered for investment. With seven offices across the UK, they like to be geographically close to the business invested. BGF can invest using unsecured loan notes as part of its equity investment but this is not regarded as being comparable with a conventional debt position because the capital is unsecured and the repayments may not start until year five and beyond.
108 The role of intellectual property and intangible assets in facilitating business finance As with other investors in the VC space, determining the strength, resilience and adaptability of the management team has been regarded as an overriding priority. BGF looks for management teams with a good track record, a proven business model and a desire to grow. BGF will also look at the market in which the business operates and the product or service offered. It is important to understand the business’ competitive advantage and how sustainable that is.
The private sector: Octopus Investments Whilst the costs of doing due diligence, desire to reduce risk and secure larger overall returns has driven many venture capital companies towards increasingly large deals, one that continues to address the SME funding gap is Octopus Investments. The Ventures team at Octopus currently has a portfolio of some 40 companies, which include a number of well-known highgrowth businesses such as Zoopla, Calastone and Swiftkey. Octopus currently has £3bn assets under management and is the largest manager of Venture Capital Trusts (VCTs) in the UK.
George Whitehead (also Angel CoFund founder) is a member of the Ventures team at Octopus.
Demand for investment is clearly high:
In the course of a year, the team at Octopus will probably review more than 2,000 business plans. However, we only end up making eight to ten new investments a year, and these are generally in companies that have been referred to us through our network of contacts, in particular the group of seasoned business professionals and entrepreneurs (Octopus Venture Partners) who invest alongside us.
We are dealing with companies worth £3m to £10m, but trying to build them up to be worth more than £100m. That’s not easy! So we will underwrite the deal initially, but always look to syndicate with our Venture Partners – it’s a really good way of testing whether we are backing good quality companies, and for businesses who pitch, their final hurdle is always to present to these really senior guys, who can help to provide the know-how and contacts these companies will need to support their growth.
How does Octopus justify investing relatively modest amounts of money into businesses where