Enterprise and Venture Capital: A Business Builder's and Investor's Handbook, 5th Edition

ENTERPRISE & VENTURE CAPITAL 5th EDITION

A BUSINESS BUILDER’S AND INVESTOR’S HANDBOOK

Christopher C. Golis, Patrick D. Mooney, Thomas F. Richardson

Enterprise and Venture Capital

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Enterprise and Venture Capital A business builders’ and investors’ handbook

FIFTH EDITION

Christopher C. Golis MA MBA SFFin FAICD FAIM Patrick D. Mooney BA MBA MAICD Thomas F. Richardson BS Finance MAICD

First published in 1989 This edition published in 2009 Copyright © C. Golis, P. Mooney and T. Richardson 2009 All rights reserved. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording or by any information storage and retrieval system, without prior permission in writing from the publisher. The Australian Copyright Act 1968 (the Act) allows a maximum of one chapter or 10 per cent of this book, whichever is the greater, to be photocopied by any educational institution for its educational purposes provided that the educational institution (or body that administers it) has given a remuneration notice to Copyright Agency Limited (CAL) under the Act. Allen & Unwin 83 Alexander Street Crows Nest NSW 2065 Australia Phone: (61 2) 8425 0100 Fax: (61 2) 9906 2218 Email: [email protected] Web: www.allenandunwin.com National Library of Australia Cataloguing-in-Publication entry: Golis, Christopher C. Enterprise and venture capital / Christopher Golis, Patrick Mooney and Tom Richardson. 5th ed. ISBN: 978 1 74175 6906 (pbk.) Noes: Includes index. Bibliography. Venture capital–Australia Business enterprises–Australia–Finance Entrepreneurship–Australia Capitalists and financiers–Australia Other Authors / Contributors: Mooney, P. R. (Pat Roy), 1947– Richardson, Tom 338.040994 Set in 11/14 pt Minion by Post Pre-press Group, Australia Printed and bound in Australia by Griffin Press 10 9 8 7 6 5 4 3 2 1

Favourite sayings

Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat. The general who wins the battle makes many calculations in his temple before the battle is fought. The general who loses makes but few calculations beforehand. Sun Tzu Profits are an opinion, cash is a fact. Unknown Hope is not a strategy. M. Henos Good judgment comes from experience, and experience comes from bad judgment. Barry LePatner There are two kinds of people, those who do the work and those who take the credit. Try to be in the first group; there is less competition there. Indira Gandhi

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The power of accurate observation is commonly called cynicism by those who have not got it. George Bernard Shaw You do not make the poor rich by making the rich poor. Nearly all men can stand adversity, but if you want to test a man’s character, give him power. Abraham Lincoln When men speak of the future, the Gods laugh. Chinese Proverb The first principle is that you must not fool yourself—and you are the easiest person to fool. Richard Feynman Timing dwarfs analysis. Bill Ferris Every company I’ve ever been involved in looked like a piece of Swiss cheese up close. Dick Kramlich, New Enterprise Associates and a VC since 1978 We divide business plans into three categories: candy, vitamins, and painkillers. We throw away the candy. We look at vitamins. We really like painkillers. We especially like addictive painkillers! K. Fong A compromise is the art of dividing a cake in such a way that everyone believes he has the biggest piece. Ludwig Erhard There are only four ways for a venture capitalist to exit a deal: IPO, M&A, redemption, or bankruptcy. You can divorce your wife, but you can’t divorce us! J. Kelly Entrepreneurs have to be comfortable with never having their desk clear at the end of the day. P. Petit Look out the window, not in the mirror. Anonymous

favourite sayings  vii 

If there had only been government research establishments in the Stone Age, by now we would have had absolutely superb flint tools. But no one would have invented steel. A.C. Clarke The Golden Rule is … he who has the gold, makes the rules. Unknown Take the money. S. Fleming The money you see on the table at the time of the close is all you are ever going to see. John Parselle There is no question that, irrespective of the horse, the race or the odds, it is the jockey (the entrepreneur) who fundamentally determines whether the venture capitalist will place a bet at all. Professor Ian MacMillan, Wharton Business School The good [employees] join because of the vision, the CEO and the opportunity to work with exciting new products. Freeriders come when success is already apparent. Steve Killelea Not houses finely roofed, nor the stones of walls well built, nor canals, nor dockyards make the city, but men able to use their opportunity. Alceus, 600 BC There are three times to sell: early, late and exactly at the right time. Selling at the right time all the time is intellectually impossible, selling too late is foolish. That leaves selling early. Nick Ferguson Chairman Schroder Venture Holdings When the tide goes out, you get to see who’s been swimming naked. Warren Buffett Someone, somewhere, is making a product that will make your product obsolete. General Georges F. Doriot I find out what the world needs, then I proceed to invent. Thomas Alva Edison

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The number one problem that keeps people from winning today is the lack of self-belief. Arthur L. Williams The greater danger for most of us is not that our aim is too high and we miss it, but that it is too low and we reach it. Michelangelo Everything you want is just outside your comfort zone. Robert Allen, co-author, The One Minute Millionaire The secret to my success is that I bit off more than I could chew and chewed as fast as I could. Paul Hogan, Australian actor

Contents

Favourite sayings Tables  Figures Acronyms Authors’ notes and acknowledgments Introduction: Playing the game Part I Starting a business 1 The entrepreneur: Have you got what it takes? 2 The market: How to analyse it 3 The competitive advantage: Why will your business win? 4 The initial financial analysis 5 Taking over an existing business Part II The venture capital spectrum 6 How the game is played 7 Seed and start-up capital 8 Expansion capital 9 Funding for management buyouts

v xi xii xiv xvii xx 1 3 9 22 28 36 43 45 65 88 101

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Part III Raising the money: What the entrepreneur must do 10 How to write a business plan 11 Choosing the appropriate structure 12 Preparing a business plan: Market analysis and market strategy 13 Preparing a business plan: The financial analysis 14 Preparing a business plan: Organisational and operational issues 15 Choosing a venture capitalist 16 Negotiations with investors

113 115 121 130 151 164 172 176

Part IV Investing the money: What the investor must do 17 Screening criteria and due diligence  18 Valuation 19 Structuring the deal 20 Post-investment activities 21 Exit mechanisms

187 189 208 224 236 242

Part V Australian success stories 22 Hitwise 23 ResMed 24 LookSmart 25 Lessons and common threads

255 257 265 274 281

Glossary Bibliography Index

284 295 297

Tables

4.1 Monthly profit and loss with percentages 6.1 Funding requirements for a high-growth company ($000) 6.2 Pro forma financing history of a high-growth company 6.3 Australian and New Zealand venture capital investment levels, 2005–07 7.1 Business stages, activities and risk levels 7.2 Key ASX admission criteria 9.1 Typical balance sheet for a small MBO 12.1 Pricing a new product 13.1 Break-even variations 13.2 Working capital ratios in sales-days for listed companies 16.1 An example of option value 18.1 Step-up levels for various industries 18.2 Growth stages in a company 18.3 The stage financing model 18.4 Implied annual compound growth rates 21.1 Australian venture capital exits (year ending 30 June) 22.1 LookSmart’s share return as valued at March 2000

32 55 56 63 66 74 110 142 155 159 184 209 216 221 223 254 277

Figures

2.1 Porter’s five-factor industry model  5.1 Risks facing businesses 5.2 Increasing equity in an LBO 6.1 Factors affecting the venture capital industry 6.2 Funds raised in stages ($millions) 6.3 Dilution of founders’ equity 6.4 Increasing value of founders’ equity ($millions) 6.5 Example of a shareholding post-listing 6.6 The double whammy 7.1 The four stages of development for a new technology growth firm 11.1 Business structures 11.2 Example trading trust structure 11.3 Company structure 12.1 Competitive analysis 12.2 The learning curve 12.3 The product life-cycle 13.1 Typical division of sales dollar 13.2 Typical break-even chart 13.3 Manufacturing company break-even chart

19 37 38 46 58 58 58 59 60 67 122 123 124 137 139 149 151 152 154

figures  xiii 

13.4 Retail company break-even chart 13.5 The Operating Cash Cycle 13.6 Cumulative cash flow curve 18.1 Required ownership stakes at exit

154 156 158 221

Acronyms

AAAI Australian Association of Angel Investors ABS Australian Bureau of Statistics AIM Alternative Investment Market (London Stock Exchange) APAC Asia–Pacific region ARD American Research and Development ASIC Australian Securities and Investments Commission ASSOB Australian Small Scale Offerings Board ASX Australian Securities Exchange ATG Australian Technology Group AVCAL Australian Private Equity and Venture Capital Association Limited AVCJ Australian Venture Capital Journal B2B Business-to-Business BEC Business Enterprise Centre BLEC BLE Capital (formerly Business Loans and Equity Capital Ltd) BRW Business Review Weekly BSI Business Strategies International CGT Capital gains tax COGS Cost of goods sold

acronyms  xv 

COMET Commercialising Emerging Technologies (Australian government program) CPAP Continuous positive air pressure CSIRO Commonwealth Scientific and Industrial Research Organisation CSR CSR Limited DEC Digital Equipment Corporation DIISR Australian government Department of Innovation, Industry, Science and Research DSO Days’ sales outstanding EBIT Earnings before interest and taxation EBITDA Earnings before interest, tax, depreciation and amortisation EMDG Export Market Development Grants scheme ESOP Employee Stock Ownership Plan ESOT Employee Stock Ownership Trust ESVCLP Early Stage Venture Capital Limited Partnership EV Enterprise value FAI FAI Insurances GDP Gross domestic product GIRD Grants for industrial research and development GST Goods and services tax HNW/VHNW High net worth/very high net worth [investor] ICT Information and communications technology IIF Innovation Investment Fund IPO Initial public offering IRR Internal rate of return ISP Internet service provider LBO Leveraged buyout M&A Mergers and acquisitions MBI Management buy-in MBO Management buyout MIC Management and investment companies NASDAQ National Association of Securities Dealers Automated Quotation System NEIS New Enterprise Incentive Scheme NICTA National ICT Australia NL No liability

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NSX National Stock Exchange NTGF New technology growth firm OECD Organisation for Economic Cooperation and Development OSA Obstructive sleep apnoea PBL Publishing and Broadcasting Ltd PDF Pooled development fund P/E Price-to-earnings ratio PMA Positive mental attitude R&D Research and development RBA Reserve Bank of Australia ROCE Return on capital employed ROE Return on equity ROI Return on investment SBIC Small Business Investment Corporation SFG Self-financing growth rate SME Small or medium-sized enterprise USM Unlisted securities market USP Unique selling proposition VC Venture capital fund or venture capitalist VHNW Very High Net Worth VoIP Voice over Internet Protocol

Authors’ notes and acknowledgments

This fifth edition of the book has been written by the three of us: Chris Golis, Patrick Mooney and Tom Richardson. Chris Golis wrote the first four editions of this book, the first being published in 1989, nearly 20 years ago. Allen & Unwin were keen to publish a fifth edition as the fourth edition, published in 2002, was in its third reprint. However, Chris Golis retired from the Australian venture capital industry in June 2007 and was keen to pursue other interests. The conundrum was solved when Patrick Mooney and Tom Richardson agreed to become co-authors of the fifth edition. Both have considerable experience with high-growth companies, Patrick as a marketer and Tom as a strategy and corporate finance advisor. The plan was that the three of us would jointly produce the fifth edition and then, when the sixth edition was needed, Tom and Patrick would work together. Thus the twin goals of continuity and updating would be met. Chris Golis would like to thank all the people that he worked with in his 23 years in the venture capital industry. During that time he considers that he must have read over 5000 business plans, invested in 50 and wished it were 25. The people who provided the lessons are too numerous to mention but I must thank my original Nanyang partners, Ian Neal and Niall Cairns, and Peter Gow of St George Bank. Finally, the proviso of the first edition still stands. We have taken all care to ensure the information contained in this book is true at the time

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of publication. However, we cannot represent the information as accurate or complete because of the changes that are continually occurring in the business, government, financial, legislative and taxation environments. The changes since the fourth edition have been significant. Readers should not use or rely on this book as a substitute for detailed advice or as a basis for formulating business decisions.

Author’s note from Thomas Richardson Co-authoring this book with Chris Golis and Pat Mooney has been a lot of fun and hard work. I must thank the very understanding people at Allen & Unwin, particularly Ian Bowring. I would also like to thank the following people for their contribution to this fifth edition of Enterprise and Venture Capital: • Allan Aaron of Technology Venture Partnerships • Maria Cook of the Business Enterprise Centre for St George and Sutherland Shire • John Dyson and Aaron Fyke of Starfish Ventures • Bevan Elliott of ANZ Capital • Kathryn McMillan, founder of Nine2Three • Brookes McTavish of the Australian Small Scale Offerings Board • Tim Peters of AVCAL • Michael Quinn of Innovation Capital • Josh Rowe and David Plumridge of Hawkesbridge Private Equity • Rob Newman of Stone Ridge Ventures • Brigitte Smith of GBS Ventures • Stephen White of Quay Partners • Marc Woodward of Neo Technology Ventures

I would also like to thank my wife, Ann, for her patience and persistent optimism!

Author’s note from Pat Mooney It was a privilege to be asked by Chris to work with him on this really interesting project. Tom and I have really enjoyed this, and learned a lot from working with Chris—who really is one of the gurus of the industry. I recommend you pick up his books, The Humm Handbook and Empathy Selling, for insights into two of the most fundamental things a young venture

authors’ notes and acknowledgments  xix 

capitalist must do: sell effectively, and attract and manage good people.  This project has been a wonderful opportunity both to revisit old acquaintances and to meet new and very interesting people working at the leading edge of entrepreneurship and venture financing. I would like to thank the following for their significant contributions to the private investment, high-growth case study and government support topics, and for their personal insights into what makes a venture successful and when and how investors should get involved: • Roger Arwas, Pauline Taylor and Hugh Moore of Small Business Victoria • Gordon Bell of DEC, investor in over 100 start-ups and inventor of the Bell-Mason Diagnostic • Yvonne Best of DIISR • Roger Buckeridge and Roger Allen of Allen & Buckeridge • Steve Duvall of Intel and Prescient Capital • Peter Farrell and Charles Barnes of ResMed • Adrian Giles, Andrew Walsh and Tessa Court of HitWise • David Greatorex, previously Chairman of the State Bank of New South Wales, board member of a range of companies and charitable bodies and investor in over 20 start-ups • Jordan Green of the AAAI • Peter Kazacos of the KAZ Group and PK Business Advantage • Steve Killelea of Software Products and Integrated Research • Rick McElhinney of the Founders Forum • Alan Milwidsky of BSI • Geoff Mullins of Venture Axess and the Asia Pacific Exchange • Lisa Nolan of Strategon • Anne Scott of AusIndustry • Steve Rank of the New South Wales Department of State and Regional Development • Evan Thornley and Martin Hosking of LookSmart

I must also extend many thanks to Ian Bowring, Ann Lennox and Sue Jarvis of Allen & Unwin for their guidance and to David Peters of Emagine and Mark Sprey of ConceroTel, for their flexibility in accommodating this activity during a period of international expansion of those businesses.  In particular, I must thank my wife Laura, son Roland and daughter Georgia for their encouragement and putting up with a cranky Dad on weekends. I must confess I am now looking forward to getting to a few more games of the Berowra Soccer Club and our beloved Sydney Swans and even dusting off my old hockey stick in the odd moment of real madness.

Introduction: Playing the game

Venture capital in the sense of financing new ventures has existed throughout history. One of the more famous examples would have been the financing by Queen Isabella of Spain of Christopher Columbus’s expedition to the New World in 1492. Before receiving funding from the Queen, Columbus wandered around offices of the venture capitalists of the time, namely the courts of Europe, seeking finance for what must have appeared to be a ridiculous venture. The business plan, to sail three ships due west across the Atlantic Ocean was based on the self-evidently absurd hypothesis the world was round. The results were beyond Isabella’s wildest expectations. The mineral wealth extracted from the New World laid the foundations for the Spanish domination of Europe for the next century. The Americans converted the ad hoc support of ventures to systematic work—that is, an industry, after World War II. General Georges F Doriot (1899–1987), a French émigré who rose to the rank of Brigadier General during World War II and became an influential professor at the Harvard Business School during the 1930s, is regarded as the father of modern venture capital. In 1946, after the war, he founded the first venture capital company, American Research and Development (ARD). In 1957 General Doriot made a majority investment (70 per cent) of US$70 000 in a fledgling company started by two young engineers from MIT, Kenneth Olsen and Harlan Anderson. Over the next fourteen years, Doriot guided Olsen

introduction: playing the game  xxi 

and Anderson until ARD eventually sold its stake for more than US$350 million. Olsen’s idea was to connect two inventions, the television and the batch computer, and produce an ‘interactive’ computer. The company was Digital Equipment Corporation. While the investment holding period was very long by today’s venture capital standards, the annualised compound return on the investment was over 80 per cent, a return that would satisfy most present-day venture capitalists. This book deals with true entrepreneurs, defined as the builders of businesses, and venture capital and private equity from an Australian perspective. While Australia has had a long tradition of business-building entrepreneurs, the formal venture capital industry started officially in May 1984 with the beginning of the government-sponsored Management and Investment Company Program. Since then, there has been a boom– bust–boom cycle of venture capital activity. In this book, we examine in detail entrepreneurs and venture capital intermediaries. While the number of successful entrepreneurs and professional venture capitalists in Australia has grown significantly over the past five years, the concepts discussed in this book have far wider applications. Among the people who should find this book of use are students of business and commerce, private investors, and those people who wish to start or run their own business. This book is aimed at people working in and building growth companies, and at managers considering buyouts. While it is not aimed at people running shops or restaurants, or consultants, the principles enunciated in it would be helpful in analysing the potential success of any small business. Reading this book will not automatically make you rich. The primary requirements for a successful business remain a receptive market, a significant competitive advantage, sufficient capital, good people, tenacity and luck. Nevertheless, if reading this book does not make you rich it could well stop you becoming poor. The authors, with a combined 40-plus years in the venture capital and private equity industry, are still amazed by the time, effort and money invested in products that have little or limited chance of success. We are further distressed by how poor organisation and financial structure have ruined potentially excellent ideas. The book is divided into five parts. The first part deals with entrepreneurs and tries to teach them how to analyse markets, products and the financials of a company. It also finishes with a chapter on management

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buyouts because the easiest way of getting to run your own business is to take over an existing company. Unfortunately the word ‘entrepreneur’ in Australia still has some negative connotations. In Australia, instead of meaning a business builder as it does in other parts of the Englishspeaking world, it still has disparaging associations, and for many people is synonymous with hustling wheeler-dealers. This shift in meaning was due in part to the business media that glorified individuals who subsequently either ended up in gaol or fled the country. Fortunately for Australia, this perception has significantly improved. Both major political parties have recognised that, to build a prosperous, growing and full-employment economy, it is necessary to have individuals who can commercialise ideas, not just create them. The second part of the book looks at the spectrum of venture capital and private equity available. Private equity is the broad term describing capital invested in unlisted securities. Private equity includes equity funding for leveraged buyouts and growth capital for  mature companies  as well as venture capital funding for seed, start-up and expansion stage companies. Simply put, private equity may be regarded as an equity investment in unlisted securities where investors expect significant capital gains in return for accepting the risk they may lose all their equity. Venture capital is a sub-set of private equity. The first chapter of Part II looks at how the venture capital game is played, Chapter 7 examines seed and start-up capital, Chapter 8 covers expansion capital and Chapter 9 examines leveraged and management buyout financing. Part III is about the nexus of the entrepreneur and the investor. It teaches the entrepreneur what form of investment vehicle to choose, how to prepare a business plan attractive to investors, what entrepreneurs should look for in a business, and how to negotiate with prospective investors. Part IV reverses the roles and examines the deal from the viewpoint of the investor. It is vital for entrepreneurs to understand the investor’s perspective, and this section demonstrates how investors see the world and their usual activities. For investors, the section teaches what makes a successful investment, how to investigate a proposal, how to do valuations and structure shareholdings, what investor involvement should occur after investing, and finally how to exit from an investment. Part V looks at how some successful venture capital-backed businesses and entrepreneurs have used the funds and leveraged their relationships

introduction: playing the game  xxiii 

with investors. It is not uncommon for young companies to suffer from ‘cheque shock’ after a capital raising, or to spend the money inappropriately in a boom–bust cycle of activity. Many are not effective in working with their investors, who should be viewed as partners in the business with different skill sets, industry knowledge and contacts that the venture really must utilise. Once the necessary capital has been secured, the real issues have only just begun. How does the entrepreneur ensure that the stakeholders in the business have a successful outcome, given their different commitments, drivers and time horizons? This comes down to using funding wisely, leveraging other people’s resources and learning from those who have trodden similar paths before. Fortunately there are many examples of success stories from which lessons can be drawn. Australian entrepreneurship has until recently had limited visibility. While the beverages, construction, mining and retailing sectors have regularly thrown up entrepreneurs and new ventures, it is only over the last 20 years that success stories in the technology sectors have received visibility. Key examples in the medical products sector are Cochlear, CSL, ResMed and Sonic Healthcare, while in the ICT sector they include Hitwise, Look­Smart, Computershare, Seek.com, MYOB, Wotif.com, Integrated Research, Kaz Software and many others. Yet, despite these success stories, Australia’s visibility as a source of entrepreneurs and innovative businesses remains poor. A recent global survey by Deloitte and the US National Venture Capital Association did not list Australia in any category as a significant source of technology. By contrast, Israel, Finland, South Korea and India (together, of course, with the United States and Western European countries) all received significant mentions. In the final section, we have selected just three of the many Australian success stories that deserve more recognition. They are Hitwise (internet marketing), ResMed (medical devices for sleep disorders) and LookSmart (online search, advertising and content management). All three leveraged multiple sources of finance, offer good lessons on successfully growing an international business, and took different paths to generating a return for their shareholders. We live in the most rapidly changing period of human history ever. Change in an organisation usually means opportunity for the salesperson. As entrepreneurs make products that people buy, change favours the entrepreneur even more than the salesperson.

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Numerous studies have shown how wealth is concentrated in just a few hands. As Vilfredo Pareto discovered in 1897, typically 20 per cent of the population of a country controls 80 per cent of the wealth. What is not often realised is the turnover within the wealthy 20 per cent. Simply looking at Business Review Weekly’s annual Rich 200 list over a ten-year period shows the extent of this turnover. By definition, the entrepreneurs of tomorrow are the young unknown people of today. Those entrepreneurs who learn today how to play the game are the ones who will dislodge the current occupants of the top 20 per cent and have fun in the process.

Part I

Starting a business

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1

The entrepreneur: Have you got what it takes?

When trying to establish whether you are an entrepreneur, you need to distinguish between entrepreneurs and entrepreneurial tendencies. A useful metaphor is to compare an artist with a person who has artistic tendencies. There are many people with artistic tendencies. These individuals visit museums and galleries, attend auctions and collect, or perhaps go to arts and craft classes. On the other hand, there are few people who have the necessary combination of creativity, talent and persistence to call themselves artists. In a similar fashion, one can distinguish between natural entrepreneurs and people with entrepreneurial tendencies. However, it is easier to become an entrepreneur than an artist. Many more people can satisfy the requirements of the entrepreneur than those of the artist. It is easier to be a successful businessperson than a successful opera singer. Let us begin by considering some of the characteristics of entrepreneurs. One feature is a high energy level. Entrepreneurs as a whole get up early in the morning. They hate to stay in bed. They tend to be enthusiastic people who realise the only thing more contagious than enthusiasm is a lack of it. As Stephen King, the immensely successful author, once said: ‘What separates the talented individual from the successful one is a lot of hard work.’ Successful entrepreneurs do not shirk from hard tasks. They get excited about applying their ingenuity

4  starting a business

and energy to building a business that will change the lives of their customers. The next quality is an interest in money. Typically, a natural entrepreneur will have had jobs in childhood and understand naturally the value of money and how to use it as a resource. Bill Gates, for example, started his first business at the age of sixteen and was filling in company tax forms by the age of eighteen. The third characteristic is a creative attitude towards obstacles. When faced with obstacles, typical entrepreneurs find a new way of overcoming them. Most people are conservative. They do not like change to occur and prefer life to become a habit. Consequently, most people respond to proposals for change with resistance and doubt. The role of entrepreneurs is to create new businesses. They conflict with this widespread conservatism. Most people are constantly putting obstacles in the paths of entrepreneurs trying to achieve their goals. The ability to overcome these obstacles with creative solutions, and do it again and again and still maintain enthusiasm, is a sign of an entrepreneur. As Peter Farrell, cofounder and chairman of Resmed, has put it: ‘You have to be able to say, “I’m really glad I got into this game” every morning, despite setback after setback.’ David Greatorex, philanthropist and serial investor in start-ups, gives the example of the ‘A’ model Ford. ‘This was developed by Edsel Ford, Henry Senior’s son. His father got so frustrated with his son being sidetracked that he took to Edsel’s new prototype with a hammer and smashed it to pieces. Edsel persisted and his design ultimately became the Model A (the second great success for the company after Henry senior’s Model T). Five million were produced between 1927 and 1932. A concept which may be familiar to some readers is positive mental attitude (PMA). PMA has long been put forward as a cure for poor sales performance, if not all the world’s ills. Optimistic tenacity can be a most useful weapon. Top salespeople don’t mind getting the first refusal from a prospect. Their philosophy is that, because it usually takes five attempts to make a sale, the first refusal means there are only four more attempts to go until a sale is closed. What distinguishes the entrepreneur from the average salesperson is that, while the salesperson returns repeatedly with the same closing technique and fails, the entrepreneur comes up with a new proposal to overcome the obstacle and often succeeds. Philippe Kahn, founder of Borland International, one of the first successful personal computer software companies, described how in 1983,

the entrepreneur  5 

after Borland had developed its first software product, there were no funds available for advertising. He wanted to put a full page in the computer magazine Byte but the cost was $20 000. He arranged prior to the Byte advertising salesperson’s arrival for two extra temporary staff to be hired and for his friends to ring the office constantly during the meeting. He also had on his desk a media plan for all the computer magazines, with Byte crossed out. The salesperson ‘inadvertently’ noticed the omission and asked why. He was told the media plan was done and that Byte was not the right audience. After a few moments’ persuasion, Kahn reluctantly agreed to place a one-page advertisement on deferred payment terms. The advertisement generated the first $150 000 of sales. Borland grew from this first step into a $250 million revenue company within thirteen years. Entrepreneurs are famous for their risk-taking ability. However, it is our experience that successful entrepreneurs are not risk-takers when compared with gamblers or speculators. Entrepreneurs usually operate on stretched resources, yet carry out a realistic evaluation of the risks. They try to establish a position where the risk is limited and the reward is substantial. In other words, they tend to look at risk–reward ratios while gamblers think only of the rewards. The best entrepreneurs extend this understanding of risk and reward to finance. They realise that start-up companies are very high risk and consequently will need to offer the opportunity for very high returns to attract investors. The four qualities of enthusiasm, interest in money, creative tendency and calculated risk-taking are necessary ingredients in the personality of an entrepreneur. You can establish whether you have sufficient amounts of these qualities by taking on positions where these traits are required. At the same time, you will gain further skills and experience. The most common reason for rejection of a business plan is inadequate management. This alone covers a multitude of reasons for rejection. However, the proven ability to sell is most important. At least three to four years’ employment in sales and sales management, particularly in the area of corporate goods or corporate services, should be regarded as critical training for the future. Corporate selling is useful because the selling cycle typically takes several months and usually requires a multi-level sale. The buying organisation contains a number of decision-­makers and recommenders, and a salesperson’s success depends on style in communicating with these various individuals working at different levels in the organisation.

6  starting a business

Running a business requires the same communication skills, plus the ability to analyse and negotiate with people. Not only are these skills necessary when dealing with customers, but similar skills are required when recruiting and motivating employees. Finally, the entrepreneur must be able to convince financiers—be they the banks, finance companies or venture capitalists—that they are as important as the customers and employees. Many of the biographies of successful entrepreneurs demonstrate either a natural selling ability or several years spent learning the skills of selling. A good entrepreneur is typically a good communicator, and is interested in the English language. Most are excellent communicators in the written form and write business letters in strong, simple English. One reason why venture capitalists prefer the business plan to be produced by the entrepreneur rather than the financial advisor is that the plan then provides a good indication of the communication skills of the entrepreneur. The next important skill in an entrepreneur is an understanding of numbers. A businessperson needs to understand the principles of accounting. Johann Carl Friedrich Gauss, one of the greatest mathematicians who ever lived, called double-entry bookkeeping the greatest mathematical achievement of mankind. We are constantly amazed to meet the number of potential entrepreneurs who do not understand the basic principles of balance sheets, profit and loss accounts, cash flows, and so on. Many do not even know how to calculate the break-even point of their business. Far too many entrepreneurs leave the figures to their accountants. Successful entrepreneurs understand how to read and analyse financial statements. Articles about entrepreneurs often describe how they started in business by working at selling jobs during the day and studying accounting at night. Night courses on accounting and  finance  are available at many institutions. These courses will vastly enhance an entrepreneur’s numeracy. Once you understand how to read company reports, the next stage is to learn how to analyse them. In later chapters, we will discuss some of the most useful techniques of financial analysis, but just reading these chapters is inadequate. The way to learn company financial analysis is to actually do it—and have money riding on the result. One way to achieve this understanding is to invest small amounts of money in two or three public companies and develop the habit of both recording and analysing their progress. The best companies are those that are in the same or similar industries. Over time you will develop a feel for

the entrepreneur  7 

the ratios and structures that represent a successful company. The Financial Services Institute of Australia (www.finsia.com) offers an excellent course on industrial equities analysis. Another skill the entrepreneur needs is an understanding of financial and company structuring, a topic dealt with more fully in later chapters. Entrepreneurs should be familiar with the difference between equity and debt, the business of investing and lending and the required rates of return on debt and equity securities. One of the biggest mistakes entrepreneurs make is trying to raise equity but only offering returns that secured lenders would consider. Equities are high-risk investments and require high returns to compensate for that risk. Entrepreneurs that do not realise this, ultimately look foolish when talking to potential investors. Many entrepreneurs make the mistake of thinking listed share market returns are appropriate for investments in private, early-stage companies. Investors in early-stage companies need returns that give them back five to ten times their investment, typically within a three- to six-year period. Entrepreneurs need to understand the time value of money. Entrepreneurs should also have an understanding of  the roles and responsibilities of directors and the law governing companies and shareholders. The other part of the legal process the entrepreneur must understand is the law of contract. This is most easily gained when working as a salesperson, but again there are simple books and courses run by such bodies as the Australian Institute of Company Directors. Another way of gaining entrepreneurial expertise is to attend one of the courses on entrepreneurship and strategy offered by many Australian universities. The Enterprise Workshop is also an excellent source of knowledge. The Enterprise Workshop is a four-month, part-time program normally run outside of business hours. It operates independently in each state and is funded by a combination of government grants, corporate sponsorship and participants’ fees. Participants first learn how to prepare a business plan. They then form into groups and prepare a business plan for an actual invention. The plans are then judged in a state competition and the state winners entered into a national competition. A number of successful companies have been conceived at Enterprise Workshops. In addition to all of the above, the most successful entrepreneurs share a powerful passion to improve people’s lives, have deep domain knowledge in their field and possess a very strong customer focus. Entrepreneurs need to think before they act, to listen and learn rapidly, and to demonstrate

8  starting a business

high ethics and fairness. Successful entrepreneurs also have good ­people skills, know how to build and motivate a team, and are not afraid to hire people smarter than themselves. Ultimately, top entrepreneurs truly understand the subject of this book: the venture capital game. Ideally, the best preparation an entrepreneur can have is to work as a general manager in charge of a profit centre for a large company. Several years spent learning the disciplines of managing people and of profit centre management are invaluable. However, there is still nothing to compare with starting up and running your own business. It is the one item on the résumé that gets venture capitalists excited. The question they ask is how many times the CEO has been around the block. By this they mean how many times the entrepreneur has started and sold out of a business. There is a key difference between management and ownership, and true entrepreneurs understand that difference.

2

The market: How to analyse it

In 1962, Thomas S. Kuhn’s The Structure of Scientific Revolutions was published. This book effectively demolished the commonly held view of science being an objective progression towards the truth. Instead, Kuhn established a different philosophy. He said each science had several theories that were widely accepted by nearly all the scientists involved. They conducted continuous experiments ‘confirming’ these generally held theories. This type of work he called ‘normal’ science. Gradually more and more experiments would generate complications to the theory that would destroy a theory’s initial simple elegance. Then an individual would inevitably put forward a radical new theory, which would explain all the earlier idiosyncrasies but would meet violent opposition from the established scientific community. Kuhn called this the paradigm shift. Afterwards, when the new paradigm had been accepted, the scientists rewrote the history of science to reinforce the idea of steady progression. Business, too, has its paradigm shifts. Two of the more famous would be double-entry bookkeeping in the sixteenth century and joint stock companies in the seventeenth. In the twentieth century, there were several paradigm shifts, including the introduction of the marketing concept. The previous paradigm was based on production. Provided the product worked and the price was reasonable, businesspeople assumed the product would automatically sell. Henry Ford best summed up the production

10  starting a business

philosophy in a statement about the Model T Ford: ‘The customer can have any colour as long as it’s black.’

The marketing concept The marketing concept takes the opposite view. Successful businesspeople continually examine and investigate their markets and develop products to satisfy their customers’ needs. A former president of Revlon epitomised the marketing philosophy when he said: ‘In the factory, Revlon makes lipstick, but in the marketplace it sells hope.’ In the next two chapters, we will explain some simple techniques for analysing markets and products. They are not meant to be comprehensive but they should provide the aspiring entrepreneur with the means of testing whether the product has a role in the marketplace. The economic institutions of the world have expended much time and effort analysing markets. A classic rule of business success is to copy those practices and policies that contribute to your competitor’s success. Let us now examine the methods by which economists analyse a market. Demand and supply analysis is basic to the procedure. Indeed, an old dictum of economists tells them to remember they have two eyes—one for demand and the other for supply. Let us first look at demand analysis, by which economists try to establish: • the demand level and type for the product; • the market size; • the market growth rate; and • buyer trends.

Demand analysis Step 1: Establish the demand type Typically, the economist divides demand into three types: consumer, distributor and producer. The most familiar is consumer demand. The demographics for consumers are well known and documented. Not only are the population and dwelling statistics available, but so are the results of expenditure surveys and so on. It is thus easy to establish the consumer demand for many products. To take a simple example, a new shopping mall has shop premises

the market  11 

available, and you and a friend wish to set up a women’s fashion boutique. The area is middle class. On a map you draw up the catchment area for your shop. First you draw a series of midpoints between the mall and the surrounding competitive malls, and then a rough circle joining up the midpoints. The next step is to establish the number of households in the area. Phoning the local council that makes up the largest segment of your catchment area and finding out how many domestic rate notices it sends out achieves this step. You then multiply that number by the ratio of the local council area to the catchment area to establish the number of households in your catchment. Your calculations indicate there are 19 000 households in the catchment area. You go to your favourite search engine, enter ‘Australian Household expenditure on women’s clothing’, go to the appropriate Australian Bureau of Statistics web page and discover the average weekly expenditure per household on women’s clothing was $9. A few seconds on a calculator tells you the total annual expenditure in your catchment area is $8.89 million. You continue your research and you find that between year X and year Y, spending on clothing and footwear fell by 5 per cent. Notably, the CPI recorded no price change for clothing over this period. You have counted  36 shops in your catchment area. Add your shop and assume everything else is equal, and you have potential annual sales of $247 000. Of course, all things are not equal; establishing the degree of inequality is the subject of the next chapter. The next type of demand is distributor demand. A good example of this is Nu-Korc, which manufactures extruded plastic wine corks. Between 2 and 8 per cent of all wine with traditional corks ends up with cork taint. This can occur even if the wine has been properly stored. About 80 per cent of the wine sold in the United Kingdom goes through the supermarket chains (they are retailers, but  effectively they are food product distributors) and these organisations above all else do not want to deal with product returns from customers for any reason, including cork taint. Therefore, they are demanding plastic wine closures for drink-now wine costing under £5 (A$10) per bottle. The trend is continuing in the rest of Europe, although there is competition from screw tops, despite their association with cheap wines. The final type of demand is producer or industrial demand. This refers to the demand of companies or governments for products or services that help the organisation produce the products they provide to the

12  starting a business

marketplace. Raw materials, business computers and merchant banking are examples of products whose sales are determined by producer demand.

Step 2: Establish the correct size of the market The next question concerns the size of the market for the business entity. A common reason for business failure is over-estimation of the size of the market and inclusion in the market estimate of prospects who would never buy anything from the business entity. To establish the size of the market, you need a clear picture in your mind of the person who is going to buy your product. Let us assume you have the opportunity to obtain Australian distribution rights for a new form of imported bath gel that retails for $15, with each bottle lasting about twelve months. Despite large expenditures on advertising and marketing, it is difficult to envisage a household having more than one bottle of gel at a time. Thus you could define the potential market as all the households in Australia (say eight million). One estimate for potential annual sales would be $120 million (eight million households purchasing one bottle per year at $15 per bottle). The next question to ask yourself is which households would buy your product. Since bath gel is a luxury or fad item bought by upper-income households, the potential market is now reduced to, say, 10–20 per cent of the total households in Australia, or $12–24 million. But you will not be selling direct to the households. You will sell to retail pharmacies, of which you estimate that there are 4500. They will want to earn a 50 per cent gross margin percentage on this product and will only provide an initial order of a dozen bottles. If the product is successful, they tell you they would expect to place the same order once a month. The market now shrinks to about $5 million. Again, you will only be able to sell to the pharmacies who serve upper-income localities so you have to apply the same 10–20 per cent rule and the market potential now shrinks to between $500 000 and $1 million. Just having a potential market is not enough; the company must penetrate the market and obtain market share. According to the US Census, about 600 000 new businesses are formed in the United States every year. Less than 200 of them reach $100 million sales in six years. About 500 of them reach $50 million in revenue. Only about 9500 of them reach $5 million turnover. It took even an exceptional company like Cisco Systems

the market  13 

ten years to reach $1 billion in revenue. The lesson here is that it takes time to grow revenue and build market share. How fast you can grow will depend on your choice of market segment and your product, its differentiation, customer benefits, price and perceived value. Again, there are some common rules worth remembering. First, it is rare for any business to gain more than one-third market share and it is rare for a product to build up market share at more than 2–3 per cent a year. Thus, for our hypothetical bath gel, we are probably looking at maximum annual sales of, say, $150 000–300 000 and initial sales of probably $15 000–30 000. Although this analysis may appear curt, it is far more thorough than many experts’ reports on products for companies that have listed on Australian share markets. The market for a new engine has been defined as all the new cars built in the world when it is really the car manufacturers. The market for a new rapid paint hardener has been described as the paint sold to industrial users throughout the world, and so on. When defining the size of the market, the entrepreneur should try to establish the following equations: Size of the market in dollars = Average purchase dollar size × Number of purchasers Size of the market in dollars = Average purchase price/unit × Number of units The reason for calculating these two equations is that inconsistencies between the number of buyers, number of units sold and average cost per purchase will quickly establish themselves in your perception of the market.

Step 3: Establish the growth rate of the market After verifying the type and size of the market demand, the next step is to establish the market growth rates. The first step is to use a search engine such as Google which will generally lead you to the Australian Bureau of Statistics (ABS) website, which houses a staggering amount of information. Similarly, if your markets are international, you should be able to find information on the web, such as via the US Census Bureau and Eurostat. Often the information you need is immediately available. Even if it is not, you can often obtain surrogate information that indicates demand growth

14  starting a business

or decline. Two useful surrogate indicators are employment in the industry and the amount of imports. If employment in the industry is growing, it is an indicator that the market for that product is growing. Growth in imports may be distorted significantly by changes in the exchange rate, but changes in import statistics do provide a useful indicator of changes in demand growth. If the ABS or relevant counterpart in your target market is unable to help, other government departments may provide useful data. In Australia, both federal and state governments usually have a Department of Industry, which may well have a section head who monitors data or produces reports on the industry in which you are interested. Similar bodies can be found in most other countries. Another potential source of information in Australia is the Productivity Commission website, which operates at the micro-economic level and produces a variety of reports (www.pc.gov. au). The reports typically begin with a detailed economic analysis of the industry, which can provide useful marketing information. There are other sources of information besides the government. Most industries in every country have some form of trade association, which can be a useful source of information even if its covert role may be to keep newcomers out. These associations often produce surveys of expectations and provide a monitoring role. They may supply a history of price movements or wage increases. If either of these indicators is moving significantly upward, so may demand. The other source of industry information is the local industry newspaper. Nearly every industry has at least one trade newspaper. (If it does not, starting one may be an excellent entrepreneurial opportunity.) Half an hour with the editor or its best reporter can provide you with a substantial amount of information. Additionally, recently retired senior executives may also provide useful information. They have often gained extensive knowledge about an industry, and it has been our experience that they welcome the opportunity to discuss it. Their analyses are usually intelligent and penetrating. Finally, there is the internet. This is a prolific source of market information about any product, market, industry or competition. Entering ‘venture capital’ into the  Google  search engine in May 2008 generated 21.4 million hits (versus 1.5 million hits when we did this in June 2001). So search the web. Local and state libraries also have a wealth of publications and searchable databases that are otherwise only available on a paid subscription basis. Globally, a number of research companies offer

the market  15 

excellent industry reports although they may cost $1000 or more. It is, however, more sensible to spend time and money to investigate your customer target market thoroughly than to spend thousands of dollars building a product that no one wants. You will find that some market segments will be growing faster than others. In some cases, the entrepreneur may be opening up an entirely new customer market without a reported growth rate or any published analysis. In this case, you need to do very careful research from the macro level right down to the grass roots.

Step 4: Establish whether the buyer trends are favourable The final stage of this initial analysis is to establish whether the consumer dynamics are favourable. To list all the buyer trends is impossible, but a key to the success of entrepreneurs is their ability to focus on what new things people and organisations will buy. Find real market needs and customer pain, get close to the potential customers, and devise a solution that meets their needs and budget. The greater the level of pain the customer is feeling, the greater the opportunity to develop a ‘painkiller’ solution that the customer will hand over their hard earned cash to purchase. There are, of course, times when customers do not know what they need—as sometimes happens with paradigm-shifting inventions. In these situations, you still must do your market research on the target customers. Do not build it and assume the customers will come. If you are building an improvement to an existing product or service, you need to understand what it will take to get customers to switch from the solutions they already use. One venture capitalist we interviewed suggested that a tenfold improvement in functionality and benefit was often required to entice customers to switch from an existing solution or product to a new one. The demographics of a country provide the basis for the demand. Among those that will characterise Australia and most of the OECD nations for the next ten years are: • ageing of the population and the shift of the Baby Boomers to retirement; • concerns about the price and availability of health care, water, energy and food; • increased use of personalised information technology, particularly mobile technology; • growing use of social networking;

16  starting a business • the shift to the sunbelt (in Australia this means to Queensland, in Europe to Spain and Portugal); • concern for the environment and sustainability of industrial activity in the form we currently know it; • concerns about personal security, due to increased visibility of terrorism and availability of destructive technologies to ‘rogue’ regimes.

Any analysis of people’s preferences and expectations is bound to be subjective. Nevertheless, writing down the type, size and growth rates of your market, followed by the dynamics of demand, and then referring to it later is a key task in any business analysis. Whether you are targeting an existing customer segment or opening up new market, you need to be an expert on your customers, so do your homework and spend significant time in the daily life and routine of your target customers.

Supply analysis With supply analysis, the focus changes from the customer to the industry. The first step in supply analysis is to establish the stage of the industry. The next step is defining the industry structure. The third step is to then use what is probably the most significant business strategy tool to be developed in the last 25 years: Michael Porter’s five-factor industry analysis model.

Step 1: Establish the stage of the industry Each industry goes through a number of phases, and the opportunities for entrepreneurs vary with each stage. The first stage is the establishment stage, when there is one product with limited variety and the companies making it are small. The industry is generally started by a technical innovation, although occasionally a change in government policy provides an opportunity. The privatisation of infrastructure assets around the world has led to the development of infrastructure funds. Another opportunity comes from social changes. Financial planning is an example of industrial opportunity created by social change. The next stage is the growth stage, when companies develop variety in their products and their marketing methods improve. More companies enter the industry, and all show good growth independent of their efficiency. The growth stage provides an excellent opportunity for the entrepreneur.

the market  17 

When demand for a product stabilises and the market gradually transforms itself from initial purchase to replacement purchase, the industry reaches the mature stage. Competition intensifies and rationalisation occurs as larger companies discover that takeovers of their smaller competitors are the easiest way to increase market share. Until recently, the opportunities for entrepreneurs in mature industries were limited. However, new financing techniques—particularly leveraged buyouts—have provided a new opportunity for entrepreneurs. Brewing, food, consumer durables and funerals are all examples of mature industries that have rationalised over the past 20 years. The final stage in the industry life-cycle model is the decline stage, when an industry’s products are superseded by new products or processes, or demand falls because of a change in lifestyle. Sometimes a technological innovation, a change in the price of a substitute product or an innovation in the prevailing business models can rejuvenate an industry and provide opportunity to entrepreneurs. A good example of rejuvenation was the coal industry, which was revived by the large increase in the oil price in the 1970s and is likely to continue to grow due to high demand from developing countries such as China. Significant effort is being put into the development of clean coal technologies which will shape the future of coal as an energy source. Blue Ocean Strategy by Kim and Mauborgne (2005) (see www.blueoceanstrategy.com) identified a number of other apparently declining industries that were completely rejuvenated by ‘value innovation’, radically redefining the industry’s current business model to bring in new customers and create greater value at reduced cost.  One example is the aviation industry, which was redefined by new pointto-point business models introduced by Southwest Airlines and Ryanair. These have made short-haul domestic and international flights comparable in price to rail or road, and much quicker and more convenient than conventional airlines when airport transit time is included. Australia’s Casella winery with its [yellow tail] wines is another example. By redefining how wine is presented to the market, a whole segment of the market who were not previously significant wine drinkers was successfully exploited and [yellow tail] became the number one imported wine into the United States. Entrepreneurial opportunities exist at each stage of the industry cycle, but the growth stage combines the greatest opportunity with the least risk. China is likely to be the world’s fastest growing market for resources, clean energy and water and information technology. Organic food production

18  starting a business

is one of the fastest growing segments of the food sector. Whatever your chosen sector, it may be worthwhile to explore its fastest growing niches to look for potential opportunities for your business.

Step 2: Establish the structure of the industry Economists define an industry structure according to the number of supplying firms. The number can range from single suppliers such as Australia Post in the postal industry, to few suppliers such as in the television industry, to many suppliers such as in the advertising industry. Structure is important, as it determines the ability of an individual company to set prices. If the number of companies in the market is large, then the company essentially becomes a price taker, concentrating on production costs and trying to establish product differentiation. With some products, differentiation is possible, but generally it is limited. There are few single-supplier industries or monopolies. Monopolies typically occur because of government licensing, either by setting up a public corporation such as Australia Post or by the granting of a patent. Xerox and Polaroid are examples of companies that have occupied monopoly positions. Monopoly companies are price makers, and typically set the price as high as the market will bear while still able to buy all the goods produced. Polaroid is also an example of how technological change can cause difficulties, even in monopolies. Between these two extremes are found most industries in the Australian private sector. One common structure is an industry with few suppliers or dominated by several large companies. Economists define this structure as oligopolistic. Competition can be based either on price or on other factors. The brewing industry provides a good oligopolistic example. In the early 1980s, the New South Wales market was subject to heavy discounting until Castlemaine took over Tooheys and Carlton United Breweries took over Tooths. The price war stopped and the competition became non-price as both companies engaged in heavy advertising and established new brands. This shift to non-price competition allowed the entry of new and boutique breweries. However, in the 1990s the price wars resumed as both Fosters and Lion Nathan attacked each other in their respective home markets. The new and boutique breweries were either taken over or disappeared. Now we are seeing the formation of niche brewing companies such as Blue Tongue. The other common structure is called monopolistic competition. In this type there are many producers, but each differs in small ways from its

the market  19 

competitors. The typical differentiation is location, although factors not related to price, such as advertising and branding, may affect competition. A good example of monopolistic competition is the  fast food  industry, with McDonald’s, Hungry Jack’s and Burger King. For entrepreneurs, structure is important for two reasons. If the competition is non-price, they have the opportunity to create product differentiation—although this may be expensive. On the other hand, if the competition is solely on price and they discover a new form of lowcost production, they will be able to penetrate a market rapidly.

Step 3: Build the Porter model for the industry Michael Porter’s five-factor model is demonstrated in Figure 2.1. One of the most useful exercises an entrepreneur can undertake is to construct a Porter model for their own business. Potential entrants Threat of new entrants

Suppliers

Bargaining power of suppliers

Industry competitors

Bargaining power of buyers

Buyers

Rivalry among existing firms

Threat of substitute products or services

Substitutes FIG0201.EPS Figure 2.1 Porter’s five-factor industry model

The first key concept in the Porter model is to establish the relative bargaining power of suppliers and customers. Among the factors that affect bargaining power, the entrepreneur should assess: • the relative fragmentation of buyers and sellers; • how significant the purchase is as a proportion of the total expenditure; • product standardisation or differentiation; • the costs of switching to another supplier; • how important the quality of product is to the buyer; • how much information the buyer has about the supplier.

20  starting a business

A good demonstration of the Porter model in action is to use it to answer the question of why institutional equity fund managers are paid ten to 20 times the salaries of public sector teachers. • First, there are many teachers to one buyer: the Department of Education. By contrast, there are more than 200 institutional buyers of fund managers in Australia but the pool of managers is limited. • There is no measure of how good a teacher is, except by hearsay. By contrast, there are about ten asset consulting firms measuring the performance of fund managers. The buyers know who the best performers are and exactly what they have achieved in the past. • Standardisation of the curriculum means switching costs between teachers is low and the buyer is indifferent to the quality. On the other hand, good fund managers can and generally do take their clients with them so, to the employing institution, the switching costs of changing a fund manager, in terms of lost revenue, can be very high.

All these factors explain why fund managers are highly paid while teachers are poorly paid. What is interesting is that the teachers’ union is ensuring that status quo remains, thereby protecting teachers who are less talented but preventing the best teachers from earning higher salaries. The next key concept in the Porter model is the threat of new entrants or substitute products. Even in a monopoly situation, there is the potential for substitute products. For example, electricity has gas as a competitor for heating; synthetic fibres may replace wool and cotton; and wine may replace beer. Strategic analysis requires consideration of such potentials. However, the threat of new entrants is probably the most important one. It has been suggested that, in an oligopolistic structure, what the few companies fear most is the entry of new companies from other industries or overseas. The entry of new companies will reduce market share and disturb pricing structures. Hence companies in oligopolistic industries try to set up barriers to entry. In the next chapter, we define how entrepreneurs must establish sustainable competitive advantage that is equivalent to creating barriers to entry. For this chapter, we will simply say that typical barriers to entry are capital costs of entry, control over distribution outlets or factors of production, brand image and advertising, economies of large-scale production and unavailability of finance. The final key factor in the Porter model is the degree of competitive rivalry. In Chapter 12 we will spend some time on competitive analysis.

the market  21 

Nevertheless, the following checklist provides a useful guide to establishing the degree of competitive rivalry in an industry: 1 numerous or equally balanced competitors; 2 slow industry growth; 3 high fixed or storage costs; 4 lack of differentiation or switching costs; 5 capacity augmented in large increments; 6 diverse competitors (some without the profit motive); 7 high strategic stakes; 8 high exit barriers (low liquidation values of fixed assets, long-term labour contracts, emotional barriers, government restrictions).

High competitive rivalry generally leads to lower industry profits. Of course, all participants will tell you how tough and competitive their industry is. However, some industries are inherently more profitable than others. For years, the free-to-air television industry in Australia has been very profitable because of government-imposed barriers to entry and few competitors. (Today the industry now faces greater competition for advertising revenue from other media  such as the internet, largely due to technological change.) On the other hand, retailers of personal computers have provided very poor returns to their investors, because of low capital entry costs, many competitors (some who were irrational about pricing), and low customer loyalty because of no perceived service value. Competition and technological change are, however, inevitable in most industries.

3

The competitive advantage: Why will your business win?

In the previous chapter, we examined methods of deciding on the size of a market and identifying the industry dynamics. The reasons for this are threefold. First, insufficient size of market is a common reason for business failure. Aspiring entrepreneurs can save much time and money if, by dint of analysis, they establish that the market is too small to support the business proposal. Second, by analysing a market in the manner proposed, aspiring entrepreneurs should be able to create another necessary criterion for success: a sustainable competitive advantage. Third, understanding the structure of the industry will help the entrepreneur plot a sensible business strategy, and anticipate opportunities and threats.

Unique selling propositions The sustainable competitive advantage is based on what the advertising industry defines as unique selling propositions, or USPs. USPs are those unique features of a product providing the benefits that satisfy the customer’s buying motive. An example will best explain the concept. Imagine you are a creative writer for an advertising agency and an agricultural marketing board has come in with a new fruit, which it is calling an ‘orange’. The board gives you a dozen of them, along with a dossier on the product, and asks you to devise an advertising campaign. After you have read the

the competitive advantage  23 

dossier and tasted the product, you take the first step in any marketing campaign and list the product features: • citrus fruit; • natural—grows on trees; • contains large amounts of vitamin C; • distinctive taste; • orange colour; • distinctive smell; • can be made into marmalade; • makes a juice; • juice can be fermented and distilled into a liqueur; • product has an impermeable skin; • skin is easily peeled; • product can be segmented; • product contains a self-reproducing mechanism (seed); • product can be sliced; • skin not easily edible; • skin can be shredded and put into Christmas and other cakes; • spherical shape; • easy to pack into display pyramids; • high fruit-to-skin ratio; • between skin and fruit is a material called pith, and so on …

The next step is to establish what might motivate people to buy the product. This list is usually far shorter. Venture capitalists are always asking themselves (about a new product or service): ‘Will the dogs eat the dog food?’ The potential reasons for buying the ‘orange’ appear to be: • desire for healthy food and drink; • pleasure; • desire to cook cakes, etc.

The next step is to write down the main features of the product that you think the customers might be looking for. Features and benefits • natural—healthy; • citrus fruit—healthy; • contains vitamin C—healthy; • orange colour—pleasant to the eye; • different taste—pleasure to taste;

24  starting a business • goes into cakes—desire to cook, etc.; • makes juice—desire to cook, etc.; • makes marmalade—desire to cook, etc.

The next step is to establish whether there are any unique selling propositions. As you go down the list, you strike out the following items: • natural—pears, apples, etc. are natural; • citrus fruit—lemons and grapefruits are citrus fruits; • contains vitamin C—lemons, grapefruit and limes are sources of vitamin C; • orange colour—tangerines are an orange colour; • goes into cakes—so does a lot of fruit; • makes marmalade—ginger, grapefruit and lemons make marmalade; • makes juice—nearly all fruit can be juiced.

Thus, at the end of your analysis, you establish that the only USP is the taste of the orange. You decide to make taste the focus of your marketing campaign. This discussion, although hypothetical, has some clear lessons: • All products or services have associated with them a whole host of features. • Customers have, by contrast, little motivation to buy. • There are in reality very few USPs that can be associated with a product.

It is the task of the entrepreneur to first recognise a product’s USPs, and then ensure the marketing campaign is based on them. Far too many products or services are established with no USPs. Even when USPs are available, they are either forgotten or buried under a host of other features. Product-related USPs that cannot be imitated are the best. The classic situation is a business based on a technical monopoly, such as that achieved by Cochlear and ResMed. Location is another good USP. Retailers have long been aware of how location is often the key competitive edge that one shop has over another. Another common USP is price. If, because of some manufacturing advantage, you have the lowest priced product then you have a definite USP. It is important to try to ensure that USPs are tangible. A friend of ours once invested in a small snap-printing business located in a side street in

the competitive advantage  25 

the centre of a major city. After several months, sales were flat and going nowhere, and he asked for help. We visited the shop and during the meeting with the management asked what made their business unique. They replied ‘service’. We then asked them to quantify service, which they were unable to do. We then carried out the exercise of listing features, motivations and benefits. We concluded the important USP of the business was two off-street parking spaces, which meant customers and couriers could easily deliver and collect printing jobs. A flyer was printed with this message, and mailed out. Business boomed.

Market niche Another technique of developing a USP is to segment a market according to some variable, and focus on that niche segment. A common variable is household income or wealth; another is the age of the customer. McDonald’s focuses on families with young children, Mercedes on more affluent households. Some accountants focus on large corporates, others on small to medium-sized enterprises (SMEs). Over time, with planning and hard work, the company develops an image appealing to its chosen market niche.

Barriers to entry Complementing the idea of USPs is the economist’s concept of barriers to entry. As the market for a product or service develops, a few companies gradually become dominant. It becomes increasingly difficult for new companies to enter the marketplace. The older companies’ success builds barriers to entry that other organisations must hurdle. Examples of barriers to entry are listed below. • Economies  of scale. The large-scale plant investment by the incumbent companies means they are the lowest cost suppliers. • Blocked  distribution channels. Retailers are disinclined to provide shelf space to new companies and prefer successful brands. Retailers charge significant fees to carry a new line of products. • Brands.  New entrants have to spend significant amounts of money to obtain any form of brand recognition. • Reference  sites and national service networks. This can be a significant barrier for new companies targeting the industrial and government markets.

26  starting a business • Large  capital requirements. Many inexperienced entrepreneurs fail to calculate the realistic capital requirements for a business. For example, it costs about US$1.2 billion on average to bring a new drug to market. This creates both a barrier and an opportunity. Few biotech companies can afford to bring a drug to market on their own, so most will license or sell their products to the big pharmaceutical companies, effectively providing outsourced R&D. The payoffs for successful biotech companies can be very high.

Will your business win? When addressing the question ‘Why will their business win?’ entrepreneurs should view the marketplace as a set of scales. In one pan is the business with its USPs and in the other pan is the competition with its barriers to entry. Will your USPs and business strategy outweigh the incumbents’ barriers to entry and enable you to win market share? How the scale pointer moves, and in which direction, provides some indication of the market share the company could expect to gain, if any.

Sustainable competitive advantage It is also important to consider the likely longevity of your USPs. If they are easily copied, your USPs will quickly evaporate and your competitive advantage will not be sustainable. Today, it is possible to spend a year planning a new product and find numerous imitators in the marketplace just weeks after its launch. The Apple iPhone is an example. Within hours of reaching consumers, it had been prised apart to see the components and design. Even prior to launch, a less expensive, very similar model was under production in Asia. Apple’s advantage is reputation, huge marketing budgets and its ability to continually fund new R&D to stay ahead of the competition as products become commoditised. You should give deep thought to how you can maintain your competitive advantage and USPs.

Conclusion This chapter has covered  the next step in analysing business potential, which is to establish whether the company has sufficient competitive advantage to get a market share that will provide adequate returns to

the competitive advantage  27 

shareholders. If entrepreneurs are satisfied the business opportunity is there, and the competitive advantage can be sustained, they can then take the third and final step: financial analysis.

4

The initial financial analysis

Let us assume the prospective business passes the twin tests of sufficient market size and sustainable competitive advantage. The next step is to establish the financial viability and financial requirements of the business.

Return on capital employed Business provides rewards in many ways, but to attract the institutional investor reward must come in some financial form. Businesspeople need capital to establish and operate a business. The capital may be in the form of equity, supplier credit, debt or some combination of these. The providers of the capital typically seek a return and this measure, the return on capital employed, is the fundamental ratio used to analyse a business. The return on capital employed is calculated by dividing the annual profit earned by a business by the capital employed in that business.

Asset intensity All businesses may be defined as enterprises that purchase inputs such as labour and materials, add value in some form (usually requiring the purchase of capital equipment), and then sell the transformed inputs.

the initial financial analysis  29 

Enterprises, besides needing capital to fund start-up costs and capital equipment, also need capital to fund the continuous purchase of materials and labour and the cost of offering credit to customers. The cycle of buying and selling is then repeated. The amount of assets needed to support one dollar of sales is called the asset intensity of a business. For example, a retailer who buys goods on credit and mainly has cash customers has a much lower asset intensity than a miner who needs to buy substantial plant and stockpile produce, and has limited trade inputs. Many clean technology businesses involve manufacturing, so they will tend to have higher capital intensity than would an internet-based comparison shopping site. One key to business success is achieving lower asset intensity than your competitors. One way to calculate asset intensity is to divide the total assets employed in the business by the annual sales. Another more common way is to subtract current liabilities from total assets and define the result as ‘capital employed’. The ratio of capital employed to annual sales is the capital intensity because it looks at the equation from the capital perspective rather than the asset perspective.

Capital employed The balance sheet of the company describes how much capital is employed in a business and how it is distributed among the various assets. In accounting terms: Assets = Liabilities + Shareholders’ funds Long-term assets + Current assets = Current liabilities + Long-term debt + Shareholders’ funds Long-term assets + Current assets – Current liabilities = Long-term debt + Shareholders’ funds Definitions: Working capital = Current assets – Current liabilities Capital employed = Long-term debt + Shareholders’ funds Thus: Long-term assets + Working capital = Capital employed

30  starting a business

As mentioned, capital employed is most commonly defined as total assets minus current liabilities.

Net profit margin Another key to business success is the difference that is obtained between the purchase price of the inputs and the selling price of the outputs. The profit and loss account is the accounting report that businesspeople use to measure this difference. Successful businesses are defined by the profits they achieve. The usual measurement is the percentage of annual sales that annual profit represents. This percentage is known as the net profit margin. The return on capital employed (net profit divided by capital employed or ROCE) may also be defined as the profit margin divided by the capital intensity: Return on capital employed = Net profit ÷ Capital employed ROCE = Net profit margin ÷ Capital intensity Many businesses target a figure of, say, 20 per cent for the pre-tax return on capital employed. However, the means by which this target is achieved varies from industry to industry. Oil refineries need extensive capital investment and usually have strong profit margins of 20–30 per cent, but their very high capital intensities of $1.00 or more per dollar of sales reduce their return on capital employed. On the other hand, retail establishments which sell mostly for cash, lease their fixed assets, and whose major asset is stock typically have low profit margins of 2–3 per cent, but their low capital intensities of $0.10–0.15 per dollar of sales lift their return on capital employed.

Funding mix Once the capital requirements are defined, the next step is to establish the mixture of supplier credit, debt and equity to finance the business. Typically, for most businesses, supplier credit is the cheapest form of financing, followed by debt and then equity. The financing task is to try to borrow as much as possible and top up any deficiency with equity. This is the leveraged buyout financing technique. The corollary is that, because interest payments must be met, debt increases the financial risk of a business. For

the initial financial analysis  31 

a start-up business, the business risk is already very high, so adding financing risk can be too much. In general, start-ups won’t find anyone willing to lend anyway. The cost of money is always linked to the risks associated with the borrower, and start-ups are very high risk. If entrepreneurs try to raise equity and fail, they are receiving an important message. The returns offered are simply not appropriate for the risks posed.

Recap of financial analysis steps Returning to the questions set at the beginning of this chapter, the steps to establish the financial viability and financial needs of a business are set out below. 1 Draw up a monthly pro forma profit and loss account of the business when it is an ongoing business and operating profitably. At this stage, the business should be generating positive cash flows. Since this will be some time in the future for a start-up, you will need to make your best estimates. Sales forecasts should be built up from unit sales and unit prices for each product offered. Unit volumes will enable you to better forecast the sales and marketing efforts, as well as the operational support, working capital and capital expenditure required to deliver the forecast volumes. 2 Calculate the gross and pre-tax profit margin ratios and establish whether they are sensible. Comparison with similar companies and industries will give an indication. 3 Convert the monthly pro forma profit and loss accounts to annual figures. Then establish the capital employed ratios for similar industries and calculate the capital requirements for the continuing business. Be alert for possible seasonality in your business that may cause large swings in volumes. Retailers in the Christmas season are an example. 4 Next, try to establish how much capital will be needed to fund the business until the business turns from cash negative to that future cash positive position. Ideally, this should not be longer than two years, but is almost always longer than one year. Early stage companies trying to build global businesses may take longer. 5 Add together the ongoing capital requirements with the start-up capital requirements and then decide whether and how you can raise the needed capital.

Example Let us now take as an example a company that wishes to manufacture a new form of electronic widget. The total market is estimated to be $150–200

32  starting a business

million and you believe that in two years, because of your pricing and technical advantages, you will obtain 10–15 per cent of the market. • You estimate widgets will cost $1500 to make and sell at an average price of $3000. You estimate that, to achieve sales of $1.8 million per month, the company will need a sales manager and four salespeople. Other necessary staff overheads include an accountant, a research and development engineer, a technician, a secretary and a receptionist. • You then draw up a monthly pro forma profit and loss as shown in Table 4.1 and calculate percentages. Note that we are assuming nothing about the method of financing and are supposing there is no interest to be paid. Thus EBIT (earnings before interest and taxation) is equal to the pre-tax profit. Fixed manufacturing costs refers to those manufacturing costs such as rent, equipment leases and so forth which do not vary with the volume of manufacturing. Cost of goods sold refers to the direct labour and material costs incurred in production, which generally vary with sales volume changes. • You then check the pro forma profit and loss percentages against industry norms and establish whether your projections are realistic. The most important percentage is the profit before tax. More business plans lose credibility with this figure than any other. Manufacturing enterprises may occasionally exceed 10 per cent, but it is rare. Resource-based businesses in good years may achieve 40 per cent but the matching cost is the enormous capital infrastructure that must be built. Some technology companies can

Table 4.1 Monthly profit and loss with percentages $ Sales

%

1 800 000

100

Cost of goods sold

900 000

50

Gross profit

900 000

50

Marketing and sales

400 000

22

Administration

150 000

8

Research and development

100 000

6

Fixed manufacturing

120 000

7

Earnings before interest and taxation (EBIT)

130 000

7

the initial financial analysis  33  continuously achieve pre-tax margins of more than 15 per cent, but again it is rare. Keep in mind that the average after-tax profit margin of S&P 500 companies over the past 50 years has nearly always hovered between 5.5 and 8.5 per cent, with some sectors such as technology helping to lift the average. Interestingly, the main net profit margin driver over the last 50 years has been salaries and wages, which for many companies is their largest expense item. When wage growth has been low, net profit margins have improved and vice versa. • The next step is to find out the asset intensity for an electronics manufacturing business. From your research, you find the typical asset intensity for an electronics manufacturer is $0.67 of assets for every $1.00 of sales. • Thus, by calculating the annual sales for the company—$21.6 million— you estimate that its asset requirements would be about $14.5 million (0.67 × 21.6 million). For a manufacturing company of this size, the assets would typically be fixed assets of $7.5 million, stock of $2.5 million, debtors of $4 million and other assets of, say, $500 000 for a total of $14.5 million. On the liabilities side of the balance sheet, creditors and leave provisions typically represent 15–20 per cent of total assets—in this case, about $2 million— leaving an operating capital requirement of $12.5 million ($14.5 million of total assets less $2 million of creditors and leave provisions) to be financed by debt and equity. • In addition, you estimate the company will take eighteen months to build up to monthly sales of $1.8 million. Thus, in the first month the company will make a gross profit of $50 000, in the second month $100 000, in the third month $150 000, and so on. Over eighteen months, the cumulative total gross profit earned will be $8.55 million. The monthly fixed costs are estimated as starting at $380 000 and growing to $720 000 at a rate of $20 000 per month. Over eighteen months, the total costs will be $9.9 million. The difference between the total gross profit of $8.55 million and total fixed costs of $9.9 million is a capital deficiency of $1.35 million. The total capital employed/required is thus about $13.85 million, being the operating capital employed of $12.5 million at the steady state forecast level and the capital deficiency of $1.35 million during the build-up period. This will need to funded by debt and equity. • Once the company achieves the steady state, its monthly profit before tax is estimated to be $130 000, which leads to an annual pre-tax profit of $1.56 million earned on total capital employed/required of $13.85 million yields a pre-tax return on total capital employed of about 11.25 per cent.

This simple example is at the required level of initial analysis. Perhaps the most common reason stated for business failure is under-­capitalisation. What under-capitalisation usually means is that the entrepreneur has under-estimated the capital requirements.

34  starting a business

The key step The key step is the second one which, after drawing up a pro forma profit and loss or income statement, is calculating the various percentages. Ken Olsen, the founder of Digital Equipment Corporation, has said the first thing he asks of any aspiring entrepreneur is to see the income statement. He does this before asking any questions about markets, technologies or previous track record. He says he knows whether the business has any chance of success from the quality of the income statement. If the income statement appears reasonable, the next step is to calculate the margins. In a start-up manufacturing company, one usually looks for gross margins over 50 per cent, marketing costs of 20–25 per cent, administration costs of 7–10 per cent, and research and development costs of 5–10 per cent. For a retail or wholesale operation, you look for margins of 25 per cent and overheads of around 18 per cent. Technological or other advantages may give your business a cost or efficiency advantage that translates into better than industry average results. Once you have estimated the income statement, the calculation of the capital intensity is a relatively simple task. Typically manufacturers have ratios of 50–67 cents per dollar of sales while retailers which can sell for cash, lease equipment and premises, and use suppliers’ credit can achieve capital intensities of 8–15 cents per dollar of sales. If you can’t get data on your chosen industry, select a sizeable sample of companies from the same or a similar sector and calculate the ratios, perhaps segmenting the data by large, medium and small companies.

The hard part The more difficult task is the calculation of capital needed to fund the business until break-even cash flow is achieved. Each business is different, but there are some rough rules of thumb. Most companies require at least a year to start making a profit from a branch operation. Another rule of thumb is that for every dollar spent on successful research and development (R&D), three dollars are needed for production engineering and six dollars for the marketing and production launch. It takes on average US$1.2 billion to bring a new drug to market, so biotechs invent and then sell or license their intellectual property to big pharmaceutical companies to fund clinical trials, regulatory approval and sales and marketing.

the initial financial analysis  35 

­ nder-estimation of the start-up capital is a major risk for both entreU preneurs and investors, particularly if the investment needs further R&D, because additional capital requirements will reduce the assumed return on capital employed. Thus a preferred alternative for many entrepreneurs is to take over an existing business; that is the subject of the next chapter.

Conclusion Your company’s return on capital employed cannot be taken in isolation. To attract external investors, your company’s return must be comparable or superior to other investment opportunities with similar risk profiles. That includes other start-ups in the case of venture capitalists and many other types of investments in the case of angel (high net worth private) investors. These calculations are only satisfactory for an initial analysis, but they do help to provide some useful indicators. Any formal fundraising will need a business plan and detailed monthly cash flow forecasts. Later chapters describe how these reports are prepared, but in Part II we examine those financial intermediaries that can provide debt and equity capital to entrepreneurs.

5

Taking over an existing business

Up to now we have been examining the initial analysis necessary for starting a new business. However, while starting a new business and succeeding can bring about some of the more spectacular gains, there are other ways to win, namely turnarounds and leveraged buyouts. When entrepreneurs take over failing (or failed) companies and by a combination of innovative marketing and cost-cutting convert the losses into profit, this is called a turnaround. Lee Iacocca of Chrysler and Victor Kiam of Remington are two well-known examples of such entrepreneurs. Their books are well worth reading, and are an inspiration to any budding entrepreneur or manager. Tassal, the Tasmanian salmon farming business that went into receivership in 2003, is an example of an Australian turn­ around, led by Mark Ryan of KordaMentha. Turnarounds are notoriously difficult, however. Successful company doctors, another name for turn­ around experts, are as rare as successful artists. Thus, if you are offered a turnaround opportunity, it is necessary to exercise extreme caution and ensure you have developed a business plan for success. The leveraged buyout (LBO) is another method of buying companies, and it has become increasingly popular over the past ten years. Leveraged buyouts have higher financing risk and lower business risk because they use significant gearing, but they involve mature businesses with stable cash flows. Conversely, start-ups have significant business risk because they

taking over an existing business  37 

have little or no operating history. All businesses are subject to failure— indeed, failure is the essence of the capitalist system. Failure redirects resources at more productive enterprises. Business failure often comes about because the marketplace or competition prevents adequate sales or margins (business risk). In other cases, the business has been financed by too much debt in proportion to equity and, because of an economic downturn, is unable to meet its interest payments. It is then foreclosed by the debt financiers (financing risk). Figure 5.1 illustrates the risks facing businesses as a simple grid. Box 1 is the well-managed successful business with low financial risk and low business risk. Typically, the debt–equity ratio is 50:50. Box 2 is a start-up financed by equity. The business risk for a start-up is always high, but the financing risk is kept small by having little debt on the balance sheet. Box 3 is a start-up financed by debt. This is usually a disaster. Box 4 is the typical leveraged buyout. A business with little risk and a strong balance sheet is purchased principally by debt financing, generally raising the debt–equity ratio up to a maximum of 90:10 (this level of gearing is rare) for mega buyouts of very large, mature companies (like Myer) and 65:35 for smaller buyouts of SMEs. In Australia, the average for all LBOs is probably about 70:30. While the gearing weakens a previously strong balance sheet, the reward for the entrepreneur and investors comes from growing the business moderately and using the cash flows of the business to repay the debt so that, in time, the ratio of debt to equity reduces to, say, 50:50. Financial risk Risk Financial

Business Risk risk Business

Low

High

Low

1

4

High

2

3

Figure 5.1 Risks facing businesses FIG0502.EPS With gearing at the maximum level of 90:10, the result—provided the business keeps the same value—is a fivefold increase in the equity. Figure 5.2 illustrates this. If the business is able to grow, which is usually a prerequisite for smaller buyouts, the increase in the value of the equity is even greater.

38  starting a business $m 12

Debt

Equity

10 8 6 4 2 0

1

2

3 Year

4

5

Figure 5.2 Increasing equity in an LBO FIG0501.EPS LBOs have become increasingly popular in Australia. Financiers and entrepreneurs now have the ability to perform cash flow analysis on personal computers. Sufficient successful examples of LBOs are available to convince doubtful lenders. One of the earliest was the Kerry Packer buyout of Consolidated Press. He bought the half shareholding his family did not own from the public in 1983 for $300 million. He then sold half the business (the Nine television network) to Alan Bond in 1987 for $1.1 billion. In turn, Bond listed the TV company. Kerry Packer then bought back a controlling interest in the listed TV company in 1989 for $200 million. In 1992 he sold off half the magazines (effectively one-quarter of the business) to the public for $600 million. He then re-merged the two entities in 1995. Besides coming from an initially wealthy family, understanding the LBO process was probably the key step towards Kerry Packer becoming, in his lifetime, Australia’s wealthiest individual. However, the transaction that started the LBO boom in Australia was the acquisition of the Pacific Brands division from the Pacific Dunlop group by Catalyst Investment Managers and CVC Asia Pacific, for $730 million. The business went to an initial public offering (IPO) in April 2004. The investment achieved an IRR of 141 per cent. This was an unheard of return of an LBO (35 per cent IRRs are considered exceptional) and put Australia on the world map. In addition, there was a terminology change from leveraged buyouts to private equity. Significant overseas private equity firms began taking a strong interest in Australia. Some of the major transactions in recent years have been the $2.2 billion purchase of Coates

taking over an existing business  39 

Hire by Carlyle Group, the $5.5 billion PBL Media acquisition by CVC Capital Partners and CVC Asia Pacific, and the $3.2 billion Seven Media Group acquisition by KKR. While these transactions grab headlines, the majority of LBOs in Australia and around the world are much smaller transactions, usually involving private companies, financed by moderate levels of debt such that the capital structure consists of about 65 per cent debt and 35 per cent equity. The success of an LBO, provided the price is right, depends on a steady cash flow. Thus one looks for businesses with solid market share and long-term, loyal customers. Quasi-monopoly situations with high barriers to entry are particularly appealing to buyout financiers. For Consolidated Press, television licences were restricted and the demand for television advertising generally exceeded supply. The cost of setting up a new newspaper or magazine in the markets served by Consolidated Press publications was prohibitive. Castlemaine Tooheys, which was an LBO executed by Alan Bond, was in a similar position. The costs of building a large-scale brewery to obtain the economies of scale, and to establish the necessary distribution, advertising and discounting, mean breweries are almost impregnable. The last attempt by a new entrant into Australia, Power Breweries, did gain initial marketing success. However, it was soon taken over by Fosters Brewing as price-cutting diminished its profits. Consumer businesses with strong brand names and few competitors are popular targets for LBOs. The $1.4 billion Myer Group buyout by Texas Pacific Group is an example. Repco is an example of a smaller retail buyout. While the LBO is the underlying financial structure, the name applied to the transaction depends on who is doing the buying. If it is a buyout specialist, it will be an LBO. If incumbent management is buying the business from its current owners—say, a multinational divesting a non-core business—then it is known as a management buyout or MBO. If it is new management buying in, then it is known as a management buy-in or MBI. Employee buyouts or EBOs are situations where the employees of a company band together to undertake the buyout. The first step in an LBO is establishing the size and stability of the market. The second step is to discover the degree of competition. It is critical to establish the potential for price-cutting by competitors. A highly leveraged company cannot afford to engage in a discounting war, and is particularly vulnerable to a squeeze on margins.

40  starting a business

Finally, the entrepreneur must establish whether the company can refinance the debt from the operating cash flow or asset redeployment. Usually a new emphasis on asset management can reduce stock and debtors by around 10 per cent, and delaying payment to creditors may significantly reduce the working capital requirements of a company. Some fixed assets, particularly land and buildings, can often be sold and leased back. On a per capita basis, Australia has the largest property trust industry in the world, and these institutions are often seeking good properties or tenants. The principal form of asset redeployment is probably reduction of stock levels. Typical measures carried out by management are: • doing product rationalisations (long-established companies typically have an excessive number of low-margin products); • introducing stock recording and control systems; • reducing set-up times on machines so the factory can produce on shorter runs.

If entrepreneurs cannot establish a means of financing the debt (because the price is too high), there is no deal. The receptiveness of debt providers is very important to the level of LBO activity. The 2007 and 2008 credit crunch has slowed the LBO market somewhat due to limited availability of debt, higher interest rates and more restrictive debt covenants. Nevertheless, in Australia and around the world, buyouts are still being completed—just at a lower pace with less debt and lower purchase prices than when debt is cheap and easily available. It will be interesting to watch how some of the highly geared mega buyouts fare in the difficult economic climate of 2008. Some will inevitably experience difficulty, but the more conservatively geared buyouts should survive. In this chapter, we have concentrated on LBOs. However, entrepreneurs contemplating a start-up can also consider the purchase of a small existing company. The purchase of a small company that already has a number of facilities in place (phone, post office box, etc.) and a developed credit history may often prove to be an intelligent step. There are several private equity firms, such as ANZ Capital and Hawkesbridge Private Equity, that will sponsor management buyouts of smaller firms. Chapter 9 will cover buyouts in more detail, including funding sources and private equity firms.

taking over an existing business  41 

Entrepreneurs should seriously consider the option of a buyout. For inspiration, remember that the winner of the ABC Flying Start Award (a competition organised to find the best growth business in Australia in 1987), DKS Pty Limited, began its corporate history with the original shareholders buying a small manufacturing company in 1979 for a five-figure sum. They sold the business to James Hardie in 1991 for an undisclosed eight-digit sum.

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Part II

The venture capital spectrum

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6

How the game is played

In Part I we described how entrepreneurs should analyse a business and decide whether it is worth trying to raise funds. In Part II we will examine the various venture capital intermediaries. Before this, however, let us first look at how the entrepreneurship/venture capital game is played. Not much in the venture capital game is new. What is different is that the game and the roles of the various players have become more precisely defined. The rules for this game developed in California during the 1960s and 1970s. It is only recently that the game has really started in Australia for industrial companies. Note, however, that the model is well known and widely used among the Australian junior resource companies. People often make the comment that there is no venture capital in Australia, whereas the Australian mining sector has one of the most well-developed venture capital markets in the world. Significant changes in the financial system of Australia during the last decade have made the entrepreneurship/venture capital game a more popular one to play. Most importantly, with the changes to capital gains tax, combined with a number of small business exit concessions (which change regularly), venture capital is by far the more financially rewarding route for an ambitious individual to follow. Figure 6.1 shows the factors that affect the venture capital industry.

46  the venture capital spectrum

Exit routes

Economic

Financial

The venture capital industry

Regulatory Innovation

Culture

Market

Figure 6.1 Factors affecting the venture capital industry

Exit routes Venture capital generates returns to its investors by successful exits. Mergers and acquisitions (M&A) and initial public offerings (IPOs) are the most common exit routes, both in Australia and globally; however, share buybacks also present a viable exit path. In Australia, the net value of exits of venture and private equity-backed companies totalled $806 million according to the 2006–07 ABS survey of venture capital and later stage private equity. These were exits through trade sales, IPOs and share buybacks, and exclude writeoffs and other changes. Australia’s capital markets are now mature, liquid and transparent, providing solid exit paths. The total of all Australian IPOs in the calendar year 2007 was 91 listings, raising $8.9 billion (an average of $97.8 million per listing) according to PricewaterhouseCoopers. Included in the 91 listings were seven private equity-backed companies, the largest of which was Boart Longyear, which raised $2.3 billion in April 2007. Of the 91 IPOs, 56 had a market capitalisation of under $100 million. The United States still tends to be the world’s largest market for exiting venture-backed companies. For 2007, the United States reported 304 venture-backed M&A exits with a disclosed value of US$23.7 billion for an average disclosed value of US$78 million. For the same period, the United States reported 86 venture-backed IPOs worth $10.3 billion for an average of $119.8 million. The upshot of this, as the astute reader will

how the game is played  47 

gather, is that in the right market conditions, IPOs tend to provide biggest exits and highest valuations. It is important to understand that the ability to exit is not as simple as having a successful company with excellent prospects. Successful exits are highly dependent on market conditions and investor appetite. Markets can move from bull-run optimism to bear-market pessimism very quickly. As an example, in the United States the fourth quarter of 2007 saw 31 venture-backed IPOs with a value of US$31 billion or an average of US$96.8 million per exit. In the first quarter of 2008, the number of VCbacked IPOs fell to just five IPOs totalling US$282.7 million, the lowest level since 2003. M&A sentiment can change just as rapidly, as evidenced by US venture-backed M&A in the first quarter of 2008 being at its lowest volume in ten years. The rapid shift in IPOs and mergers and acquisitions was largely due to economic uncertainty stemming from the sub-prime credit crisis in the United States that emerged in 2007.

Financial Since 2001, there has been a substantial increase in unused commitments by Australian investors to venture capital and private equity. The 2007 ABS survey of the venture capital industry showed $5.7 billion available for drawdowns by private equity and venture capital managers, up from $2 billion in 2001. Ninety-five per cent of the undrawn commitments were from Australian investors. The survey stated that there were 186 active venture capital fund managers managing 280 investment vehicles with 1076 investee companies. Only $431 million of these available commitments are targeted at earlier stage ventures.

Regulatory It might surprise some people, but of the 58 countries surveyed in the 2007 Global Entrepreneurship Monitor, Australia ranked second in terms of ease of starting a business—only Canada was rated as easier. On the taxation front, the situation has become more favourable to entrepreneurs than it has been for some 30 years. The halving of the capital gains tax rate has already been noted for individuals. The taxation rate for companies is now 30 per cent. The introduction of the Goods and Services Tax (GST) in 2000 enabled the removal of wholesale sales tax and various indirect

48  the venture capital spectrum

state taxes, making Australian exporters—who previously carried a terrible tax burden—significantly more competitive. The legal framework is now also generally more favourable for fund­ raising. The prospectus rules have now been relaxed for approaches to professional investors. Companies can now make personal offers and accept 20 new shareholders on a rolling twelve-month basis for total amounts of less than $2 million (the 20/12/2 rule) without having to register a prospectus. While regulatory and legal frameworks have generally improved, entrepreneurs and investors must seek legal and tax advice for their activities.

Innovation Because of the tyranny of distance, Australia has always been an innovative country, with or without government support. The Safe-n-Sound baby safety capsule, Hills Hoist clothes line and Caroma dual-flush toilet were all Australian inventions. As of June 2008, the government programs to support innovation are under review with a report of recommendations due in July 2008. There was some good news in the 2008 federal Budget, with $1.9 billion earmarked for various programs to tackle climate change and environmental issues. These include a $150 million energy innovation fund, a $500 million green car innovation fund, a $500 million national clean coal fund and a $500 million renewable energy fund. Also on a positive note, the Budget included $250 million to establish Enterprise Connect Innovation Centres, an additional $50 million for the Export Market Development Grants Scheme and $42 million for Business Enterprise Centres. COMET grants, Innovation Investment Funds and Pre-Seed Funds remain available for now but changes are likely when the Labor government responds to the recommendations of the Cutler inquiry, handed down in September 2008. On the downside, the Labor government’s budget proposals in May 2008 cut $2.5 billion from existing government grant programs, including the Commercial Ready grant program. In addition to varying degrees of government support, the various scientific research institutions such as the universities (the bionic ear, the cochlear implant, was invented by Professor Graham Clark of the University of Melbourne) and the CSIRO (where the first prototype solar hot water heater was built) are actively looking for commercial collaborators.

how the game is played  49 

Economic Australia is the fifteenth largest economy in the world, and the economic climate over the past decade has been very stable, providing a fertile environment for entrepreneurs. From 1997 to 2007, Australia experienced 3.4 per cent real GDP growth, ranking ahead of the United States, the United Kingdom and Canada. As of September 2008, despite the financial crisis and threat of recession in the United States, Australia had avoided the worst of the fallout from the sub-prime market’s collapse. Inflation has become a concern, driven by the expansionary budgets of 2006 and 2007, tight labour markets, high capacity utilisation and rising energy and food prices worldwide. Until September 2008, the RBA raised interest rates twelve times in six years to cool the economy. In September 2008, as the economy showed signs of deterioration, it reversed this policy with the first interest rate cut since 2002.

Culture The key questions are whether Australia embraces an entrepreneurial culture and how it compares to the rest of the world. These two topics are frequent subjects of debate in the media. According to the Global Entrepreneurship Monitor’s 2007 report, Australia has one of the highest percentages of entrepreneurs (just under 12 per cent of the adult population) when compared with other high income-earning countries. Australia’s rate of entrepreneurship is on par with the United States and substantially higher than the United Kingdom. Some great Australian inventions have previously been mentioned, and it’s worth keeping in mind that other great inventions commercialised overseas, such as the Warren black box flight recorder, also originated in Australia.

Market The key factor here is to have large and growing markets. The small size of Australia’s domestic market is often said to be a weakness. Its small size does force Australian companies to think and grow globally much earlier than companies in the United States or the United Kingdom. With the fifteenth largest economy on a GDP basis, Australia is not as small as is often thought. For example, Sydney ranked 26th on a 2005 list of

50  the venture capital spectrum

the world’s richest cities in GDP terms, with Melbourne ranking 33rd. In terms of personal earnings, Sydney ranked fifteenth out of the 70 richest cities in the world. Australia overall is ranked fifteenth out of 191 countries in terms of GDP per capita, so the nation as a whole is relatively well off. Further, if Sydney and Melbourne were in the United States, where would they rank in terms of population? Sydney (4.3 million) would be the second largest city in the United States, ranking behind New York City (8.25 million), and Melbourne (3.8 million) would be the fourth largest, just behind Los Angeles (3.85 million). Many countries in the world have no world-class cities; Australia is fortunate to have two very large, prosperous cities and five cities with populations over one million.

Shortage of quality investments Many budding entrepreneurs may find this next point difficult to believe, but a big problem facing the Australian venture capital community is the lack of good early-stage investment opportunities. Good investments for an investor are innovative, early-stage businesses with global potential run by outstanding entrepreneurs and presenting the opportunity for returns in the order of five to ten times money invested within three to seven years. This is a tall order, and Australia is not alone in this predicament. Venture capitalists in the United States had the same difficulty in the late 1960s and early 1970s. However, understanding gradually developed of how the entrepreneurship/venture capitalist game was played. It spread by word of mouth and has now been documented in several books. In this book, we have tried to summarise how to play the same game in Australia.

The venture capital game players There are many players in the game, but the two most important are obviously the entrepreneurs and the venture capitalists. Venture capitalists in essence are financial intermediaries. Investors typically subscribe equity capital into a fund. Venture capitalists in turn invest the funds raised into small private companies, mainly in the form of equity. The objective is to grow the value of the investment portfolio and generate capital gains. Venture capitalists earn their income from two sources:

how the game is played  51  • a management fee, which is usually a percentage of the amount of funds under management; and • a performance fee in the form of a percentage (typically 20 per cent) of the value added to the initial investments made.

Venture capitalists achieve the bulk of their remuneration as capital gains on exiting investments. The exit mechanism is generally either by an initial public offering or an acquisition by a larger corporation. Typically, they invest in companies with a value of up to $10 million and seek to grow them to valuations of $50–100 million or more. To achieve a successful float on the Australian Securities Exchange (ASX), a company should have a valuation of at least $30 million, with most brokers and underwriters preferring IPOs with a valuation of $50 million or greater. A practical limit of $20 million is set simply by the need to attract the support of the institutions such as the large insurance companies and pension funds. The institutions prefer to invest minimum amounts of $1 million and prefer to own less than 5 per cent of a company, hence $20 million. If they own a larger amount and wish to sell, the selling program may depress the exit price. According to PricewaterhouseCoopers’ Survey of Sharemarket Floats, the median price to forecast earnings ratio of surveyed floats with valuations under $100 million was 9.1 times for 2006 and 10.3 times for 2007. To achieve a valuation of $30 million a new float should have a history of gradually increasing profits, a profit after tax of $2–2.5 million for the year preceding the float and a prospective forecast profit after tax of $3–3.5 million. These figures are the minimums for a chance of success, and their magnitude indicates that a high rate of profit growth is typically needed for a successful exit. This is precisely what venture capitalist and private equity investors seek—investments in growth companies or in LBOs where there is significant potential for growth in the value of the equity. Incidentally, applying an average net profit margin of 10 per cent suggests that to list in Australia requires a minimum of about $25 million to $30 million in historical revenue and solid prospects for near-term revenue growth (at least of 15 to 20 per cent forecast revenue growth). For some international perspective, the average NASDAQ IPO valuation is about US$330 million and raises US$133 million of fresh capital. The average size of US IPOs has grown significantly over the past fifteen years. Cisco Systems debuted in 1990 at a market value of US$226 million

52  the venture capital spectrum

and raised US$53 million. E Trade Financial Corporation listed in 1996 at a market value of US$165 million. Most of the equity value growth of these two companies has occurred post-IPO. Today, Cisco and E Trade have market capitalisations of US$149.6 billion and US$1.85 billion respectively. Given the escalating size of IPOs in Australia and abroad, entrepreneurs should think and aim big because that is what is required to attract investors and get a successful exit.

Entrepreneur defined The definition of entrepreneur in the Concise Oxford Dictionary is ‘a person in effective control of a commercial undertaking’. A better definition of the entrepreneur is a person who converts an idea into things or a service people buy. Entrepreneurs may do this for many reasons, but the successful entrepreneur does it for one underlying reason, and that is to get rich. If the profit motive is not there then a necessary ingredient for success is missing. Note that a desire to get rich is not sufficient. Many of the wheeler-dealers of the 1980s had the desire for wealth in abundance but, instead of being entrepreneurs as they claimed, they were arsonists, destroying the companies they acquired. The most successful entrepreneurs genuinely want to improve their customers’ lives. They get rich in the process of achieving this higher goal. Great entrepreneurs also learn quickly, build strong teams, take calculated risks and seek advice from other successful people. How do entrepreneurs become rich? In the 2000s they best fulfil this aim by owning shares in a public company. It is worth analysing some figures provided by the Australian Securities Exchange. As of April 2008 there were 2002 companies listed on the Main Board of the Australian Securities Exchange, up significantly from 1230 on 31 December 2000. Each of these companies has a market capitalisation that is defined as the product of the number of shares on issue times the last traded share price. The market capitalisation is the valuation placed on the company by the market. The total market capitalisation of the Australian stock market at April 2008 was $1.3 trillion (almost double the $671 billion of 31 ­December 2000). Thus the average capitalisation of a company listed on the stock market was $638 million (versus an average at 31 December 2000 of $545 million).

how the game is played  53 

Such a figure is misleading because the 300 companies that make up the ASX 300 Index and represent 86 per cent ($1.1 trillion) of the total market capitalisation dominate the share market. What we should look at is the average market capitalisation for IPOs valued at less than $100 million, which was about $28 million in 2007. If an entrepreneur owns 10 per cent of an average non-index listed company he or she thus has a relatively liquid asset of $2.8 million.

Debt versus equity The major constraint on entrepreneurs is the recognition that they should be seeking equity funding rather than debt. From the perspective of the provider of funds, equity is more risky than debt and is often referred to as risk capital because equity providers have no guarantee either of any return on their investment or of its repayment. By contrast, debt has predetermined rates of interest and principal repayments and a fixed term over which the money is lent. Hence equity requires significantly higher returns to compensate for its significantly greater risk. While an entrepreneur may feel that backing them is risk free, equity investors balance the potential upside against the possibility of losing part or all of their investment. As early-stage companies pose greater risks than mature companies, venture capital investors in early-stage businesses demand very high potential returns. From the perspective of a business, however, debt is more risky than equity, and financiers use the ratio of debt to equity, known as gearing, as a measure of financial risk. In late 2007 and into 2008, well-established, high-profile listed companies such as Centro Properties, MFS, Allco Finance and ABC Learning Centres saw their share prices plummet due to high perceived financial risk resulting from excessive gearing. For a new company, there are many obstacles to success, so the business risk is high. Therefore the entrepreneur should minimise the financial risk. The source of funding should thus be equity rather than debt. In the United States, high-tech companies have little or no debt on the balance sheet. Early-stage companies typically have very little collateral along with their high level of business risk, hence lenders are usually unwilling to lend to early-stage businesses, forcing the entrepreneur to seek equity. This is in stark contrast, of course, to the buyout of a mature company where there is lower business risk, stable cash flows and usually some collateral, hence banks are more willing to provide debt finance.

54  the venture capital spectrum

Constraints on the venture capitalist The major constraint on the business of the venture capitalist is operational. The fees from a $15 million fund will support one venture capitalist and administrative overheads. The maximum number of investments a venture capitalist can manage is around six, which puts an automatic average funding amount of $2.5 million per investment and a minimum amount of around $1.5 million. Today the preferred investment range of most Australian venture capitalists is $2.5 million to $5 million, invested in tranches over the period of their involvement with the company.

How the game is played Now we have defined the objectives and constraints, it is necessary to define how the entrepreneur/venture capital game is played. Perth has long had the reputation of being the entrepreneurial capital of Australia. Various reasons have been suggested. The major industry in Western Australia is mining. If you wish to set up a company for exploration, you do not go to the bank for funds. What you try to do is raise equity, and the most common way to do this is by small public company listings or private subscription. These exploration companies are effectively startups without track records and without any collateral to support debt, so equity is their funding solution. The entrepreneurship/venture capital game has seven rules: 1 A rapidly growing business is always short of cash and the over-financed start-up company does not exist. 2 Raising cash is done by a series of capital placements, which results in continual dilution of the equity holdings of earlier investors and founders. 3 The founders strive to avoid having any individual shareholder with control, hence they play a game of divide and conquer with their investors. The objective of the founders is to have a mix of investor shareholdings when their own shareholding is eventually diluted below 50 per cent. What the founders aim at avoiding is having one shareholder with more than a 50 per cent holding and singular control of the company. Balance in the share registry is the key here. 4 All the shareholders are driven towards the goal of building the business and maximising after-tax profits and an eventual exit by public listing or a takeover by a large corporate or multinational.

how the game is played  55  5 Entrepreneurs who worry a lot about voting control usually have nothing to worry about. 6 There is no limit on what you can do or how far you can go—if you don’t mind who gets the credit. 7 The probability of success of a small company is inversely proportional to the size of the entrepreneur’s office multiplied by the monthly lease on his or her car. In other words, entrepreneurs need to be frugal.

Let us examine an imaginary company (see Table 6.1) where: • sales and after-tax profit double every year; • there is a gross margin of 50 per cent (technology companies should strive for higher than this); • 10 per cent is earned in after-tax profit (technology companies should strive for better than 10 per cent but the long-term overall S&P 500 average is 5.5 to 8.5 per cent—varying, of course, by industry); • all its fixed assets are leased; • debtors pay 60 days after receipt of invoice; • creditors and provisions require 30 days and represent 50 per cent of cost of goods sold; • stock levels are two months of cost of goods sold; • 80 per cent of after-tax profit is retained in the company.

Table 6.1 Funding requirements for a high-growth company ($000) Year

2

3

4

5

1000

2000

4000

8000

16 000

100

200

400

800

1600

Retained earnings

80

160

320

640

1280

Stock

82

164

329

658

1315

164

329

658

1315

2630

21

41

82

164

329

Working capital requirements

226

452

904

1808

3616

Less: Retained earnings

80

160

320

640

1280

Funding requirements

146

292

584

1168

2336

Sales Profit after tax

Plus: Debtors Less: Creditors and provisions

1

56  the venture capital spectrum

As can be seen from the table, even a business with such attractive characteristics is still short of capital, mainly because its retained earnings are insufficient to fund the growth in working capital. Faced with such a scenario, the entrepreneur has two choices. One is to slow down the rate of growth and fund the working capital increase from retained earnings. This is called bootstrapping. The other choice is to go to the venture capital market repeatedly to fund the working capital requirements arising out of rapid growth. Once a track record is developed over two to three years, and provided the company is selling to blue-chip customers, it is sometimes possible for the company to borrow against its debtors. This is referred to as debtor finance and is a good source of working capital. The amount that can be borrowed varies, ranging from 75 to 85 per cent, and only debtors less than 90 days old are normally eligible as collateral. Table 6.1 is made more relevant by the following practical example (see Table 6.2), which shows the financing history of a company over a four-year period. The company begins with the founders subscribing $150 000 in the form of 1.5 million 10 cent shares. At start-up, two angel investors put in a total of $500 000 for a combined 25 per cent of the company. A year later in round one, a single venture capitalist puts in $1 million for 25 per cent of the company (25 per cent is probably the smallest level of ownership an early-stage venture capitalist will be willing to accept). The following year, a syndicate of two other venture capitalists put in $1 million each for a combined 27.3 per cent ownership stake. Finally, the company lists in the following year, raising $3 million from the public who own about 17 per cent of the company. Table 6.2 Pro forma financing history of a high-growth company Stage Month

Founders’ Start-up Round 1 Round 2 issue 0

Issued shares

Float

Postfloat

0

12

24

36

48

1500K

2000K

2666K

3666K

4416K

New shares

1500K

500K

666K

1000K

750K

Total shares

1500K

2000K

2666K

3666K

4416K

4416K

Share price

$0.01

$1.00

$1.50

$2.00

$4.00

$10.00

Post-funding valuation

$15K $2000K $4000K

$7333K $17 666K $44 166K

how the game is played  57  Funds raised

$15K

Pre-funding valuation

$0

Cumulative funds raised

$15K

Share structure

$500K

$1000K $2000K $3000K

$1500K $3000K $515K

Shares on issue No. %

$1515K

$0

$5333K $14 666K $44 166K $3515K

Percentage holdings

$6515K

$6515K

Value

Founders/ employees

1 100 000

55.00

41.25

30.00

24.91 $11 000K

Managing director

200 000

10.00

7.50

5.45

4.53 $2000K

Marketing director

100 000

5.00

3.75

2.73

2.26

$1000K

Finance director

40 000

2.00

1.50

1.09

0.91

$400K

Operations director

60 000

3.00

2.25

1.64

1.36

$600K

Investors: Angels 1&2

500 000

25.00

18.75

13.64

11.32 $5000K

Round 1: VC1

666 667

25.00

18.18

15.09 $6666K

Round 2: VC2&3

1 000 000

27.27

22.64 $10 000K

Public float

750 000

Total

4 416 667 100.00% 100.00% 100.00% 100.00% $44 166K

16.98 $7500K

What happens (as illustrated by Figures 6.2, 6.3 and 6.4 respectively) is that (1) funds are raised in stages; (2) the founders’ equity is diluted at each stage; and (3) although the percentage holding becomes smaller, the real value of the holding becomes greater as the value of the company increases. This results in the following:

58  the venture capital spectrum 3.5 3 2.5 2 1.5 1 0.5 0

Start-up

Round 1

Round 2

Float

Figure 6.2 Funds raised in stages ($millions) FIG06.01.EPS % 80 60 40 20 0

Start-up

Round 1

Round 2

Float

Figure 6.3 Dilution of founders’ equity FIG06.02.EPS 20 15 10 5 0

Start-up

Round 1

Round 2

Float

Post-float

Figure 6.4 Increasing value of founders’ equity ($millions) FIG06.03.EPS

This example is important and all budding entrepreneurs should study it carefully. It demonstrates a number of key principles of the venture capital game: •  The founders and management end up owning 34 per cent of the business; the holding is worth $15 million compared with an original value of $150 000. This is a return of 100 times their original investment and, over four years, represents an internal rate of return (IRR) of more than 200 per cent. • The angels make ten times their original investment, the first-round venture capitalist makes 6.7 times their original investment and the second-round venture capitalists each make five times their original investment. The postfloat performance is strong and gives the public IPO subscribers uplift to 2.5 times the IPO subscription price. You can see that the returns diminish as the investors join the party later. These lower returns as a multiple of capital invested reflect the lower risk of the company as it matures.

how the game is played  59  •  The founders, while they end up with less than 50 per cent of the company, make sure that no other individual investor ends up with more than 50 per cent. A key to successfully achieving this is to play ‘divide and conquer’ among the shareholders, always striving for a balanced share register. Second, the entrepreneur must aim at raising equity from more than one investor. Post-listing, the shareholding in our hypothetical example would be as shown in Figure 6.5. Public 17%

Founders 34%

VC3 11%

VC2 11%

Angel 1 6% VC1 15%

Angel 2 6%

Figure 6.5 Example of a shareholding post-listing FIG06.04.EPS

• Entrepreneurs should see their company as a wheel around them, and their shareholders as spokes. The more spokes, the stronger the wheel. If there is only one investor shareholder and it holds more than 50 per cent, the entrepreneur and the team are effectively employees. On the other hand, if the founders/management team members end up with a minority position but split up the remaining majority shareholding across a diversity of venture capital institutions and the public, voting control of the company is very reasonably balanced. • Money invested stays in the company and is used to finance the growth of the business. • Equity is used to compensate the executives and the employees. Everyone in the company has a vested interest in increasing the value of the company’s shares. The executives do not erode profits by taking high salaries, leasing expensive cars or having elaborate offices. Because the founders and key management are shareholders and all shareholder interests are aligned, everyone is motivated to work towards earning large capital gains as early as possible.

60  the venture capital spectrum •  The fundraising never stops. The finance director is responsible for raising the next round of equity. Typically, in the intervals, the finance director arranges debt as bridging finance to cover timing differences. • While only the founders are initially diluted by the start-up angel investors, in subsequent rounds the earlier investors share the subsequent dilution with the founders. •  The increase in value of the company is a combination of two processes. First, there is the increase in value generated by the continual increase in profitability, which financial analysts refer to as the ‘quality of earnings’ effect as earnings and growth are proven to be sustainable. As a business grows in earnings year by year, the price-earnings multiple applied to that business also grows. Second, there is the increase in value that comes from the conversion from a private to a publicly listed company. As a rough rule of thumb, a company may be valued as follows: – one-third the all-industrials P/E when private; – two-thirds the all-industrials P/E on listing; and – 100 per cent of the all-industrials P/E after making the forecasted profit stated in the prospectus. This effect (the increase in P/E ratio as the profit after tax increases and the increase in P/E with increasing liquidity) is known as the double whammy (see Figure 6.6). Market capitalisation

$m 60

P/E PAT

40

20

0

1

2

3

4

5

6

7

Figure 6.6 The double whammy FIG06.05.EPS

Five stages of small business growth Entrepreneurs and investors should also realise at what stages venture capitalists invest. The seminal paper on small business growth was first published by Churchill and Lewis in the May–June 1983 edition of the Harvard Business Review. In this paper, the authors first begin by dispelling

how the game is played  61 

the myth that companies follow the classic product cycle of start-up, rapid growth, maturity and decline. Instead, they developed their own five-stage model of small business growth (detailed below). You will not typically hear these stages referred to by venture capitalists, but they are an excellent portrayal of small business development.

Stage 1: Existence At start-up, a company’s strategy is to remain alive. The owner does everything and is the major supplier of energy and direction and, with relatives and friends, capital. Systems are non-existent. The owner controls the company by watching the bank balance.

Stage 2: Survival At this stage, the company is at marginal profitability. Many ‘mum and dad’ stores are at this stage. The owners may have some employees and an external accountant. If the company appears to be succeeding, it may raise capital from wealthy individuals known as ‘angels’, or from the ­public ­sector, or very occasionally from venture capitalists.

Stage 3: Stability The company has succeeded and is showing an economic return on investment. It is generating cash. Professional managers in the form of a financial controller and an operations manager join the company and basic systems are introduced. The owner then has two choices. He or she can decide to disengage from the business and use the money to finance a pleasant lifestyle. As outlined earlier, another common strategy in Australia has been to use the cash flow from the business to buy property. Lifestyle businesses are very common worldwide. The other strategy is to go for growth. In Australia, this would mean opening interstate or international branch offices, for example. Now the owner must be deeply involved. He or she can use several different financing strategies. Franchising is a good technique for consumer products, provided the gross margin is large enough. Bakers Delight is a good example of a wellrun franchised operation. What started as a single bakery in the Melbourne suburb of Hawthorn in 1980 has grown to become the world’s largest bakery franchise with more than 700 bakeries across four countries. The other method is to seek equity from venture capitalists and go the growth–dilution route outlined above. This technique works best with

62  the venture capital spectrum

products and services sold to the business, industrial and government markets, although there have been successes with consumer-oriented business models (e.g. Google).

Stage 4: Rapid growth In this stage, the company grows rapidly. The two key problems facing the business are financing the growth, and organising the delegation and decentralisation of responsibility. Two mistakes often occur. The owner does not realise that dilution with equity value growth is the name of the game and that the best protection is to ensure a spread of ownership and not let one party control the company. It is at this stage that multiple fundraisings from venture capitalists occur. The other common mistake is for the owner not to realise that the business and ownership have become separate and that the business is going to need other management resources besides him or her to run the company.

Stage 5: Resource maturity At this stage, the company has delegated and decentralised management and formal planning systems in place. The company has arrived. If it can preserve its entrepreneurial spirit, it will be a formidable force in the market. It is generating cash and the problem now becomes one of maintaining an entrepreneurial flair in a much larger company and further strategic planning and other activities to maintain its competitive advantage. The point about this model is that it describes the businesses venture capitalists seek. They generally do not seek companies at Stage 1 or 2. Occasionally, when this does occur, it is the stuff of legend. Digital Equipment Corporation, mentioned earlier, is a case in point. These companies, known as new technology growth firms, or NTGFs, are discussed in more detail in Chapter 7. They follow a slightly different model. However, for many companies—even those claimed by the venture capitalists as successes, such as Apple in the United States and Neverfail Spring Water Co. in Australia—the initial start-up financing was done by the entrepreneur and friends, the survival stage was financed by ‘angels’, and only in the stability and rapid-growth stages did the venture capitalists appear. Neverfail Spring Water Co. is a good example of the equity dilution– high growth model in action. The company started in the late 1980s and listed on 1 July 1999. During that period:

how the game is played  63  • the turnover went from nothing to over $57 million annually; • the total venture capital raised was $15 million from four institutions; • the founder went from 100 per cent to 13 per cent ownership; • the founder’s shareholding grew in value from $60 000 to $44 million; and • the share price went from $1 to $376 over thirteen years, or a 66 per cent annual compound growth.

It was not just the skill of the management, or the implementation of the business concept, but the method of financing that was a key to the success of Neverfail.

Venture capital investment activity in Australia The amount of new investment by Australian venture capitalists according to the annual Australian Bureau of Statistics survey is shown in Table 6.3. The ABS survey includes early-stage investment that is more in the nature of organised angel investment as well as institutional venture capital investment; therefore the ABS survey of investment activity tends to be greater than that reported by the surveys conducted by the Australian Private Equity and Venture Capital Association. Table 6.3 Australian and New Zealand venture capital investment levels, 2005–07 2005–06

2005–06

2006–07

2006–07

Number

$m

Number

$m

Pre-seed

27

6

25

13

Seed

27

38

15

13

Start-up

45

88

30

77

Early expansion

73

353

60

509

Late expansion, Turnaround & Buyouts

92

1015

99

1759

264

1500

229

2371

Total

64  the venture capital spectrum

Expansion funding, which is covered in Chapter 8, is still the single largest class of earlier stage funding in Australia. The other major class of venture capital is the leveraged buyout/management buyout/management buy-in (LBO/MBO/MBI) market. This segment showed strong growth in 2006–07, but the credit crisis of late 2007 and 2008 has reduced the availability of the debt that is required for these transactions. Chapter 9 looks at the financing of LBOs and also explains how the rules of the LBO game differ. With the credit crunch and rising interest rates in Australia, the authors expect to see greater investment activity in turnarounds as private equity and venture capital come to the rescue of companies struggling in a higher interest rate, higher inflation and lower growth economy over the next few years.

7

Seed and start-up capital

As indicated in the previous chapter, the entrepreneur who is trying to build a high-growth business must realise that the fundraising never stops, and the process is one of staged development and staged equity dilution. In this chapter, we analyse the various sources of seed and startup equity funding. The hardest part is raising seed money; why this is so will become clear as you read on.

Stages of company development The nature and availability of funding will depend on your stage of development. As industries mature over time, so too businesses go through stages of development. The activities undertaken and the level and nature of risk in a business change as the business develops, and the sources of funding also vary with the risk and activities of the business as it evolves. Table 7.1 shows the various stages of business development and the typical activities, traits and risks of businesses in each stage, from the perspective of venture capitalists and other finance providers. With negative cash flow, no track record and minimal intellectual property, it is clear that businesses at the seed stage are extremely high risk, hence the difficulty entrepreneurs face when securing seed funding.

66  the venture capital spectrum

Table 7.1 Business stages, activities and risk levels Stage

Seed

Start-up

Early expansion

Late expansion

Typical business activities

•  Idea •  Planning •  Early team •  Technical research •  Market research

•  R&D •  Prototypes •  Grow team •  Market research

•  Sales •  Marketing •  Production •  R&D •  Grow team

•  Sales •  Marketing •  Production •  Exit plans •  M&A •  Grow team

Business traits

•  Minimal IP •  Negative cash •  No track record •  No ‘collateral’

•  Growing IP •  Detailed plans •  Negative cash •  No track record •  No ‘collateral’

•  Customers •  Protected IP •  Negative cash and losses •  Met milestones •  May be collateral

•  Repeat customers •  IP inventory •  Positive cash and profits •  Track record •  Collateral

Risk

•  Extremely high

•  Very high

•  High

•  Moderate

The nature of your business As discussed in Chapter 6, it is very important to recognise that the sources and availability of funding will also vary depending upon the type of business you are building. Companies that go for growth, particularly technology-driven businesses, will have far more available funding options than will traditional businesses such as retailers and wholesalers and, of course, lifestyle companies. The reason for this is that fast-growth, technology-driven businesses tend to offer significant opportunity for large profits and capital gains, features that make them attractive to investors. Your target customer markets will also have a big impact on your funding options—businesses serving very large markets, particularly ­global markets, will normally have more funding options than businesses that serve just Australia or a local market within Australia. So you must think

seed and start-up capital  67 

carefully about the type of business you are tying to build and consider its characteristics carefully when developing your funding strategy.

New technology growth firms (NTGF) Gordon Bell, in his 1991 book High-Tech Ventures: The Guide for Entrepreneurial Success, developed one of the more thorough models of the NTGF. Bell was the second computer engineer hired by Digital Equipment Corporation, and is justly famous as the product architect of DEC’s PDP and VAX product lines. He left DEC in 1983 to move to Silicon Valley and has invested in over 100 start-ups. On a flight back from a National Science Foundation meeting in 1988, he was thinking through the common factors for success and the common growth issues of the 600-plus early-stage ventures he had worked with to that date. During that flight, he identified four common stages of development and twelve ‘orthogonal’ (independent) dimensions that determine new technology growth firm (NTGF) success. The critical thing was that these stages and factors could be easily identified or measured: ‘With some companies I could predict to the day when they reached the next stage.’ The four development stages are set out below and shown in Figure 7.1.

Concept Stage I

Seed Stage II

Product development Stage III

Market development Stage IV

Figure 7.1 The four stages of development for a new technology FIG0701.EPS growth firm

Concept stage While the idea for a company may come from anywhere, what drives the formation of an NTGF are new ideas for innovating technology and building products in ways that have significant market benefit and commercial impact (e.g. $50 million in sales over five years). Generally, two to three people begin this process and they are usually working either at a university or industrial research department, or for another high-technology

68  the venture capital spectrum

marketing company. Six months is the typical duration of the concept stage, and the founders of the company fund their own activities from their own resources (sometimes referred to as ‘hurt money’). They prepare a ‘skeletal’ six-to-ten page business plan, which includes the central, unifying vision of the company and statement of requirements for the seed stage. It is ideal if one of the founders is capable of leading the company (as its CEO) through initial product development and market entry, though in reality it is not at all unusual to find a change of leadership occurring during the various stages of a company’s development because the activities and characteristics of the business vary considerably over the stages of development, usually requiring different skill sets over time. It is quite rare for the founder to lead the company from concept to late expansion (Bill Gates is a good example of the rare talents who can do this). Even Google’s founders had to step aside and let Eric Schmidt take over as CEO, a decision on which they are today probably very happy to have agreed. Entrepreneurs should keep in mind that they may have to transition ­leadership of the company to others as the company evolves (this willingness is one of the key traits that investors look for in entrepreneurs—the best entrepreneurs care more about growing the business than they do about their job titles and egos). In addition to funds from the founders, two typical funding paths are used to fuel the company. One is to secure seed financing, sufficient to reinforce technology/product uniqueness and complete adequate business planning for the subsequent stages. The other is to obtain financing to cover all activities through what Gordon Bell calls Stage III, the product development stage (more commonly known in the venture capital community as start-up). A key to achieving funding success is validation of the idea by three reputable outside sources.

Seed stage The seed stage lasts from three months to a year, and is when the concept for the company and product is explored in greater detail and planned. The stage is marked by an infusion of capital by the founders, venture capitalists or other outside sources. The purpose of this stage is to conduct further research on the technology or product, including preparing prototypes of critical areas and/or components, and to build the formal business plan for the company. The key task is the translation of innovation to market benefits. If marketing aspects are unclear, then time must be

seed and start-up capital  69 

spent defining assumptions, building hypothetical applications using prospective user profiles and market models with a ‘map’ of the marketplace, including the most likely means of distribution to the user. Segments are sized according to a cursory market model and ‘missionary’ programs are developed to persuade buyers. The detailed business plan is developed at this stage, and serves two purposes. The first is to secure the funds necessary for product development. Second, and more importantly, the business plan is the document that will guide the company’s operations, establish controls, and set goals and objectives for the firm. Because of this, a detailed business plan should always be prepared during the seed stage, even in cases where additional funding may not be required.

Product development stage Under Gordon Bell’s model, the product development stage consists of four phases: 1 Product specification. During this sub-stage, the engineering team is hired, the product detail specified and detailed planning done for the project and all the supporting design processes. In the product specification phase, marketing and engineering must agree on the product specifications. 2 Product design. This consists of formal testing of the specification, simulating the actual design and building operational prototypes for use. By the end of this phase, the quality and timeliness of the product design is a direct reflection of the quality of the team. 3 Alpha (internal) product testing and product refinement under operational conditions with real use. 4 Beta (external) product testing at customer sites in actual operational and environmental conditions.

Market development stage In the market development stage, all the resources of the company are aimed at producing revenue. The first customer shipment marks entry into this stage, and exit is usually marked by company acquisition, initial public offering (IPO) or a decision to remain private. When the product has proven itself, the company must begin to spend significantly more money producing, marketing and selling its product. The rate of expenditure typically triples when the company enters this stage, provided that the inventory costs can be kept to a minimum. The market development stage includes three distinct sub-stages:

70  the venture capital spectrum • Calibration, lasting three to nine months. These first months in the marketplace serve as an initial ‘acid test’ of all of the company’s plans and programs. Most critically, the market planning is tested and fine-tuned now, by ascertaining whether targeted customers will buy the product as predicted, and according to the marketing and sales departments’ models of market development and revenue generation. The company’s priority is to support sales in all ways possible. Exit from calibration occurs only when the company is certain that, based on successful marketing and sales performance (75 per cent of plan or better), it has a valid financial model and business plan for operating the company. • Expansion, normally six to twelve months’ duration. With a refined business plan and market/sales model, the company begins to expand the market for its product(s), both in terms of sales volume and additional applications and market segments. Exit from expansion occurs when the company achieves its first quarter of profitability. • Steady-state operation, marked by six consecutively profitable quarters. Having achieved profitability, the company demonstrates that it can operate as a stable business entity with solid, long-term prospects.

Funding sources We have discussed the various stages of company development and their traits and risks because these are key determinants of the type and availability of funding for the business. As stated in the previous chapter, the usual process for entrepreneurs is to either use their own resources or that of friends and family for seed funding. Investment of the entrepreneur’s own resources is sometimes referred to as ‘hurt money’ or ‘having skin in the game’. It is vitally important for entrepreneurs seeking outside funding to invest a meaningful amount of their own net worth in their business as it shows the self-belief and commitment that outside investors require. There is considerable government and venture capital support available in Australia so the entrepreneur can access other sources of seed and start-up funding in addition to their own funds and that of family and friends. Until the late 1990s, Australian venture capitalists typically only provided early and late expansion finance when they believed the company’s business had been proven to be viable. However, the past decade has seen venture capitalists move lower down the feed chain in earlier stages of financing into the seed and start-up stages. According to the Australian Bureau of Statistics 2006–07 venture capital survey, $77 million of new investment was made in start-ups and $26 million invested in pre-seed

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and seed-stage ventures. This combined $103 million of investment into earlier stages was 17 per cent of total non-buyout investment for 2006–07 while 83 per cent went to early and later expansion stage companies. These percentages are consistent with the Silicon Valley where 15–20 per cent of venture capital typically goes to start-ups. For a start-up to attract funding, the business must be a compelling high-growth story with unique and strongly protected IP and outstanding management.

Private individuals This remains the largest source of funds for seed ventures and start-ups, both in Australia and overseas. The first category is affectionately dubbed ‘the three Fs’ (‘family, friends and fools’). These are individuals who back a company because they wish to support the people or because they are caught up with the excitement of the technology or business idea. The three Fs can be vital and should be explored but never pressured by the entrepreneur. Why? If the business doesn’t fly and expectations are not realistic, this can be a major source of family conflict or lost friendships. It can be a source of legal wrangles when an investor who has been ‘starry eyed’ about the idea is confronted with the reality of lost capital. Consequently, it is vital that the entrepreneur positions the venture as high risk and explains the risks fully to investors in this category. These people need to be able to lose the money, smile and move on! The second category is high net worth individuals who are not close to the business and invest for commercial gain, to ‘put back’ into the industry or on philanthropic grounds. While the term ‘angels’ is widely used to describe these people, most of them hate it and prefer to be viewed as sophisticated private investors. Within this category, there are some key sub-categories: • high net worth individuals such as lawyers, doctors and accountants who don’t have experience in the entrepreneur’s industry but have accumulated sufficient capital to invest in Stage I–III ventures. These typically invest $20 000–100 000 as individuals and do not play an active role in the business; • successful entrepreneurs, who have become in many cases very high net worth (VHNW) individuals. These can bring valuable industry experience, contacts and the ‘brand’ value of their names as well as capital in the range $50 000 to $2 million per investor. They may take on board or executive roles, or may mentor or coach the CEO and key team members. It is not

72  the venture capital spectrum unusual for them to have strong views on how to grow the business. These views should always be listened to and are often well placed, but sometimes their prior experience is in a sector with very different market conditions. As Steve Killelea, founder of Integrated Research, puts it: ‘Prior business success is not necessarily the same as success in your environment. Sometimes also it’s hard for people who’ve been in big companies to make the shift. Always look at the situational intelligence of your (VHNW) investor.’ Occasionally it is necessary for the venture CEO to remind the very active VHNW investor who is actually running the business. In our experience, this kind of feedback is usually respected.

The size of angel investor market in Australia has not been accurately identified and estimates have conflicted. The Australian Association of Angel Investors (AAAI) is currently undertaking a survey and has a preliminary estimate of $500 million having been invested by ‘angels’ during the calendar year 2007 alone. A federal government study in 2006 estimated angel capital in the range $1 billion to $2.55 billion. Until recently, the private individuals market in Australia was accessed mainly through informal networks. Now there are a number of mechanisms to reach these very important sources of early-stage finance and expertise. Professional investors are best accessed through accountants, formal angel networks (such as the AAAI) or companies providing growth consultancy services and investor forums (such as BSI or Strategon). Some industry associations like the Victorian Employers Chamber of Commerce and Industry also provide matching services. Successful VHNW entrepreneurs can be accessed through similar groups, but also through networks that specialise in VHNW, which include the Founders Forum, Asia Pacific Growth Partnerships, T3 Capital or the South Australian group BioAngels. Typical services include business evaluation, investment readiness workshops, assistance in preparation of investment memoranda and pitches, and regular pitch fests where entrepreneurs pitch their business opportunities to an audience of angels. Some will also assist the entrepreneurs to negotiate the deal with the prospective investors. Probably the best list of angels and business introduction services is the Australian Venture Capital Guide, published by Private Equity Media (www.privateequitymedia.com.au). The Australian Private Equity & Venture Capital Association Limited (AVCAL) website (www.avcal.com.au) also lists business angels (six were listed in the directory as of July 2008).

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Share market listing Another method of trying to raise seed and start-up money is by registering a prospectus, and raising the money with the promise of listing the company. This can only be done during a very strong bull market. The ASX had more than 440 IPOs for the 26 months from 1 January 2006 to 11 February 2008. Over 240 had a market capitalisation of $20 million or less. However, of these 240 IPOs, 210 were minerals or energy explorers seeking small amounts of start-up capital, generally in the range of $4–8 million. Clearly if you are an entrepreneur with a mining or energy venture, you can travel this well-worn path, provided the share market is on a bull run. As an example, Windy Knob Resources Limited raised $2.4 million in February 2007 at a market capitalisation of $4.4 million for minerals exploration in Western Australia. The company was incorporated in October 2006. Prior to listing, the company had no income and net assets of $148 000 but held the promise of an increase in value should its exploration efforts identify valuable deposits. The costs of the IPO were $272 000 or 11.3 per cent of the capital raised. Parties involved included brokers, lawyers and accountants as well as an independent geology expert. For entrepreneurs outside of mining and energy, there are some useful lessons among the 30 or so non-mining/non-energy companies that listed between 1 January 2006 and 11 February 2008. While not large in number, the 30 companies spanned such sectors as biotech (e.g. Incitive Limited), VoIP and telephony services (e.g. My Net Fone Limited), pharmaceuticals (e.g. Vita Life Sciences Limited), health-care services (e.g. Capital Health Limited), food, beverage and tobacco (Oz Brewing Limited) and apparel (e.g. Costarella Design Limited). Incitive Limited is an example of an early-stage, non-mining company that successfully raised capital by a share market listing. In May 2006, Incitive raised $3 million at a market capitalisation of $8.2 million for the development of anti-inflammatory and immunosuppressant drugs. The company was incorporated in August 2005 and had raised an initial $1 million of seed capital and prior to the listing had $962 000 of net assets (mostly cash). The capital raising costs were $428 000, which is 14.3 per cent of the $3 million raised.

Difficulties with share market listings Despite the success of mining companies (and the occasional non-mining company), there are a number of reasons why the listing of a start-up

74  the venture capital spectrum

company on a stock market is very difficult. It is expensive for small companies to list on the ASX, so the first difficulty is cost. To produce a prospectus, a company needs a sponsoring broker, advisors, underwriters (the two examples provided were not underwritten, so underwriters are not always required), investigating accountants, independent experts and a solicitor. Under the prospectus requirements, these individuals, along with the directors and executive officers of the company, are generally liable for any misrepresentations or misinformation in the prospectus. Therefore they must all carry out extensive due diligence. All these advisors want fees, documents must be printed, and listing and share registry fees must be paid. Costs vary, but in our two examples the companies spent $272 000 (11.3 per cent of funds raised) and $478 000 (14.3 per cent of funds raised) to raise their capital. Fundraising fees are capital costs and cannot be written off in the year of fundraising. Besides the initial costs, publicly listed companies also face the ongoing costs of listing fees, stricter financial reporting requirements and continuous disclosure. Thus, while public listing is a tremendous achievement and is one of the important exit paths in venture capital, it should not be done lightly. For the effort and cost of the listing to be worthwhile, entrepreneurs should consider raising at least $5 million and have a clear use of proceeds to drive fast growth. Some of the key criteria for admission to the ASX are listed in Table 7.2. Table 7.2 Key ASX admission criteria ASX admission criteria Number of shareholders

Profit test

Asset test

Source: ASX website.

ASX general requirement Minimum 500 investors @ $2000 or Minimum 400 investors @ $2000 and 25 per cent held by unrelated parties $1 million net profit over past three years and $400 000 net profit over past twelve months or $2 million net tangible assets or $10 million market capitalisation

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Another difficulty is obtaining the required minimum number of shareholders under the listing rules. The Australian Securities Exchange requires that a listed company must have minimum spread of 500 shareholders, each holding a minimum parcel worth $2000. This represents a total of $1 million. You will need a broker with an extensive client base, and your investment opportunity must have strong prospects to attract the minimum shareholder numbers. Mining and energy companies meet this requirement by tapping the vast number of Australians who enjoy speculating on mining stocks. Institutions prefer not to support small capitalised companies if they have no earnings history. As a general rule, institutions prefer to invest in amounts greater than $1 million and have holdings less than 5 per cent of a company. This leads to a minimum capitalisation of $20 million, which is greater than the capital subscription of many start-ups. Another problem is the volatility in the share price caused by instability in the share register. The share prices of small companies tend to fluctuate more wildly than older, more established companies so you need to be prepared for this if you choose to raise funds from the listed public markets.

Public sector funding For entrepreneurs, one key to making a successful NTGF is to realise that a major source of seed and start-up funding is the public sector. In most OECD countries, the public sector provides seed finance to technologybased industries, and no doubt will continue to do so. A wide range of such programs are deployed in different countries. Common areas of focus are R&D grants and tax concessions, funded ‘public interest’ projects where intellectual property is subsequently transferred to industry (e.g. in the agriculture and defence sectors), early-stage investment incentives, assistance in funding market research and business planning and investment promotion. Governments have progressively placed more emphasis on support of high-growth potential companies and reduced their commitment to more generic SME programs. For political (‘equity’) reasons, governments have rarely announced this shift in emphasis or formally expressed the reasons. Nevertheless, the economic reasoning is sound. Since World War II, world trade has expanded significantly. The segments showing the highest rate of growth have been elaborately transformed manufactures, services, ICT and, more

76  the venture capital spectrum

recently, online business. The Espie Report noted as far back as 1983 (Australian Academy of Technological Sciences 1983) that it is not small companies that provide the growth in the elaborately transformed manufactures sector, but rapidly growing companies. Over the past ten years, Australia has seen a number of these manufacturing NTGFs emerge, such as Cochlear, ResMed and Vision Systems. Similarly, in the ICT, services and online sectors, we have seen the rapid emergence of Mincom, Integrated Research, Seek.com, Wotif.com, Look­ Smart, MYOB and many others. In other words, to establish a more favourable balance of trade, Australia does not need to promote small business across the board, but rather rapidly growing international businesses. If we define a rapidly growing business as one that doubles in turnover every year, then if the first year’s turnover is $1 million, the company’s cumulative sales over a five-year period will total $31 million. Let us assume research and development expenditure is 10 per cent of turnover and the R&D budget is split equally between new products and product enhancement. In addition, if the average product life-cycle is five years, then the initial R&D funding base for the first product will need to be of the order of $1.5 million—a large sum relative to the personal capital of most start-up entrepreneurs. This shift in the focus of public sector funding has created a substantially more favourable environment for entrepreneurs in Australia. There is now an excellent opportunity to raise significant seed funding from government sources. The number of grant programs provided by the federal and state governments is substantial. The principal channel for federal government assistance is AusIndustry (www.ausindustry.gov.au) and state governments also have programs in this area. The following programs in particular should be examined closely.

COMET Commercialising Emerging Technologies (COMET) is an Australian government program which since its inception in November 1999 has approved funding of over $78 million for some 1470 projects. COMETfunded grantees have raised capital of over $478 million. COMET is a ‘merit-based’ program designed to support early-stage growth companies, spin-offs and individuals in commercialising innovative products, processes and services. It assists successful applicants

seed and start-up capital  77 

by providing financial assistance and access to business advice through a COMET business advisor. COMET assistance is available for up to two years, and successful applicants are required to work with a COMET advisor to develop and implement an assistance plan through third-party service providers. This may involve: • management development—for example, skills development courses; • engagement of mentors; • strategic, business or export planning; • market research; • establishing market validity; • intellectual property strategy; • proving technology (including finalising working prototypes).

COMET financial assistance is available through a two-tiered funding structure. Tier 1 provides grants up to $64 000 (exclusive of GST) at 80 per cent of the eligible expenditure, while Tier 2 provides grants up to an additional $56 000 at 50 per cent of the eligible expenditure. Grants to individuals are available up to $5000 to develop commercialisation skills. Eligibility criteria include the innovation having commercial potential, 51 per cent of the applicant’s business being within Australia, the applicant owning the IP and the applicant company having less than five years’ trading history, with aggregate turnover less that $8 million or $5 million in any one year. The COMET advisor is also entitled to a success fee on the capital raising. Applicants are assessed against management capability to commercialise the innovation with appropriate COMET support, market opportunity and strategy, technical feasibility of the innovation and a demonstrated need for the COMET funding.

R&D Tax Concession This allows companies to deduct expenditure on R&D when lodging their tax return, as follows: • a general deduction of up to 125 per cent of expenditure on R&D; • an incremental (175 per cent premium) tax concession for companies increasing their R&D expenditure and which have a three-year history of registering and claiming the 125 per cent tax concession, or of receiving grants for R&D under Innovation Australia’s R&D Start and Commercial Ready programs;

78  the venture capital spectrum • an R&D tax offset for companies with group turnover under $5 million and a grouped expenditure of up to $1 million for the year; • an R&D incremental (175 per cent international premium) tax concession for companies belonging to a multinational enterprise group for additional R&D expenditure on behalf of a grouped foreign company above a rolling three-year average of expenditure.

Taxation of R&D is a highly specialised area, and specialist advice should be sought. The points above are generalisations and the underlying specific rules are quite complex.

Pre-seed funds Pre-seed funds invest in companies or projects and provide management and technical advice to universities to develop the commercial potential of Australian research. There are four pre-seed fund managers with tenyear licences: Allen & Buckeridge, GBS Venture Partners, SciVentures and Starfish Ventures. GBS Venture Partners are specialising in the life sciences and Allen & Buckeridge in information and communications technologies. SciVentures and Starfish Ventures are investing in a broad range of technologies. The program has over $100 million in capital, of which the Australian government is providing $72.7 million. As at 31 March 2008, the four funds had invested in 67 companies and projects. The maximum investment in any project or company is $1 million. The program encourages commercialisation of and private sector investment in research from universities and Australian government research agencies such as the CSIRO, Cooperative Research Centres and National ICT Australia (NICTA). Investee companies must be commercialising research and be controlled by a university, a public sector research agency or a qualifying researcher. Alternatively, they may be using intellectual property that is at least 50 per cent owned by a university, a public sector research agency or a qualifying researcher. They must be incorporated and operate substantially in Australia and must not have generated any sales revenue. In the case of projects, at least 50 per cent of a project’s intellectual property must be owned by a university, a public sector research agency or a qualifying researcher. It must also be controlled or supervised by a university, or a public sector research organisation, be undertaken in Australia and not have generated any sales revenue. To apply for the program, companies or researchers should approach the fund managers directly.

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Innovation investment funds The Innovation Investment Fund (IIF) program was announced in the May 1997 federal Budget. The program aims to create a self-sustaining Australian early-stage, technology-based venture capital market and to improve the commercialisation outcomes of Australian R&D. Specific objectives include developing early-stage fund management experience, addressing capital and management constraints and encouraging the development of new companies involved in commercialising R&D. The intention is that IIF will evolve into a ‘revolving’ or self-funding mechanism. IIF is administered by AusIndustry and currently comprises nine licensed funds. A further ten licences are expected to be awarded over the next five years. To 31 March 2008, 82 investee companies had received support under the program. Several of the original IIFs have invested all their capital. Most have gone on to become established venture capital managers, raising subsequent funds. Fund managers are appointed under a competitive application process, based on: • training and development of staff in early-stage venture capital investment; • the proposed size of the fund and level of management fees; • capacity and experience in early-stage equity investing; • experience with Australian and international investments, products, services and management; • qualifications and skills of the management team; • willingness to operate within the intent of the program.

Investee companies are required to directly approach the licensed fund managers, who make investment decisions in accordance with their own practices, based on the program’s eligibility criteria. An eligible investee under the program is a company that on the date of the initial investment: • is incorporated under the Corporations Act 2001 and has an Australian Business Number (ABN); • is at the seed, start-up or early expansion stage of its business development; • has a majority of its employees (by number) and assets (by value) inside Australia, or will use the whole of the initial investment within Australia; • has an average annual revenue over the previous two years of income that does not exceed $5 million per year;

80  the venture capital spectrum • is not an associate of a company that has average annual revenue, over the previous two years of income, in excess of $5 million per year.

Funds operate in the following manner: • Australian government funding is matched by private sector capital up to a maximum ratio of 2:1 for previous (Round 1 and 2) licensed funds and up to 1:1 for funds licensed via the current Round 3. The government’s commitment for Round 3 will not exceed $20 million per fund. • Investors in the fund must not be an investor in or be in a position to influence the individual investment decisions of the licensed fund manager. • All funds are for a period of ten years, with an option of an extra three years to allow realisation of investments in a prudent manner. • Under Round 3, no new investments can be made after the fifth anniversary of the fund. • Investments can only be in eligible early-stage companies that are commercialising Australian research and provide all goods and services through commercialising R&D activities to persons who are not associates. • Investee companies for Rounds 1 and 2 must not receive funds in excess of $4 million or 10 per cent of the fund’s initial capital, whichever is the smaller. For Round 3, an investee must not receive funds in excess of 20 per cent of the funds total committed capital.

The key principles for distribution of returns are that: • capital will be returned on a pro-rata basis to all investors plus interest at the long-term bond rate; • any further available distributions are to be divided between the Commonwealth (10 per cent) and other investors and the fund manager (90 per cent); • Distributions during the life of the fund are in the following order: – capital; – accumulated interest; – profit/carried interest.

Early stage venture capital limited partnerships Another Australian government initiative aimed at the venture capital sector is the Early Stage Venture Capital Limited Partnership (ESVCLP) program. It is aimed at stimulating early-stage investment in innovative companies and industries in Australia. The program is also aimed at developing a skilled pool of local venture capital investors. If the program

seed and start-up capital  81 

succeeds, entrepreneurs should find more venture capitalists coming on the scene, and hopefully larger sized funds. The program is aimed at fund managers considering raising a fund for early-stage venture capital investment. To qualify for registration, funds need to meet several criteria. In particular, the fund needs to have a business plan (yes, even venture capitalists have business plans!) clearly aimed at investing in the venture capital sector, have management expertise and access to capital. A venture capital fund registered as an ESVCLP will be entitled to flow-through income tax treatment and a complete tax exemption for income, both revenue and capital, received by its partners whether resident or non-resident. To qualify for registration as an ESVCLP, a fund must be a registered partnership with no more than $100 million in committed capital and must invest in businesses with total assets of no more than $50 million just before the investment. An ESVCLP must also divest itself of any holdings once the total assets of the investee exceed $250 million.

Pooled development funds The Pooled Development Funds (PDF) program closed to new applications on 21 June 2007 and has been superseded by the ESVCLP program. The program was first announced in the February 1992 Economic Statement as a new vehicle to replace the MIC program, which expired in June 1991. The scheme has been modified on several occasions. The PDFs that were approved under the program were given certain advantages: • Income of PDFs is taxed at 15 per cent. • Distributions of dividends from PDFs are tax exempt or carry franking credits. • Australian pension funds investing in a PDF will have any tax paid by the PDF proportionally rebated. • Capital gains on the disposal of PDF shares will be tax exempt.

In return for the above-mentioned special treatment, the PDFs have to comply with a number of criteria. In general, the PDFs: • must be companies; • may only invest in newly issued shares in companies having total assets less than $50 million; • may not invest more than 30 per cent of committed capital in any one business; • may not take up less than 10 per cent of each investee;

82  the venture capital spectrum • may not invest in retailing operations or real estate other than tourism projects or industrial buildings used in a manufacturing project; • may not have a shareholder with greater than 30 per cent shareholding unless that shareholder is a bank or life insurance company; and • must invest 65 per cent of funds raised within five years.

PDFs have been used as a mechanism for investing in small listed equities, mainly in the resources area. However, a number of venture capital fund managers have used the PDF structure for some of their managed funds. The most popular structure is as a listed retail fund, but the unlisted institutional fund has gained popularity in recent years. The AusIndustry website (www.ausindustry.gov.au) provides a list of registered PDFs that entrepreneurs can contact about funding.

Clean Business Australia In the 2008 Budget, several new programs were introduced with a focus on the environmental sector. Clean Business Australia has three main components: Climate Ready, Green Buildings and Retooling for Climate Change. With funding of $240 million allocated, AusIndustry is the first point of contact for details. • Climate Ready is a program designed to support the development and commercialisation of environmental technologies. Grants of between $50 000 and $5 million are available on a 1:1 matching basis. Eligible activities are research and development, proof of concept development and advisory services to small business on commercialisation. This program has $75 million allocated over four years. • Green Buildings supports activities to improve the energy efficiency of existing buildings. Fifty per cent of eligible project costs are provided up to a maximum of $200 000. This program has $90 million allocated over four years. Entrepreneurs in the clean tech sector may find this of particular interest, as it essentially provides subsidies to a potentially lucrative target customer segment. • Retooling for Climate Change provides funding of $10 000 to $500 000 for improvement of production processes to the following: – Creative Industries Innovation Centre; – Clean Energy Innovation Centre; – Innovative Regions Centre (based in Geelong); – Mining Technology Innovation Centre (Mackay); and – Remote Enterprise Centre (Alice Springs).

seed and start-up capital  83  Services will include: – a review of business activities and support available; – ongoing support and mentoring; – linking firms with the best knowledge and research available; – assistance with problem-solving; – assistance in accessing other government programs; – provision of industry intelligence, workshops and networking activities.

Business Advisory Centres Thirty-six centres have been created to provide advice in suburban and rural areas on access to government programs and training. This program has had $42 million allocated over four years.

Getting help There are a wide range of business assistance programs available to Australian NTGFs, estimated at over 500. Accessing the right ones can be quite a daunting task. Accordingly, the federal and state governments have a single entry point for government assistance programs and services in Australia, called AusIndustry (www.ausindustry.gov.au). On that site is a summary of federal programs relevant to early-stage fundraising. While we have covered the most relevant current programs, there is regular change and the Cutler innovation review which was handed down in September 2008 to the federal government is expected to result in further changes. AusIndustry is the right agency to contact for gaining an update of the situation.

State government agencies It is also wise to consult with your local state Department of Industry. They typically have programs designed to complement AusIndustry and address specific needs in their state. For example, the New South Wales Department of State and Regional Development has an Innovation Advisory Service, which provides free commercialisation advice to companies and low-cost access to market ‘desk’ research resources. This is provided by externally contracted specialists. It has also established a mentoring program called Stepping Up, where in a workshop environment companies are given feedback on their ventures by consultants. Another program, the NSW Enterprise Workshop, which has been running for 25 years, provides access to $10 000 in fees (in some

84  the venture capital spectrum

instances subsidised) for 65 hours of face-to-face coaching of a management team through the process of developing and presenting a business plan. In Victoria, VicStart (believed to be winding down) provides advice and training for entrepreneurs in technology commercialisation and ­fundraising, including internships with venture capitalists. It also provides links to research centres and companies to facilitate technology transfer. InnoVic, which also houses IP Australia and Information City, provides advice, referrals and information. Opening Doors for Export provides up to 50 per cent of certain exporting costs—for example, attendance at trade missions and fairs. Grow Your Business provides grants up to $10 000 for construction of business and market plans while the Regional Business Investment Ready Program provides workshops on business planning and capital raising for companies in rural areas. A Business Loan Finder on the Industry Department’s website provides links to banks and venture capital firms.

Consultants There are many consultants who specialise in raising money from government bodies for early-stage companies. These typically operate on a retainer plus success fee or, in rare instances, success-only basis. Typical success fees, depending on the funds raised, are between 2 and 6 per cent. Consultants can be most useful providing they are wired into the network. The only way to find out about this is to establish their track record. The good consultant should be able to screen your proposal and provide realistic counsel on the potential for fundraising. Second, the consultant should have good lobbying contacts and be able to advise on the preparation of grant applications. Your local AusIndustry office should be able to supply a register of suitable consultants.

Private sector institutional funding While the IIF, Pre-Seed and other programs provide a mixture of public and private equity, a number of private venture capital companies provide early-stage funding. Some venture capital funds are totally dedicated to early-stage funding, while others allocate part of their committed capital. Success on raising funds depends as much on exogenous factors as indigenous ones. Key issues such as how well the company performs to

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its business plan, its product competitiveness and its perceived intangible value will all determine funding availability. However, exogenous factors such as the condition of the overall economy, desire of a given source of funds to be in a particular sector, and the current health of the financial community are equally important. For example, up to March 2000 an internet-based business plan was very attractive to venture capitalists. Six months later, the prefix e- or the suffix .com would be enough to kill a transaction. Today, clean technologies are attracting substantial investor interest worldwide. Every venture capital fund will have its own specific criteria as to stage, industry and geographic location of the business. Nearly all have specific preferences as to the way they like to receive opportunities. Entrepreneurs should do their homework and visit the websites of the venture capitalists and identify those whose criteria meet their company’s profile. If at all possible, find a person who knows the venture capitalist personally and engage them to make an introduction for you. Venture capitalists are investing in you as much as they are in the company, so you need to demonstrate that you do your homework and that you value other people’s time. There are two very useful sources for listings of early-stage venture capital investors. You should look to the Australian Private Equity and Venture Capital Association (www.avcal.com.au), which at March 2008 listed 30 early-stage fund managers in its Member Directory. You should also obtain the most recent edition of The Australian Venture Capital Guide (The Guide). The Guide is published by Private Equity Media, which also publishes the very informative monthly Australian Venture Capital Journal (see www.privateequitymedia.com.au).

Legal considerations There are some legal matters to consider when raising equity capital, and entrepreneurs should be careful not to break the law when seeking equity funds. Consequently, we strongly urge entrepreneurs and investors to engage reputable legal and tax advisors. Under the Corporations Law, generally speaking a prospectus must be registered unless there is a relevant exception. This is not the place to list all the exceptions contained in the Corporations Law (refer to Chapter 6D of the Corporations Act for the details) but some the key ones for entrepreneurs are:

86  the venture capital spectrum • an offer of at least $500 000 per investor; or • an offer to an investor controlling net assets of at least $10 million; • an offer to executive officers, their immediate relatives and family companies; • offers made through a financial services licensee (licensees need to follow a few rules for this exemption to apply, however); • an offer made to no more than 20 persons in the previous twelve months totalling no more than $2 million.

These exemptions make it unlikely that any entrepreneur who wishes to follow the entrepreneur/venture capital game (see Chapter 6) need worry about having to register a prospectus. Still, entrepreneurs should confirm with their legal counsel that their funding approach will fall within one of the Corporations Law exemptions. On the other hand, any entrepreneur should still follow the main precept of all prospectuses now being issued. The Corporations Law section 710(1) sets out the general rules for prospectus disclosure. In simple terms, all prospectuses must contain all the information that investors and professional advisors would reasonably require to make an informed assessment of: • the rights and liabilities attaching to the securities offered; • the assets and liabilities, financial position and performance, profits and losses and prospects of the entity.

Thus entrepreneurs can form a company, prepare a business plan, and go out and seek money from private investors and venture capital companies. Provided they comply with the exemptions and requirements of the Corporations Law, they can do this without fear of legal retribution. We do urge you to seek legal advice prior to launching your capital raising!

Conclusion Close to $490 million of government funding was spent on R&D during 2005–06, according to the Australian Bureau of Statistics. More than $10 billion was spent on R&D across Australia when corporate spending is included. The total investment in pre-seed, seed and start-up stage businesses commercialising R&D was only $130 million for the same period, according to the Australian Bureau of Statistics. Early-stage investment in commercialisation represented just 26 per cent of total government-funded

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R&D (and only about 1.3 per cent of total Australian R&D spending). Professor Gordon Murray, perhaps Europe’s leading academic expert in venture capital, defined this imbalance in funding as the ‘hourglass’ effect. A large amount of funded R&D was not able to be commercialised because it was squeezed by the lack of early-stage funding. The IIF and Pre-Seed Fund programs have made a substantial difference to this funding bottleneck. Even so, the providers of early-stage capital regard their biggest problem as finding high-quality management teams with suitable investment opportunities. Part III describes how to access this stock of seed and start-up capital, but in the next chapter we consider the sources of expansion-stage financing.

8

Expansion capital

In this chapter, we examine the significant sources of expansion finance. Expansion finance is the generic term for larger second-stage companies and development financing. A second-stage company is one making sales and losses; expansion financing in this case refers to companies with annual revenues greater than $5 million. Development financing is provided to a company making sales and profits. Again, funding is available from many sources. According to the 2006–07 Australian Bureau of Statistics venture capital survey, $509 million of new investment went into expansion capital, representing approximately 83 per cent of non-buy-out private capital. This chapter adopts the same format as Chapter 7, discussing public sector funding first, followed by private sector funding.

Public sector funding Public sector funding for expansion-stage businesses is predominantly in the form of government grants, government-supported technology parks, business incubators and business enterprise centres, and pooled development funds.

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Export market development grants One of the most popular sources of federal funding for expansion capital is the Export Market Development Grants (EMDG) scheme, which is operated by Austrade (www.austrade.gov.au). Using the EMDG, companies recoup expenditure made to promote exports. The scheme targets small and medium-sized exporting companies, and reimburses up to 50 per cent of expenses incurred on eligible activities, above a $15 000 threshold. Up to seven annual claims can be made by eligible applicants. To access the scheme for the first time, businesses need to have spent $15 000 over two years on eligible export marketing expenses, have income of not more than $30 million in the grant year and have incurred at least $15 000 of eligible export expenses (first-time applicants can combine two years’ expenses). Eligible expenditure activities include: • overseas representation, up to $200 000 per application; • marketing consultant fees up to $50 000; • marketing travel costs, including a per diem of $300 per day; • communications expenses (mobile, fax, email, etc.); • free samples provided; • trade fairs, seminars and in-store promotions; • promotional literature and advertising (like brochures, videos, DVDs or website development); • the cost of bringing potential buyers to Australia, up to a maximum of $7500 per buyer per visit and a maximum of $45 000 per application.

The scheme is widely used by exporting small businesses. One example is GroundProbe, a Brisbane-based developer of technologies for the mining and civil infrastructure industries. Its Slope Stability Radar is used for stability monitoring of open-cut mine walls. GroundProbe received three EMDG grants which helped support representatives in Chile, market and site visits, attendance at trade shows and provision of advertising material to prospective customers. Austrade also helped set up meetings with prospects and clients and provided local knowledge, translation and recruitment support during the establishment of one of its international subsidiaries. GroundProbe now exports to South Africa, Botswana, Tanzania, Canada, the United States, Chile and Peru, and is expanding further into North America and India. Because of the small size of the Australian market, many rapidly growing companies should plan to have export sales. The term ‘Born

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Global’ has been applied to companies that plan to export even at their formation stage. The EMDG scheme is a useful source of funds for such companies. What the entrepreneur should do is carefully time the first expenditure to ensure maximum recoupment. The maximum expenditure which can be recouped in the first year is $200 000. Usually, a US office will cost about $500 000 to set up and it will take about a year before sales start. Hence, as the Australian financial year runs from the beginning of July to the end of June, it makes sense to begin operations midway through the financial year. The enterprise should then be able to recoup start-up costs over two fiscal years.

State-run venture capital firms Most of the state governments, while enthusiastic supporters of having venture capitalists in their state, withdrew many years ago from having state-run venture capital firms. The massive writeoffs during the late 1980s of the Victorian Economic Development Corporation and the West Australian Development Corporation have probably ensured that state public sector involvement in terms of venture capital investment will be restrained.

Technology parks, incubators and business enterprise centres Technology parks are another state government initiative. Also available are incubators which usually have a combination of state, federal and local funding (some are privately run). Incubators and technology parks do not provide funding directly; however, they often have connections with venture capitalists and angel investors so they can help indirectly in this area. What technology parks and incubators offer are premises, infrastructure, advice and other support, usually at below market cost. They also offer the benefit of clustering developing companies together which allows entrepreneurs and their teams to network with other business builders. You will find technology parks and incubators in most Australian states and territories. In Western Australia, the Technology Park Bentley Precinct claims to house over 100 businesses with more than 2700 employees. In Victoria you will find the La Trobe University Research and Development Park as well as the Ballarat Technology Park. Queensland has the Brisbane Technology Park as well as i-Lab near Brisbane and the Sunshine Coast Innovation Centre. In New South Wales, there is the

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Australian Technology Park and the Macquarie University Research Park in Sydney. Tasmania has the Tasmanian TechnoPark in Hobart while South Australia has the well-known Adelaide University Research Park. The Australian Capital Territory has the Canberra Technology Park and in the Northern Territory, a desert knowledge precinct is to be developed. This is just a small sample of the technology parks and incubators available in Australia. An internet search on Australian technology parks and Australian business incubators will help you find the nearest and most appropriate park for your needs. Technology Parks and Incubators Australia Limited, the ‘industry body’ for technology parks in Australia, is a good source of information. Business Innovation and Incubation Australia, an association of business incubators in Australia, lists more than 60 incubators and technology parks. In addition to technology parks and incubators, it is also worth enlisting the support of your local business enterprise centre (BEC). BECs are a national network of local non-profit organisations that aim to grow businesses and foster local economic development. The BECs offer advice, mentoring, networking and training opportunities. Many BEC services are free, but some have nominal charges. Any early-stage business is well advised to speak with their local BEC office. For more information and to find your nearest BEC, go to www.beca.org.au.

National Australia Bank microenterprise loans National Australia Bank offers special microenterprise loans of $500 to $20 000 to eligible applicants. These are not large sums but the funding can certainly help an entrepreneur make a start. The NAB loans are to help people on low incomes build businesses and are for businesses with five or fewer employees. The loan applicant, rather than the business, is liable for repayment of the loan, so these are personal loans. The loans are generally for a three-year period at a fixed interest rate and have a 90 day interest-free period. Visit NAB’s website for details and application forms. There are four options under the NAB’s Microenterprise Loan Program: • Enterprise Start is for businesses involved in business enterprise centres (the business must have been operating for six months to be eligible). • Enterprise Plus aims to support businesses that have taken part in the Australian government’s New Enterprise Incentive Scheme (NEIS). NEIS helps eligible unemployed people start and run new, viable businesses.

92  the venture capital spectrum • Young Entrepreneurs is for Australians between eighteen and 29 years of age who wish to start a business. • Incubation Connect is for businesses involved with small business incubators who are members of Business Innovation and Incubators Australia (the business must have been operating for six months to be eligible).

International experience with technology parks In the United States, sociologists have observed that the two largest hightechnology clusters are next to universities. Silicon Valley is between Stanford and the University of California; Route 128 circumscribes Harvard and Massachusetts Institute of Technology. One may debate the causality in this correlation, but the correlation alone was seen as a justification for technology parks. However, while universities may act as a provider of skilled labour, their proximity is not the only factor in a successful technology park. There is also a danger of regarding all universities as the same. Most people would include the four American institutions named in any top ten list (it is doubtful that one could name another group with as many Nobel Prize winners). In addition, the four are all richly endowed and have a long tradition of funding prototypes. HewlettPackard, DEC and Wang are all examples of companies whose first sales came from producing prototypes for universities. Silicon Valley and Route 128 also have other significant advantages. Boston and San Francisco are significant financial centres; both cities would have larger venture capital funding bases than either Sydney or Melbourne. Both areas have access to inexpensive labour—Silicon Valley has Mexican immigrants while New England had a large pool of unemployed from the closure of the original New England textile factories. The history of technology parks overseas has in fact been mixed. In the 1980s, the Japanese agency MITI and local governments actively supported the creation of a number of ‘technopolises’, or science parks. The idea was that they would promote the advancement of high-tech industries and provide employment possibilities for young graduates. They would help shift the competitive base of Japanese industry from its previous world-class position for ‘incremental’ innovation and ‘Just in Time’ manufacturing techniques to a new competitive paradigm based on a higher level of domestic invention. The policy was developed against the backdrop of the post oil-crisis Japanese depression of the 1970s. The prolonged domestic depression, globalisation of the Japanese economy and stagnation of private company

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investment all contributed to its failure. The Technopolis Act was terminated in 1998, and the program discontinued. The government developed new policies with a focus on promoting venture business and links between industries and universities. There was an attempt in the 1980s to transfer the ‘technopolis’ model to Australia in the form of the ‘multifunctionpolis’. The first site was to be in Queensland, with lifestyle advantages (access to good beaches and golf courses) to enhance its appeal to world-class researchers. It became the subject of interstate bidding contests and was eventually located in South Australia and never reached the scale originally envisaged. Other ‘technopolis’ type examples in the APAC region include Hsinchu City in Taiwan, and Malaysia’s multi-media corridor, also considered to have had only mixed success. The model has evolved significantly in recent years and a wide range of technology parks and incubators are now listed on the website of Technology Parks and Incubators Australia. There is no doubt that many contribute significantly to the business incubation process and can list successful incubation and growth acceleration stories. The entrepreneur is advised to approach them like any investor or business partner—in other words, look carefully at their track record in commercialisation of similar businesses and evaluate the specific value of the support resources they bring to your business.

Private sector funding Private sector funding consists primarily of debt and equity capital. The most obvious sources of debt funding are the trading banks and finance companies which, provided they have security, will generally lend. Other sources of expansion capital include venture capital funds investing in early- and late expansion-stage businesses, corporate or ‘strategic’ investors and the Australian Small Scale Offerings Board. Another new source of expansion capital, due to launch soon after writing, is the Asia Pacific Technology Exchange, located in the proposed Pacific Technology Corridor between Macquarie University and North Sydney. This will operate like the NASDAQ in the United States for technology-based businesses. The National Stock Exchange (NSX) is also a potential source of capital and has less onerous listing requirements versus the ASX. In an interesting example for the NSX, over 300 local people from the town of Inglewood in Victoria (north of Bendigo) banded together to invest more than $500 000

94  the venture capital spectrum

to buy their local branch of the Bendigo and Adelaide Bank in June 2007. The company that was used to buy the branch was scheduled to list on the NSX in June 2008. Entrepreneurs whose companies have strong local profiles may be able to tap the local community for expansion capital either privately (within the bounds of the Corporations Law) or possibly via a listing on the NSX.

Corporate investors Corporate or ‘strategic’ investors from the same industry as the entrepreneur are a significant alternative source of expansion funds. While typically most active in this stage or at exit, some are also active in seed and start-up funding. Some, like Intel, have established dedicated venture financing operations. Typically, these investors are looking to flesh out the product or services range of their existing business and they invest off balance sheet. The amounts can be significant, ranging from $2 million to $200 million plus at this stage of the venture’s growth. The advantages of working with corporate investors are their market reach, knowledge of the industry, ability to provide follow-on capital and complementary resources (e.g. products or marketing budget) and their ability to fill out human resource gaps. Disadvantages can include the significant time investment required to negotiate the deal then be visible inside the investor, the potential for loss of control over strategic direction and bureaucracy. Entrepreneurs should be very careful to research prospective corporate investors beforehand to assess how much value is likely to be added, culture fit, track record investing in or partnering with other young companies, and so on. It is worth talking to prior SME suppliers, partners and investors before making the approach. Entrepreneurs should be aware that, while corporate investors can be a potential acquirer of 100 per cent of the company, thus providing an exit path as well as funding, corporate investors can also stand in the way of an exit, possibly vetoing a lucrative offer from a competing corporate. You should seek legal and business advice if you are contemplating funds from corporate investors.

The Australian Small Scale Offerings Board (ASSOB) The ASSOB has its origins back in the early 1980s when the founder, Tony Puls, lobbied the then Corporate Affairs Commission to create a market

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for small companies to raise capital. Its current form was established in 1997, when he secured a Class Order under section 708 of the Corporations Act and developed the current website and systems in 2005. ASSOB’s mission is to assist small and medium-sized companies to raise capital without the need for disclosure or expensive legal and accounting advice. The investment stage is generally early expansion with most of the companies trading one or two years and having some developed products, some customers and sales (although most businesses raising capital tend to have less than $1 million of revenue). The ASSOB is a matching service operating under CO 02/273 to section 708 of the Corporations Act 2001 that, among other things, allows: • people who subscribe to the company’s website to be deemed to be ‘persons interested in offers of this kind’ and therefore can view offers without full disclosure; and • companies to raise $5 million per annum (rather than just $2 million under section 708).

Companies raising capital via the ASSOB also do not have to provide two years’ audited financial statements. The class order has benefits that position the ASSOB favourably to develop an extensive investor basis, while reducing the legal and compliance obligations for companies raising capital. According to the ASSOB, at April 2008 there were 65 companies with offers ‘listed’ on the board. They quote an impressive success rate on capital raisings with 50 per cent of companies joining the board raising their full targeted first round within 90 days and 77 per cent of companies raise at least some money within 90 days. The ASSOB works much like the venture capital game. You go to an ASSOB nominated advisor (contact ASSOB for the advisor nearest to you) and make an initial application (the cost is $495). The initial application screening criteria are stringent. Your company must have a board of directors and management with experience and depth in your industry. The board and management must have prior track records of success in business and they must have some of their own money invested in the company. Your business model is carefully vetted. Background checks, including credit checks, are conducted on the board and management. If the application is accepted, you work with your ASSOB-nominated advisor and they assist you to put together a detailed Offer Document including information about your business and assist you to raise capital.

96  the venture capital spectrum

It generally takes about four to six weeks from application to listing on the ASSOB. Companies listing on the ASSOB follow a consistent valuation methodology that includes discounted cash flows, comparables and the last transaction between a willing seller and a willing buyer. During the preparation process, the funding need, key achievement milestones and valuation are set for three rounds of funding on the ASSOB. Generally, the first round of capital is about $200 000 to $300 000 and comes predominantly from ‘personal offers’ to people who are related to the company and who know about the business—for example, clients, consultants, suppliers, people related to the directors. These people don’t require much education about the business, the industry or the principals and management, and are therefore already interested in a personal offer of investment. The ASSOB-nominated advisor helps you raise the two subsequent rounds, if further funds are required, as well (typically $700 000 to $1 million for Round 2 and $2 million to $3 million for Round 3), at the predetermined valuations. Each round is done at a higher valuation than the preceding round (due to the meeting of milestones, increasing profitability and decreasing risk of the business). These subsequent rounds generally begin to attract more ‘outside’ investors as the company gains a track record. The ASSOB advisor monitors your progress against agreed milestones and helps you prepare for your eventual ‘exit’ from the ASSOB, by trade sale, IPO or share buyback. Companies listed on the ASSOB are required to file quarterly reports on their progress, which also adds to business discipline. Your ASSOB advisor provides coaching, guidance and support in terms of packaging and advertising your offer. In addition, your offer is promoted through ASSOB’s channels, which include a monthly newsletter, investment expos and state events. The advisor also provides assistance with investor meetings and negotiations. The ASSOB has become a viable source of funding for small businesses at the expansion stage of development. Its advantages are significant, and its governance, risk and compliance requirements are much more relaxed than a share market listing. The ASSOB provides guidance and support to your business to further develop your corporate governance in preparation for a future share market listing, trade sale or private equity transaction. Exits are facilitated by the ASSOB’s Start Securities Group of companies. ASSOB-nominated advisors are trained and licensed. The cost of engaging an ASSOB advisor is approximately $9500 (half is payable on

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signing with the ASSOB and half when the offer document, strategic growth plan and advertising copy are completed) plus a 9.9 per cent commission on funds raised (both figures include GST) for capital raisings of less than $2 million. These fees do not include any legal or accounting advice that you might need. The fees are charged per round of funding and applicants must sign a three-year agreement with the ASSOB and the nominated advisor. For rounds of more than $2 million (usually Round 3), the success fee is 6.6 per cent (including GST). In addition to the primary issues board described above, the ASSOB has a secondary issues board. Your investors can list their shares on the secondary board and have the potential to sell/transfer their shares with other ASSOB secondary board participants, although sales are still small. As an aside, any unlisted company can apply to list its shares on the ASSOB secondary board, creating a potential market for the shares in unlisted firms. The ASSOB is also establishing an early-stage fund (Start Innovation Fund) to invest in seed and start-up businesses to develop Australian innovation with a triple bottom line focus. Also on the agenda will be a service to match executives to ASSOB members who need management and directors willing to work solely for sweat equity. If you are thinking of the ASSOB, visit www.assob.com.au. You should also talk to a sample of people who have listed on the ASSOB (beyond those listed on the website’s success stories) to get a good understanding of the process, its benefits and its costs.

Proposed Asia–Pacific Technology Exchange The Exchange, planned to be launched in the second half of 2008, will focus on technology-based companies with high growth potential. While a number of companies have indicated readiness to list from the information technology, medical, bioscience and sustainability sectors, it will be sector agnostic. The idea has emerged from the New South Wales government’s 2030 Sydney metropolitan strategy. It has attracted support from the federal government, some significant research bodies, VC firms and consulting firms working in the commercialisation field. It has also received media interest in the Asia–Pacific (APAC) region—for example, in Singapore and India—where it is seen as a potentially attractive alternative to NASDAQ or AIM.

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The Exchange’s method of operation is to be confirmed, but is likely to involve listing requirements similar to the ASX and an evaluation of fit with its target market. Assessment criteria may include proprietary technology, scalability and export potential in the APAC region.

Debtor finance The use of debtors as security for a bank loan is growing in popularity. This is an excellent source of working capital and is commonly available from banks and finance companies. There are different forms of debtor financing, and today most leave the ownership and collection of the invoices to the borrower, so the borrower remains in complete control of its customer relationships. Provided the business has a strong customer base, it is possible to borrow up to 85 per cent of the value of the debtors ledger. Any amounts over 90 days past due are not eligible as security. Generally, debtor finance will be available to companies with $100 000 turnover and upwards, provided there is a sound operating history. An example of the use of debtor finance will help to illustrate its benefits. A fast growing importer and manufacturer of sporting goods wanted to offer its customers credit terms longer than the usual 30 days. With the help of an advisor, the company was able to find an institution to lend 85 cents for every dollar of the company’s debtor book. The strategy worked very well with strong customer takeup of the extended credit terms, resulting in a doubling of sales revenue. The debtor finance facility funded 85 per cent of the working capital requirement. The balance of the working capital was provided by the shareholders.

Inventory or Purchase Order Finance Inventory or purchase order finance is also available as a source of working capital funding. Whereas debtor finance helps bring forward the collection of cash from customers, with inventory finance lenders advance funding for stock that has not yet been sold to customers. It is an expensive but sound source of funding for expansion-stage companies that are profitable and growing. Generally, lenders will require a three-year sound operating history and a gross profit of at least 20 per cent. In substance, these lenders take a percentage of the company’s gross profit in exchange for making the loan. For example, a company’s current working capital financing can sustain $3 million of sales per annum and the company has a gross profit margin

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of 40 per cent. Assume the company has demand for another $1 million of sales from customers but cannot finance the stock. The company could look to inventory finance to fund its additional working capital need to meet the $1 million of additional sales demand. The cost of the money might mean a reduced gross margin of 35 per cent on the incremental sales rather than 40 per cent but for some companies, sacrificing some gross margin is worthwhile given the potential increase in sales revenue. Also, clever entrepreneurs may be able to leverage their increased inventory purchases to negotiate volume discounts from suppliers, freight companies, enabling them to partly offset the high cost of the finance. There are several providers of inventory finance in Australia but Provident Cashflow is probably the largest.

Why security and guarantees? Sometimes entrepreneurs complain when seeking funding from banks or finance companies because they must provide either security or guarantees. They ask why security is necessary when the banks have so much money. They forget that, while the banks do have money, it is nearly all in the form of deposits; only a small part of the total assets of a bank is equity. Surprising as it may seem, most banks and finance companies are equity short. Indeed, one reason why the banks are on lower price earnings multiples compared with most other industrial companies is the threat of recurrent rights issues. For example, banks make most of their profit on the interest spread between the funds they borrow and the funds they lend less administration costs. The actual profit on total assets is less than 1 per cent, so retained earnings build up slowly. The regulatory authorities require every $100 of deposits to be supported by a specific amount of equity. A common prudential ratio for a bank is $1 of equity to support $12.50 of debt. The banks not only suffer a loss of equity by writing off a bad debt, but they also have to suffer an opportunity cost by having to reduce debt levels by $12.50 for each $1 of bad debt. Consequently, banks usually adopt a policy of equity maintenance by undertaking few, if any, venture capital investments. Sometimes, as happened in the late 1980s when the Australian government ran a lax monetary policy and allowed explosive credit growth, this policy is ignored. Then the bad debt writeoffs become significant when the ­bubble bursts.

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Suppliers’ credit Apart from the banks, another source of ‘debt funding’ is suppliers’ credit. Retailers and wholesalers have known this for years and many a business has funded itself by stretching out payments to suppliers and obtaining cash from customers. Overseas suppliers, especially those trying to build market share, are often able to offer generous payment terms. These terms are often available because of a loan guarantee supplied by a government trying to encourage exports or by a government body set up to encourage exports. However, while debt funding and creditors are important components of the financing of any company, fast-growth entrepreneurs need to use venture capital as there will invariably be a funding gap that working capital finance cannot fill. Fortunately, over the past ten years the venture capital industry has shown strong growth.

Conclusion The capital available for expansion-stage companies is significantly greater than for the seed and start-up stages. Sources include venture capital, debtor finance, inventory finance, suppliers’ credit and government grants. To attract funding, expansion-stage enterprises must follow similar rules and ensure their companies stand up to strict due diligence. This requires a talented management team, a strong track record, protected intellectual property and a sound business plan.

9

Funding for management buyouts

We have now examined two of the three major types of private equity and venture capital funding. Seed and start-up venture capital is funding for companies that have neither sales nor profits. Expansion venture capital is funding for companies that have sales but whose profits can grow significantly. The third major type is for those companies with stable sales, profits and cash flows, and which are targets for a buyout. Buyouts have become increasingly common in Australia as managers have seen the benefits of obtaining a meaningful equity stake in a mature business and vendors have seen the value of buyouts as an exit path. Financial investors—either private or institutional—are usually involved in buyouts, although employee buyouts funded by vendor finance and employee share ownership plans are also possible. The institutional private equity investors are nearly always involved in complex deals that require large amounts of capital. There are three classes of buyouts: small, mid-market and mega. There is also a separate specialist class of private equity transaction called the turnaround. With $8.3 billion of private equity raised for late stage deals, mainly leveraged buyouts, each of these presents opportunities for entrepreneurs to lead a syndicate to take over an existing business, sponsored by a private equity firm or consortium of firms.

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Buyouts by size Mega buyouts have received considerable media coverage in the past few years in Australia. The $1.4 billion Myer department store takeover and the $1.8 billion takeover of Brambles waste management (Clean­away) and industrial services businesses are two transactions that made headlines. Also in the news was the attempted private equity takeover of Qantas. Mega buyouts are large deals (billions of dollars) with high leverage. Mega buyout transactions are usually completed at high valuation multiples because it is typically a very competitive process to acquire large companies (often listed companies are targeted). High valuation multiples mean high prices, and that is where the availability of debt is a key determinant to a successful acquisition. The credit crunch of 2007 and 2008 has made debt much more difficult to source, and caused risk premiums and interest rates to increase significantly, temporarily making mega buyouts more difficult to complete—though not impossible. When credit markets return to more normal behaviour, mega buyouts will again be fairly common. One of the better known Australian players in the mega buyout market is Pacific Equity Partners (PEP), with more than $6 billion of available capital. As evidence that mega deals can still be done in tighter credit markets, in May 2008 PEP completed a $1 billion acquisition of American Transfer & Trust Co., which it intends to merge with Sydneybased Link Market Services Ltd. This acquisition of a US company shows the growing international reach of Australian buyout firms. Mid-market buyouts, still large in that they are usually in the hundreds of millions of dollars, are much more common but often go unnoticed as the media do not usually cover these transactions. Mid-market deals are also highly leveraged but usually less aggressively geared than the mega buyouts. An example of a large mid-market player is Quadrant Private Equity, which has a $500 million fund for equity investment into buyouts. Smaller buyouts of companies with at least $2 million of earnings before interest, tax, depreciation and amortisation (EBITDA) are slightly less common but becoming more so. A number of funds now focus on smaller and smaller mid-market buyouts, including ANZ Capital, Hawkesbridge and Advent. There are even some private investors backing mini-buyouts in companies with greater than $1 million of EBITDA. There is far less capital available for these very small transactions.

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Basic structure of buyouts The basic financial structure is similar for all leveraged buyouts. The cash flow of a target company is used to service and repay debt secured by the assets of the company. Debt-to-equity ratios of 4:1 are common for large buyouts compared with the financial norm of 1:1. Smaller buyouts are more likely to be geared 2:1. When the current management organises the purchase of the business from the owners with the backing of a private equity sponsor, the transaction is called a management buyout (MBO). One of the most famous and successful MBOs was Kerry ­Packer’s purchase in 1983, for $350 million, of the 50 per cent of Australian Consolidated Press his family did not control. If the LBO acquirer also provides the management, the transaction is sometimes described as a management buy-in or MBI. Also possible, but less common, are partial buyouts in which owners partially sell down their equity but retain some ownership after the transaction.

Benefits to vendors Vendors typically sell businesses to management for a number of reasons. One is to shed a non-core activity. Another is if the vendor is under financial pressures (restructuring and turnaround situations). A third reason is if the vendor wants to rearrange the assets in a portfolio of businesses that the vendor may hold. Very often, owners of mid-market companies nearing retirement age favour a sale to the employees over an IPO or a trade sale to a large firm. The sale to the staff usually retains the brand that the owners had invested years to build. In a trade sale to a large firm, those brands ­usually disappear, and sometimes many of the employees are made redundant. The IPO route carries significant costs and compliance requirements and does not usually allow the owners to sell down 100 per cent of their shares. The MBO offers the advantages of speed and confidentiality, the retention of special relationships (particularly the management with key clients and suppliers), and the positive public relations that may occur.

Benefits to management Management participates in a buyout for several reasons, such as gaining control over its destiny and achieving ultimate strategic responsibility

104  the venture capital spectrum

for the business. While both these are personally satisfying, the other key reason is gaining wealth through ownership. For many managers, it is the only opportunity they will have to make serious money, defined as millions of dollars.

Analysing a buyout Unlike early-stage investments where venture capitalists prefer businesses with global market opportunities, buyouts are possible for companies with strong domestic markets, solid profits and stable cash flow. Entrepreneurs interested in buyouts must not apply the debt and valuation multiples of the mega buyouts reported in the media to smaller buyouts. Multiples paid for smaller buyouts have been in the range of three to five times historical earnings before interest, tax, depreciation and amortisation. Multiples of five to six times historical EBITDA are the typical maximum and are reserved only for those companies with larger EBITDA, clear leadership positions in their market niche and outstanding prospects for fast growth. Generally, the smaller the company and the greater the difficulty of raising debt, the lower the price multiple and the greater the importance of the potential to grow the business rapidly. Managers and business owners interested in buyouts must understand the concept of enterprise value (EV). This is best explained by way of example. If a company has $3 million of EBITDA and is available for sale at a multiple of four times EBITDA, then the EV of the business is $12 million. EV is the value of the business, not the value of the equity. If we assume the company has $2 million of bank debt (net of the cash in the bank account), then the equity value is $10 million (EV minus the outstanding debt). Buyouts of companies that are already highly geared are difficult because the current owners have very little equity in the business. If we assumed the company had $9 million of debt rather than $2 million, the equity value would be just $3 million ($12 million EV less $9 million of debt). Managers need to analyse the current financial position of the company and be cautious not to overstate the potential purchase price to the vendor. Another common misunderstanding in the application of valuation multiples for buyouts is the belief that stock and fixed assets are to be added to the EV. That is not the case. The EV is the value of the business, including all its core assets. The only time specific assets are adjusted in the determination of EV is when there are significant

funding for management buyouts  105 

non-core assets such as real estate that are not used in the business or investments in other listed or unlisted companies. Where these assets exist, their contribution to profit should be removed from the calculation of EBITDA or their contribution to expenses/losses should be added back. This will enable the calculation of the EV for the core operating business. Managers should also take care to normalise the EBITDA for non-recurring expenses, one-off expenses and other abnormal items. As an example, some owners do not draw a market salary, preferring instead to pay themselves dividends. In this case, if the owner is involved in the management of the business, the EBITDA must be reduced to reflect a market-based salary for the role he or she performs. Managers should conduct preliminary analysis like that outlined above, and approach lenders and private equity sponsors with their buyout proposal. While accounting firms can help you with this analysis, managers are generally better off speaking to professional buyout advisors (like T3 Capital Pty Ltd) who understand and regularly advise on buyouts.

Structuring a buyout Assuming you have a reasonably priced buyout opportunity with a sound current financial position, the company’s ability to service debt and the available collateral are the next critical success factors. Cash flow must carefully and sceptically be analysed, as that is the key to debt serviceability. Assuming the business is for sale at a reasonable price, you must first consider the historical (last three to five years) and forecast (next three to five years) EBITDA. The history should be steady—businesses with significant volatility in their earnings will need to be geared more conservatively. The forecast EBITDA should also be steady with growth potential. EBITDA alone does not determine debt serviceability. Next you must examine the historical and forecast capital expenditure of the business. Capital expenditure can be a major use of cash flow, thus highly capital intensive businesses (or those where capital expenditure has been ignored and the business infrastructure is in need of upgrading to support operations) will need to be geared more conservatively. The current condition of key fixed assets will require examination to evaluate the appropriateness of historical and future capital expenditure. In addition to capital expenditure, the working capital requirements of the business must be analysed. A demonstration of working capital analysis was provided in Chapter 6.

106  the venture capital spectrum

There are sometimes excellent opportunities to better manage working capital after the change of ownership. In one example in a large buyout, a reduction in inventories saved $30 million of working capital investment which the new owners, including management, used to pay down some of the expensive debt used to fund the buyout. Businesses with inefficient working capital management or with large working capital requirements will generally require more conservative gearing. Once it has been established that the target has a history of steady cash flow, that the future cash flow is reliable due to a strong industry position and that the management team is strong, the next task is to try to finance the deal. The first task when seeking finance is to carry out due diligence on the assets of the enterprise and establish how much secured financing could reasonably be raised, subject to the ability to service the debt. Within the lending industry, several rules of thumb have developed about the amount lent on the asset provided. These are rules of thumb only and the nature of the business, its assets and the general credit climate at the time of a transaction can have a significant bearing on the actual availability of debt. You also need to keep in mind that the maximum gearing seen in most deals is generally 4:1 for large buyouts and 2:1 for smaller buyouts. Property and debtors are regarded as the safest assets for security, and accordingly one can borrow up to 75–80 per cent of asset value. This ratio will vary according to the quality of the asset. Debtors’ ledgers that are riddled with bad debts and contain large clients with poor credit ratings will be regarded as poor collateral. So will a poorly located factory. Stock and plant are considered less safe assets for security and most lenders have had the bitter experience of the monetary results from a stock or equipment auction. Consequently these assets will often only secure lending facilities of up to 50 per cent of book value. Stock that has a low turnover or high risk of obsolescence, such as fashion items, may secure less debt. Similarly, equipment with a limited resale market will have lower collateral value. Besides the value of the assets, the other key to obtaining secured lending is to demonstrate how the loan principal will be repaid. Banks and merchant banks are the usual sources of secured debt, and banks in particular want to see principal repayments in any debt-servicing plan. On the other hand, while merchant banks will consider rollover financing, the interest charged usually makes merchant bank financing the earliest to be paid off. Secured lenders will often want additional charges over personal assets of the managers or shareholder guarantees; however, this requirement

funding for management buyouts  107 

should not be necessary for most leveraged buyouts. Fortunately, the deregulation of the finance sector has led to increased competition, and astute entrepreneurs should be able to find a lending institution willing to lend without seeking extra collateral. If entrepreneurs cannot get the financial support from institutions, the fault probably lies more with the deal itself rather than the lender.

Management’s investment The next step is to establish how much equity the managers can invest. A key success factor in successful buyout has been the alignment of interests between management and the private equity sponsors. Managers wishing to participate in a buyout will need to invest meaningful personal funds into the transaction. Its difficult to define a specific amount. In the United Kingdom, a figure of two to three times the salary of each manager is used as a guide. If management lacks the liquid assets to make the required investment, sometimes the financier will lend sufficient funds to the manager on a full recourse basis, meaning the lender can take control of any assets of the borrower if the loan is not repaid.

Mezzanine funding The difference between the consideration required by the seller and the sum of the secured lending and manager’s equity is the financing gap. If the financing gap is zero or negative, the deal can go ahead; otherwise unsecured lenders and equity from private equity investors must cover the difference. This unsecured lending is often referred to as mezzanine financing because it ranks between the upper levels of debt and the bottom floor of equity in the unfortunate event of liquidation. The financing instrument used by mezzanine financiers is typically a hybrid debt/equity instrument. The usual instruments are either subordin­ ated debt with options, convertible notes or convertible redeemable preference shares. These instruments are described in more detail in Chapter 19.

Other funding sources There are other providers of funds besides private equity firms and mezzanine financiers. One key provider of finance can be the vendors, who

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may abstain from providing equity (except in a partial buyout where they retain some equity) but will sometimes provide debt. The provision of a seller’s note can often be structured as a discount security, which means the interest payment is paid at the same time as when the principal is due. Vendor finance can be a useful way to fill a funding gap in the buyout structure. The other source of funds is the business itself. Usually one aims at a 5–10 per cent reduction in working capital as the managers realise it is their money at stake. The sale of non-core or surplus assets has been a common source of funds as is sale and lease-back of property.

Alignment of interests The key to success is alignment of the interests of the managers and the private equity sponsors. You share in the spoils of success together and you share the pain of failure together. Management brings knowledge, relationships and operational expertise to the deal in addition to just money. As a result, each dollar of management investment usually gives them a greater ownership percentage than each dollar from the private equity investor. There is no opportunity for the buyout firm without management with strong incentives to perform. The envy ratio expresses the relationship between the value of private equity money and the value of management’s money. For example, a private equity firm invests cash to acquire 90 per cent of equity and management invests cash sufficient to acquire 10 per cent. Management, however, is given 25 per cent of the equity in the company while private equity holds 75 per cent. In this example, the envy ratio is 2.5:1 (25 per cent ownership for providing just 10 per cent of the cash). Envy ratios are being displaced by arrangements that give management the increased ownership if the transaction achieves certain milestones, usually a minimum IRR or ROI. This approach more closely aligns the interests of the management team with the needs of the private equity sponsor. Ultimately, private equity investors—much like venture capitalists—want their management teams to be motivated to drive strong performance and returns, even if times get tough. Another very important factor for managers planning a buyout is ensuring there is alignment of objectives with the private equity sponsor. As with early-stage opportunities, there needs to be agreement on the

funding for management buyouts  109 

potential for capital growth, the aggressiveness of gearing, the aggressiveness of the growth strategy and time to the exit event. Managers must also understand that high leverage not only has the potential to greatly increase returns, but also increases financial risk and magnifies losses. In smaller buyouts, ordinary dividends are not paid and all profits are reinvested or used to pay down debt. The return expectations of the private equity sponsor should also be understood. In smaller buyouts, investors look for IRRs in the range of 20–25 per cent, which can be achieved by the combination of a solid company, moderate gearing and moderate profit and cash flow growth. In mega deals, 15 per cent may be sufficient. Buyouts of large infrastructure assets (such as tunnels or water utilities) could have target IRRs as low as 10 per cent. Generally, smaller companies are considered to pose higher risk and therefore require higher targeted IRRs. Exit paths include secondary buyout by another private equity firm, a trade sale, an IPO and share buybacks.

Example buyout structure The following is a typical small company buyout structure. The target is a business with annual sales of $30 million and an EBITDA of $3.3 million (shown in Table 9.1). On a valuation of $14 million, the price/EBITDA ratio would be 4.2 times. As mentioned previously, typically buyout funds prefer price/EBITDA ratios of three to five times for smaller companies. In this example, the senior debt-to-equity ratio is 4.3 times and the senior debt-to-EBITDA ratio is about two times. Including the mezzanine debt, the total debt-to-equity ratio is 8.3 times, so this example is quite aggressively geared; however, let us assume that cash flows were deemed to be sufficiently large and stable to obtain this level of debt funding. In Australia, the mezzanine financier would normally also be the specialist buyout fund, although today there are a number of specialist mezzanine finance providers, including Rothschilds, Investec and Arya Capital Partners. Where the specialist buyout fund also provides the mezzanine funding, it would be looking for an overall return of 25 per cent internal rate of return on the total of its equity and mezzanine financing. It would achieve this IRR by convincing the bank to allow the mezzanine debt to be repaid first, usually by way of the growth of the company’s EBITDA and cash flow, enabling the business to comfortably borrow more senior debt, with the proceeds used to reduce the mezzanine funding. Say this was

110  the venture capital spectrum

achieved in three years. The company’s EBITDA had grown to $5 million and the banks were comfortable increasing the senior debt from $6.5 million to $10 million and the $3.5 million of additional senior debt was used to reduce the mezzanine debt from $6 million to $2.5 million. Note that the total of the combined senior debt and mezzanine debt has stayed the same, only the mix and source has changed. Assume also that valuation multiple had not changed from 4.2 so that with $5 million of EBITDA the company’s EV would now be $21 million. Deducting the total debt of $12.5 million leaves the total equity valued at $8.5 million. Management’s portion is 30 per cent or $2.55 million and management has made more than five times its money in three years, or an IRR of nearly 80 per cent. The buyout fund’s equity portion is now worth $5.95 million plus the remaining mezzanine loan worth $2.5 million, but it did have exposure of $7.05 million in total at the beginning. Assuming 20 per cent interest per year on the mezzanine financing with quarterly interest payments, the private equity sponsor would have a three-year IRR of close to 27 per cent. Those are very good returns and the company simply had to service its debt and grow EBITDA at a solid but reasonable 15 per cent per year. Table 9.1 Typical balance sheet for a small MBO Assets

$m

Liabilities

$m

Debtors

4.3

Bank debt

6.5

Inventory

9.0

Mezzanine debt

6.0

Goodwill

2.0

Fund equity

1.05

70%

Fixed assets

2.2

Management equity

0.45

30%

less creditors and provisions

(3.5)

Total

14.0

14.0

The problem with this buyout is the investor’s exit. Assume depreciation of $500 000, mezzanine interest of $500 000 per year and senior bank debt interest of around 12 per cent or, say, $1.2 million per year. Assuming an EBITDA of $5.0 million and a corporate tax rate of 30 per cent the post-tax profit is about $2 million. A company with a

funding for management buyouts  111 

post-tax profit of $2 million is at best only a marginal prospect for an IPO. The investors and management would look to a trade sale for an exit or continue to grow the EBITDA, and borrow additional senior debt to pay down the mezzanine and to fund a buyout of the private equity firm’s equity stake. Another possibility is for the company to make an acquisition of one or more competitors to increase its scale. The acquisition of a competitor of equivalent size would lead to an entity with post-tax profits of around $4 million which would start to look like an attractive candidate for a small public listing, giving the management and buyout firm an additional exit path. These are commonly called buy and build, where a platform company is acquired in a buyout and further strategic acquisitions are bolted on to expand the business. Another take on this strategy is a consolidation play or roll-up where a platform company is acquired in a buyout and used as a base to consolidate a highly fragmented industry sector. In a normal buyout, management must continually focus on achieving reasonable growth, controlling costs and minimising working capital. Capital expenditure is managed carefully to ensure the business infrastructure can support the growth of the company without placing excessive strain on cash flow. Roll-ups, consolidations and buy and build strategies can be very successful; however, making additional acquisitions and integrating the acquired business places additional pressure on the company and will stretch even the most experienced management team. The rewards can be very great, though.

Conflicts of interest Buyouts generate conflicts of interest. Management is seeking to take over a business, so it has the role of a buyer, and buyers seek to make purchases at low or reasonable prices. Management team members are also employees of the vendor, and in that role they have a duty to the company to maximise its value. Involving an advisor and a private equity firm to act as instigators and to lead the deal can help to manage these conflicting interests. At some point, the management team needs the consent of the board or owners to be involved in a takeover of the business.

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Conclusion There is little question that ownership is a powerful incentive for management to perform. It is this powerful alignment of interests that has made buyouts tremendously successful. Buyouts have delivered great returns to managers/entrepreneurs, private equity sponsors and the LP’s invested in private equity funds. The MBO/LBO market in Australia can be expected to grow further. As predicted in the 4th edition of this book, the Public to Private market has grown substantially. This refers to the privatisation of listed public companies by a debt-financed vehicle. Examples include Just Jeans, Ausdoc, Sabre Group, Freedom Furniture, Tempo and Colorado Group. With credit crunches of 2007 and 2008, expect to see more restructurings and turnarounds. The strong Australian dollar also makes international buyouts such as the previously mentioned PEP acquisition more financially viable than ever before. Finally, the weaker, more volatile share market of 2007 and 2008 is likely to spark an increase in Public to Private transactions. The May 2008 proposed takeover of Funtastic by Archer Capital is an example of a take-private transaction that is also a turnaround situation. The availability of private equity sponsors to back managers to share in ownership of large, mature businesses has never been better and the flood of retiring Baby Boomers in the next ten years should provide entrepreneurial managers with great opportunities to participate in buyouts.

Part III

Raising the money: What the entrepreneur must do

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10

How to write a business plan

In this and the six chapters that follow, we outline the various steps entrepreneurs must take to raise funds. As suggested earlier, the preferred method is to raise equity from venture capitalists, angel investors and other sources. If you are planning a buyout, your equity capital source will be private equity firms. Thus, in this section, we will concentrate on this fundraising method in our choice of examples and techniques. Nevertheless, the principles and advice provided are equally applicable to other sources of funds, such as banks and finance companies. A formal business plan is essential to success. While Andy Bechtolsheim invested US$100 000 in Google without reading a business plan,  Larry Page and Sergey Brin did show him a demo of their engine.  There are some legendary examples of entrepreneurs who raised funds without a written plan, or at best one written on the back of a napkin; however, these are the exception rather than the rule. The chapters that follow provide considerable advice on the content of a business plan, but in this chapter we shall focus on generalities. The first question concerns who should write the business plan. The answer is simple: the entrepreneur and his or her team. The business plan is the demonstrable proof of how thoroughly entrepreneurs understand their business. If they cannot write about the business, it is unlikely they

116  raising the money

will be able to run it. Many entrepreneurs are good at talking but the successful entrepreneurs are generally good at writing too. There are many companies and individuals offering a consultancy service for the preparation of business plans. However, as a rule entrepreneurs should not use consultants to write a plan unless the entrepreneur makes a substantial contribution. Consultants are best involved in conducting research for you to incorporate into your plan or in reviewing the plan overall. It is critical to remember that the process of planning, researching, developing and testing assumptions is as important as the final document. Hence you and your immediate team need to do most of the planning work. Preparing a business plan is not simple and is often neglected. The procrastination is often due to deficiencies of the business concept. In an oral presentation, it is easy to work up an idealistic fervour. However, the oral presentation should be regarded as a sketch—the business plan stands as the finished product. For most people, it is easier to talk about a concept rather than to write about it. The absence of a plan usually indicates some combination of laziness, inadequate business experience or poor business concept. A business plan is more than a method of raising funds or separating entrepreneurial wheat from chaff. It is the blueprint for building the business. Just as it would be folly to renovate a house without architectural drawings, so entrepreneurs and investors would be foolish to invest time and money in a business without a formal business plan. The business plan’s role as a blueprint transcends its use as a fundraising document. Anyone who has renovated or built a house knows the first plan is usually different from the finished product. When the concept is down on paper, it is easier to change and improve. A plan will go through several modifications. Even more importantly, it may demonstrate the impracticality of the concept. It is disappointing to prepare a business plan and later conclude the business idea is weak. But the disappointment is minor compared with the pain and anguish which results from a failed business enterprise. Planning resembles the process of science. A hypothesis is proposed (this product can be built, customers will buy it and it will generate a profit that yields a return that will attract investors), data are gathered and the hypothesis is tested. Entrepreneurs should adopt a similar approach to planning. A business plan is not just a prospectus or information memorandum.

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For those readers unfamiliar with the terms, a prospectus is the formal document used to raise funds from public non-professional investors. It is usually a typeset document that must be registered with the Australian Securities & Investment Commission (ASIC permits electronic prospectuses provided a paper prospectus is lodged and certain other criteria are met). Companies wishing to go public, finance companies raising funds via debentures and unit trusts seeking subscriptions from the public are organisations that prepare prospectuses. Information memoranda are similar documents, used when raising funds from professional investors.  They are typically prepared for institutional fundraising by private placement or for financing projects. A prospectus or information memorandum is not a business plan. However, a business plan used to raise money from professional investors is an information memorandum. While the business plan should not just be a device for raising funds, whether the plan raises funds or not is a good measure of its potential success. It is the key selling document for getting a foot through the door of the venture capitalist (or a private equity firm in the case of a buyout). Typically, the average venture capitalist probably receives around five business plans a week—often more. Thus if entrepreneurs want their business plan read they should keep it under 40 pages and ensure it will fit into a briefcase. If not, the plan will sit in the pending tray for several weeks until guilt finally forces the venture capitalist to spend ten minutes skimming the contents and writing the rejection email. One venture capitalist interviewed for this book suggested 35 pages of content, including a one to two page executive summary, and no more than a dozen exhibits or appendixes. Guidance on business plans is available on the websites of some venture capital firms. If you can construct and document your business plan thoroughly with fewer pages, so much the better. Many business plans conform to the saying attributed to Oscar Wilde: ‘I have written you a long letter because I did not have the time to write you a short one.’ Plans do not necessarily have to pass a ‘weight test’. The most important section of the business plan is the executive summary. This section should be written last but have the most time spent on it. The executive summary should probably be rewritten six or seven times. The first paragraph is crucial and the first sentence critical. Just as in an advertisement, the first sentence of the executive summary must grab the reader’s attention. The executive summary needs to contain

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the salient points of the business, but three sections are fundamental: the concept, the objectives and the deal. The concept, sometimes called the mission statement, defines the business in terms of what is to be bought, by whom and why. Google’s mission is to organise the world’s information and to make that information universally accessible and useful. Theodore Levitt, in a paper entitled ‘Marketing Myopia’ published in 1960, illustrated the importance of defining the business mission. He provided two now-famous examples: the railroad industry, which declined because management failed to realise its customers were buying transport; and the movie industry, which slumped until management understood its customers were buying entertainment. The managing director of a large Australian chemical company that had just completed a three-year period of sustained growth was asked for the secret of his success. He replied: ‘I spent the first three months talking to management, customers, suppliers and employees working out what we did. I then spent the next three months agreeing with management a 25 word mission statement for our business, which made no reference to chemicals. The next two and a half years I spent reminding the management and employees of the jointly prepared mission statement.’ Without a mission statement, a business can muddle through but it can rarely sustain a high rate of growth. The objectives should be twofold: financial and personal. Financial objectives are simple. They comprise the target figures for sales, profits and returns on investment. Personal objectives are equally important. Far too often, the founders of the business realise too late that their personal objectives conflict with the needs of the business. In the end, much of the capital accumulated by these businesses has ended up in the bank accounts of lawyers. If one founder wants to reinvest the capital to grow the business while another wants a high income to pursue an expensive lifestyle, then it is better to resolve the conflict now rather than later. The alignment of objectives of the team and the investors is of paramount importance, whether you are building a start-up or planning a buyout. Finally, the executive summary must specify the deal. Valuations and structures are discussed in subsequent chapters. The executive summary should at least state the funding requirements and the basis on which the investors are expected to invest. The deal will change during negotiation, but it can save much time if the investor understands the entrepreneur’s expectations. Offering a deal that is attractive to investors is obviously

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critical if you want to raise capital. You must understand the risk and return requirements of your target investors. The executive summary should enable a potential investor to answer five key questions: • What customer problem is the business solving or planning to solve? • How urgent is that problem? • How much money does it want? • What is it going to do with the money? • How much money am I going to make?

The sixth question any investor tries to answer is ‘What are the risks?’ While some mention may be made of risk in the executive summary, risk analysis and how these risks are to be mitigated is a critical section. No two business plans have the same structure, but they have certain segments in common. In the marketing segment there is typically a ten-page market analysis section. This should be followed by a five-page market strategy section that defines how the product or service is to be sold. The next segment should contain operational information. Typically, there should be sections on people, management structure, corporate ownership, future product development, product ownership and manufacturing. Overall, this segment should contain fifteen to 20 pages. Finally, there is the financial segment, which contains summaries of the cash flow, profit and loss, and balance sheet projections. One or two years’ history combined with three years of estimates, tabulated on two to four pages, are all that is necessary. Notice the large allocation of content to markets and customers relative to the other sections. You must know your market, your customer and the customer problem your firm is solving. Once the business plan is completed, the entrepreneur should ask several associates who work in the business to read and criticise it. The feedback should be invaluable. You want a hard-nosed critique because that is how investors will review the plan. The key questions to ask are whether they would invest in the concept, and if not, why not. If the reply is negative then the entrepreneur must seriously reconsider continuing. The entrepreneur should either forget the project or try licensing the product or process. Budding entrepreneurs should realise that for most inventions licensing is the preferred alternative. While the potential reward is lower, the risks and time spent are far less. If you wish to investigate the

120  raising the money

licensing path, a good place to start would be the Licensing Executives Society website (www.usa-canada.les.org). The site has a number of very useful links to get you started. You should also enlist business and legal advisors specialising in licensing arrangements to help you with the process. As a guide, entrepreneurs should ask for upfront or minimum licence fees, remembering that these are difficult to negotiate. Royalties can vary greatly but often fall between 1 and 5 per cent of the licensee’s revenues. Expect extensive due diligence on your technology, particularly on your title to the technology. A great example of a successful licensing arrangement is Arthur E. Bishop. Bishop invented a variable-ratio power steering system for cars and, rather than manufacture, chose the licensing path. The technology, developed in 1971, is now used in more than 20 per cent of all vehicles worldwide and his firm now has over 400 patents and patent applications. The frequent complaint of inventors that licensees do not take up their inventions is usually a result of the inventor’s wishful thinking rather than reality. The pressure of competition usually means that if an invention or process does have a chance of commercial success, it will be tried. One only has to look at the statistics (where over 95 per cent of products launched fail in the marketplace) to realise that companies must often be enthusiastic about new products but that it takes many attempts to find some big successes. Before proceeding to the chapters on market analysis and strategy, operational issues and financial analysis, we will first consider the types of business structures available and the steps required to form a company. While this may appear to be putting the cart before the horse, the appropriate capital structure is a key decision, and takes time to implement. Formation of the company should be done in parallel with the preparation of the business plan and, when completed, will provide a useful bargaining tool when negotiating with investors.

11

Choosing the appropriate structure

In modern society, the public sector represents perhaps 40 per cent of a country’s gross national product. Besides acting as a major consumer of goods and services supplied by the private sector, the public sector interacts with the private sector by making laws and regulations. The legal environment in which a business operates may be divided into two broad categories. Statute laws are the laws made by the federal and state parliaments; common law represents the decisions made by judges and followed by others to the extent that they become generally accepted practice. Entrepreneurs and investors are reminded that this chapter contains only general guidance, that for every rule there are numerous exceptions and that they should always seek legal and tax advice when deciding on an appropriate legal structure for their business or investments. While businesspeople cannot hope to become experts in commercial law, they need to develop a working knowledge of it. The more businesspeople know about the laws and regulations, the more effectively they can manage their businesses. Moreover, they can avoid the costs and time involved in legal action, which can cripple the operation of a business. Fortunately, many booklets and courses are now available for businesspeople to learn about the legal process without paying large fees. Under common law, of particular importance is the law of contract— especially with customers, suppliers and employees. Under statute law,

122  raising the money

the most important Acts are the Income Tax Act, Trade Practices Act, the Intellectual Property Protection Acts (e.g. patents, copyright, designs, trademarks) and the Corporations Act. The national statutes in company law, combined with the complementary state legislation and the Ordinances of the relevant territories, are generally collectively described as the Corporations Law. There are also various Acts empowering government departments to apply regulations on the use of premises, hours of trading, safety and fire precautions, electrical installations, use of weights and measures, and so on. It is not the purpose of this book to provide an introduction to business law. On the other hand, there is one area of law where the entrepreneur and venture capitalist do interact: the ownership and control of business enterprises. A small business may operate in one of four ways, of which two need a separate legal entity. Figure 11.1 illustrates this. The sole trader is the simplest structure to set up and run. A sole trader is only suitable for a small business and not for an enterprise that intends to grow rapidly. No separate entity

Separate entity

Sole trader

Trading trust

Partnership

Limited company

Figure 11.1 Business structures Partnerships, too, do not involve a separate legal entity. A partnership is generally defined as a relationship between two or more persons carrying on a business with a common view to making profits. Partnerships can become large—for example, the bigger accounting and legal firms operating as partnerships in Australia have hundreds of partners and employ thousands of people. Partnerships usually have one major drawback to investors, namely the joint and several unlimited liability of all partners for a firm’s debts and obligations. An investor who invests under the aegis of a partnership has an individual liability for the debts of the partnership and the actions of the other partners, and can be personally sued for the liability of the partnership. Litigants tend to sue the richest partner. Even if there is a formal partnership agreement, which restricts the number of partners able to incur debts, it may be insufficient protection and if litigants are unaware of the restriction they may sue the other partners for recovery.

choosing the appropriate structure  123 

The general advantage to investors of a partnership is that, in certain circumstances, they will be able to claim any losses made by the investment as a tax deduction by treating the loss as an expense against other forms of income. However, investment in a partnership will often limit the potential for capital gains because of the small market for selling a share of a partnership. As indicated earlier, the object of the venture capital game is to accumulate wealth by capital gain, so a partnership structure is the wrong structure because it severely restricts the potential capital gain. It is also an unsound structure because investors will often invest on the basis of an expected income tax deduction during the start-up period. In our experience, we have never seen a venture capital investment into a partnership or sole proprietorship although there may be cases out there. Thus the question becomes which of the two separate legal entities to choose: the trading trust or the limited company. While a book could be written on the pros and cons of either structure, tax considerations (ironically) affect the choice. The trading trust structure was the preferred option until the mid-1980s. A typical trust structure is shown in Figure 11.2. Founders hold shares in and are directors of

owns

Assets of business

earn income

Trustee company

Trading trust

transmits income

Beneficiaries (founders)

Figure 11.2 Example trading trust structure FIG1102.EPS

A trading trust generally pays no income tax, provided all the income passes to the beneficiaries. The beneficiaries would normally then pay income tax on any income received. The trustee company would generally operate on a nominal profit basis covering expenses out of the trust income and have paid-up capital of $2. If the trust goes into receivership, the creditors usually have no recourse against the assets of the beneficiaries. The creditors would, however, generally have recourse against the assets of the trust and could also move against the trustee. The action would generally gain $2. However, directors of a trustee company are

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typically jointly and severally liable for claims made by creditors if there are insufficient assets, unless the contracts between trustees and the creditor deliberately exclude the liability. The inclusion of such clauses usually makes it difficult to gain reasonable credit from suppliers. Without credit from suppliers, it is not really viable to build a fast-growth company. The company structure, illustrated by Figure 11.3, is simpler than the structure of the trading trust. Effectively, the founders subscribe to shares in a new legal entity and become directors of that company. The company is liable for any debts incurred and upon liquidation the shareholders’ maximum loss is usually limited to their shareholding (however there are examples of situations where the ‘corporate veil’ has been pierced. There are extensive legal duties owed by company directors so the company will not always offer protection in every circumstance; therefore, entrepreneurs and investments must bear in mind that directors can sometimes be held personally liable, and even face civil and criminal penalties. Shareholders

appoint

invest in

Directors manage

Company owns Assets

Figure 11.3 Company structure FIG1103.EPS As mentioned, creditors do not generally have recourse to the personal assets of shareholders or directors unless they can establish either fraud or negligence. There are always exceptions, however, so entrepreneurs and investors must seek legal and tax advice when choosing structures. This concept of liability being limited to the subscriptions of shareholders originated in England during the eighteenth century, and was a primary reason for the entrepreneurial explosion which occurred during the Victorian era. For many years, the problem of double taxation largely negated the benefit of limited liability in Australia. Years ago, companies paid a tax on profits—company tax—at a rate of between 40 and 50 per cent (today the rate is generally 30 per cent). What remained could then either be

choosing the appropriate structure  125 

retained in the company or distributed as dividends. The recipient of the dividends then paid tax at their marginal rate of taxation. Private unlisted companies faced a further complication that, if they retained profits above a certain level (even for the justifiable reasons of funding further expansion), they had to pay an additional undistributed profits tax. It would be difficult to devise a taxation regime more likely to inhibit economic growth. Either population growth or increases in productivity endogenously generate economic growth. One cause of productivity growth is the technological innovation developed and introduced into the economy by new companies. If the taxation environment restricts new companies from adopting new technologies, the economy will grow at a correspondingly slower rate. Australia’s later introduction of dividend imputation and the taxation of profits made by public trading trusts at corporate rates significantly reversed the anti-company bias of the taxation system. With these legislative changes, corporate profits are now effectively taxed only once as a general rule. Dividends received by shareholders on which Australian company tax has been levied are known as franked dividends. Shareholders who receive franked dividends and whose marginal tax rate is the same as the company tax rate generally do not pay any further tax on the franked portion. Indeed, those shareholders whose marginal rate of taxation is below the corporate tax rate will usually receive a tax credit. The tax matters discussed here are only generalisations, and entrepreneurs and investors should seek advice when deciding upon the most appropriate structure for their situation. There are other taxation benefits that generally accrue only to companies, such as the 125 per cent research and development tax deduction. Another potential advantage for small companies is the capital gains tax relief that occurs for owners on the sale of their business before retiring. The guidelines in this area are constantly being changed and professional advice must be taken, but the tax relief can be very substantial.

Setting up a company The current legal taxation environment now generally supports setting up a company. The questions then become how and what type. Effectively, there are two types of companies: proprietary companies, which cannot offer their shares to the public; and public companies, which may

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sell their shares to the public. Proprietary companies generally require a minimum of one shareholder and one director and allow up to a maximum of 50 shareholders. Public companies generally require a minimum of five shareholders, three directors and a company secretary, and have no upper limit on the number of shareholders. While all listed companies are public companies, a public company is not necessarily listed. As stated before, the objective of the venture capital game should be to create a listed company. While it is possible to later convert a private company to a public company, entrepreneurs who wish to play the venture capital game should consider starting with a public company. The administration is perhaps more onerous, and name changes take longer to execute (which is one reason for starting on the task earlier rather than later), but the later savings may be immeasurable. To convert a private company to a public company requires several administrative steps which may be worthwhile avoiding. If you have already managed to attract several venture capitalists, they will all hire their legal firms to analyse the changes—at your cost. Incorporating these changes earlier avoids costs and delays. You must seek legal advice when making the decision of public versus proprietary company. The basic document that details the way a company operates is called the company constitution. The constitution defines the capital structure. As there is now generally no minimum size par value share, shareholders could issue, say, a million shares at $0.001 per share or $1000 worth. In addition, the company will also almost certainly be issuing redeemable preference shares, so if you will be seeking outside investors, it is advisable to consider setting up, say, ten classes of redeemable preference shares defined as ‘A’, ‘B’, ‘C’ Class, etc. at the beginning. The constitution is important and needs close scrutiny. It should allow rapid calling of shareholders’ and directors’ meetings; implementing share issues, transfers and sales by ordinary resolutions, and should allow the use of modern methods of communication. Entrepreneurs and investors must get legal advice when designing their constitution so that it suits their needs and objectives. The simplest way to set up a public company is to buy one ‘off the shelf ’. Most of the larger legal firms located in the city will have a shelf company available for the cost of around $1500. Once you have set up or purchased your company, several key issues must normally be addressed, namely:

choosing the appropriate structure  127  • how much share capital should be subscribed; • the appointment of directors; and • the appointment of a company secretary.

The issue of initial share capital is important because it gives a clear sign to investors of how much you, as an entrepreneur, are willing to risk.  Many  companies establish themselves with  an issued capital of $2, being two $1 shares. Thus one potential way of distinguishing your balance sheet from other companies is to subscribe capital. If you go to an investor with a balance sheet that contains, say, $20 000 of subscribed share capital, he or she will treat it far more seriously than a proposal based on a company with $2 of issued capital. In general, the more personal funds the entrepreneur has invested and put at risk, the greater the comfort investors will have in the potential of the business. As mentioned in the previous chapter, it is very important when forming a company that the shareholders have similar goals and objectives. A classic problem is two partners forming a company on a 50/50 shareholding. The company is successful. One partner wants to reinvest profits and go for growth. The other, happy with his lot, wants to take dividends. Conflict arises and with a 50/50 shareholding the debate can become acrimonious and may often finish in court. As a precaution, there should be a shareholders’ agreement in place or a mechanism for the company to buy back shares embedded in the constitution. The choice of directors is important because it provides entrepreneurs with one of their few opportunities to independently test their business plan and gain credibility for their proposal. Promoters of public companies are aware of the importance of a reputable board, and spend much time in choosing the appropriate independent directors. For entrepreneurs, the same opportunities are available. An important initial task of the entrepreneur is to recruit a chairperson who is independent, commercially experienced and who will provide credibility. The chairperson should provide independent questioning and advice, and not merely be a supporter, as this will dissipate the motivation and enthusiasm so necessary in a business start-up. The other key appointment is the company secretary. In time, this should be an employee of the company but at the beginning one possibility might be to use a lawyer as a tradeoff for a directorship.

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As this chapter has tried to point out, the law plays a large part in the operation of a company. The person charged with the responsibility of ensuring the company is meeting its legal requirements is the company secretary. Unfortunately, the importance of this role is often under­estimated. Before investing, venture capitalists will require the company to be in complete compliance with the Corporations Law. Among the areas they will scrutinise are: • filings with the Australian Securities & Investments Commission; • issuing of shares and the share register; • quality of the minutes of shareholders’ meetings and board reports; and • quality and timeliness of the seal register.

The company secretary, besides ensuring the company is meeting its legal requirements, also plays an important role when disagreements occur among founders and investors. The company secretary controls the timing, calling and recording of various board and shareholder meetings. Another advantage of the company structure is that when things go amiss there is a considerable body of statute and common law to protect the rights of shareholders. Part-time company secretaries are available and should be considered.

Conclusion This chapter recommends the entrepreneur adopt the unlisted public company structure because, in most cases, it eases the process of eventual public listing. The ultimate financial benefits generally outweigh the administrative costs. Although the company structure in some ways restricts the entrepreneur’s freedom compared with a partnership, they will usually appoint themselves the directors of the company. The Constitution lists the directors’ powers. However, legislation requires that shareholders meet at regular intervals and for certain decisions, such as appointing directors and setting directors’ fees. The law also places quite onerous duties on the directors to act for the benefit of the company. They have a general responsibility to avoid conflicts of interest, and must declare personal interests in transactions that might involve the company. Directors must also certify that the company keeps proper accounting records. At the beginning, it is usually necessary

choosing the appropriate structure  129 

to hire an outside accountant but the task should become an internal function as soon as possible. Creditors generally do not have recourse to directors for debt. However, the law states that directors are personally liable and subject to criminal penalty where they allow the company to incur debts of which repayment is unlikely. Lending institutions will frequently require directors’ personal guarantees before lending to the company. Introducing substantial equity into the company is a method of removing the need for these guarantees. Forming a public company is a key task in raising equity, and legal and tax advice must be sought. Another key task is preparing a business plan. The next three chapters deal with this task.

12

Preparing a business plan: Market analysis and market strategy The March 1887 edition of the Scientific American contained the following passage: Inventors often complain of the difficulty experienced in inducing capitalists to join them in their enterprises. Not infrequently the blame rests as much with the inventor as with the man of money. The capitalist is often blamed for not seeing into the advantages of an enterprise, when the fact is it has never been presented to him in the right light. Every man, therefore, who would seek the aid of capital in furthering his plans for introducing an invention should first be prepared to show the whole state of the art covered by such an invention, and wherein the improvement lies. Second, he should, if possible, show what particular market needs to be supplied with such improvements, and something approximating to the returns which reasonably may be expected. Third, he should have some well-settled plan of introducing the new product or furthering the new scheme. If his invention is worth pushing, in nine cases out of ten there will be little trouble in procuring financial help if the proper methods be employed.

It is doubtful whether better advice on how to prepare a business plan has since been given. A key to the successful business plan is separating the market analysis from the market strategy. In Chapter 2 we demonstrated the technique of analysing a market. We analysed the demand for

market analysis and market strategy  131 

the product and then we separately analysed the industry structure. These techniques for analysing a market may also be applied to the business plan; instead of screening, we use the techniques to develop a strategy. If the results of the screening are positive, then the market analysis section of a business plan will contain answers to the questions posed in Chapter 2. In this chapter we will first discuss several extra techniques for market analysis.

Market analysis Key elements that should be included in any business plan are market segment analysis, customer decision analysis and competitive analysis. These answer the fundamental questions: • Which customers are we best placed to serve? • What do they want? • What is our role in the industry? • How will we execute and achieve high growth?

Market segment analysis Customers are never identical. You only have to look in your own family to see the different interests and preferences of family members. The only thing that is common between us is that we are all different. The challenge for the entrepreneur is to successfully meet the needs of a large enough group of customers to grow rapidly and in a profitable way. This is where customer segment analysis comes in. This involves identifying clusters of customers with similar needs that match the offering well and are accessible. Typically for consumer products, the analysis looks for common needs based on age categories, income levels, family status, location, profession or mobility. For industrial products or business-tobusiness situations, the analysis is typically focused on size of customer, location, industry, spend on category, ease of implementation or support requirements. Very few businesses, with the possible exception of utilities and postal authorities, can service the entire market. Even these companies segment their customer base and provide different offerings to different customer groups—for example, postal authorities provide mailroom and

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bill printing services to corporates. Start-ups, with their limited resources, will find it extremely difficult to attract capital if they are unable to demonstrate focus on a market segment that really needs them. So which market segment/set of customers should the entrepreneur focus on? Typical criteria for deciding this include: • size or value of the entry segment (net returns to the venture after channel and supplier margins are taken out); • growth rate of the entry segment; • likely profitability (NTGFs should be looking for gross margins of at least 50 per cent); • readiness for the offer—not too early, before acceptable complementary products exist or the customer perceives a problem (e.g. 3G phones)—and not too late to secure market share; • accessibility—the customer can easily be reached for promotion, after-sales service and support. (The internet has dramatically increased the accessibility of consumers, which of course means they are also more accessible to competitors.); • referenceability to other market segments (i.e. segments containing ­people with similar needs, who can be influenced by customers from the entry segment).

Even when the entry and adjacent segments have been identified, ­ eople within customer segments respond in different ways and at differp ent speeds. Moore’s (1999) book Crossing the Chasm describes five types of customer within a given market segment—innovators, early adopters, the early majority, the late majority and ‘laggards’. • Innovators (typically 1–3 per cent of the segment) were defined as people who like to be first with a new gadget, whether it is an iPhone, flat-screen TV or concept car. They are knowledgeable about and interested in technology, and are not concerned if a product is not yet fully ‘debugged’. They may be significant influencers of other customers in the market segment as they give technical credibility to the product. They tend to be excited mainly by new features. • Early adopters (3–5 per cent) are influenced by innovators and are people who understand the ramifications of new technologies quickly, and can see the potential applications and benefits. These ‘change agents’ are excited by being first to gain advantage from the innovation (and sometimes by being seen to be first). • The early majority (30–40 per cent) are practical people who are interested in how an innovation can give them greater productivity in their business

market analysis and market strategy  133  or life. They are not particularly interested in the technology, but expect it to work and be reliable. A great way to sell to them is to flag that a competitor is introducing the solution. • The late majority (30–40 per cent) tend to be technology averse, want to be sure that the product works and require significant support. • Those in the final group, laggards, are not interested in technology or the product and will only buy it if it is embedded in other products they trust. 

It is important that the entrepreneur can identify people or companies in the entry segment that will adopt the product at each stage and who can be referenced to other customers. As Peter Farrell of ResMed has said, ‘you have to find the 4–10 per cent who really want your product first and focus on them’.

Customer decision analysis A fundamental question for any business is deciding who the customer for the product really is. Customer decision analysis consists of establishing the purchase dynamics of the product. These are the answers to the famous questions posed by Rudyard Kipling: Six true and faithful friends have I; What, Where, How, When, Who and Why?

In other words, entrepreneurs find the answers to the following questions: • Who will make the decision to purchase? • What are the decision criteria? • Where is the product bought? • How is the product bought? • When is the product bought? • Why is the product bought?

Entrepreneurs typically use two techniques to establish the answers to these questions. The first is desk research (reading available market reports and searching relevant topics, customers and competitors on the internet). They then arrange meetings with potential buyers and ask them the questions listed above. Both are important. Desk research, done well, identifies unknown opportunities and potential competitors and is

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a good way of developing very specific questions that need to be asked of customers. Customer discussions provide prospective relationships, understanding of the situation the customer is in (empathy) and if done well, some tangible data. They may also provide some prospects for the product/service. Entrepreneurs can also gather data about the competition in order to prepare a formal competitive analysis.  While desk research and reading are important to develop a broad picture of the opportunity, the most dangerous place from which the entrepreneur can view the world is behind a desk. You must get out into the field. Successful entrepreneurs are aware of their need to stay in touch with the market. They know the best way is to meet face to face with prospective and actual customers. Even in the largest companies, the successful executives are the ones who get into the offices of their customers. What applies to successful entrepreneurs applies even more to potential entrepreneurs. They must go into the field early and talk about the product to prospective customers. After each meeting with a customer, the first task is to write up notes. If possible you should tape-record the meeting. It has long been known that researchers suffer from confirmation bias: they unconsciously seek out data and information that support their hypotheses. Consequently, good scientists try to set up experiments to disprove a favourite theory. Entrepreneurs must approach market research the same way. They must be careful not just to seek information in support of a new product and reject information that indicates possible failure. When interviewing prospective customers, entrepreneurs need to be careful. Their passion for a product will often blinker them from any negative reaction from the market. They must provide a calmly optimistic description, which allows the prospect to react. If the prospect’s reaction is not enthusiastic within five to ten minutes, there is cause for concern. Over the last 50 years, we have seen many new products introduced: colour television, video-cassette recorders, personal computers, compact discs, mobile telephones and so on. The market response has been enthusiastic and immediate. The authors have also been associated with the launch of several product successes and even more product failures. The successes did not take long to build up momentum. Word of mouth seemed to ensure their success. The data collected from the field should be written up and summarised. The individual reports of the meetings should be kept in a separate file and treated as a confidential sales and customer management resource. It is very

market analysis and market strategy  135 

important to maintain confidentiality unless the prospect or customer has made it clear they are comfortable with the information being shared. The entrepreneur cannot afford to undermine trust, particularly among key early customers that it is hoped will become future ‘marquee’ or ‘lighthouse’ ­customers and recommend the entrepreneur’s business to other customers. If entrepreneurs do obtain an enthusiastic response from prospective customers, they should seek to crystallise the enthusiasm with a formal endorsement or letter of intent on the customer’s letterhead paper. It is also worth asking whether you can video their testimonial for your website. Such endorsements are valuable, and are among the most useful documents start-up entrepreneurs can provide as part of a business plan. These two steps by the entrepreneur are vital in testing the validity of the entrepreneur’s assumptions and building the necessary understanding of key customer drivers, market structure, competition and factors for success. Prospective investors—quite rightly—can be expected to probe hard in these areas. Investors are also aware of the natural optimism of the entrepreneur. They know that the background of most entrepreneurs is rarely in market research, and that in raising capital the entrepreneur will want to ­maximise the appeal of the investment opportunity. Consequently, prudent investors will also require independent validation of the market potential. A third step is often required to allay their concerns, and this is where specialist consultants can add significant value by building on the qualitative understanding the entrepreneur has developed to provide a more detailed assessment of market size, competition, growth and takeup rates. A significant part of the value added they bring is a (perceived and sometimes real) independent perspective. Besides customers, there are many other people who can provide useful information about a market and how it operates. As mentioned earlier, we have found the most useful to be: • former executives in the industry; • specialist consultants in the industry, often identified through industry associations; • potential channel partners; • likely suppliers; • editors of trade journals or specialist journalists in business magazines; • government advisory bodies for the industry; and • university professors.

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Many of these people will have presented papers or done interviews that are now held on the internet.

Competitive analysis Another important technique is competitive analysis. All businesses face competition—even government monopolies. When analysing competition, you must think broadly and consider all the ways in which people today cope with the customer problem you are trying to solve. This means considering every major substitute, alternative and work around. Before the internet, social networking existed in other forms. Before sports drinks, athletes drank water and concocted their own drinks for energy and rehydration. A distinguishing characteristic of successful businesspeople is their realistic appraisal of their competitive strengths and weaknesses and the development of a competitive strategy. While there are many different ways of analysing competition, a method that we have found both easy and effective is illustrated in Figure 12.1: simply fill in the required information. There are several sources that can be used to complete the chart. Facts on the individual companies can be obtained from the Australian Securities & Investments Commission or credit agencies such as Dun & Bradstreet. Product brochures and newspaper searches are another source of information. Do research on the internet and interview suppliers, distributors and customers of the competitors. In the majority of Australian business plans, little if any attention is paid to the competition. Omitting any reference to the competition probably does more to damage the credibility of a business plan than any other action. The entrepreneur who says there is no competition does not understand their target market and target customers. Fans compete with air-conditioning. In water heating, hot water heat pumps compete with gas, electric and solar water heaters. Including a short, realistic analysis and then using the analysis to develop a competitive business strategy provides a good indication of management capabilities. While the chart begins with some suggested quantitative information, it is not necessary to be precise. Big organisations in stagnant markets may spend hundreds of thousands of dollars establishing market share to 0.1 per cent; such research is a luxury unavailable to the small and growing company. It is far more important to establish a qualitative feel for the market and the competition. What entrepreneurs need to do is establish the value

market analysis and market strategy  137  Name of competitor Estimated market share Regional spread/presence Estimated yearly sales Value proposition or ‘tag line’ Key product features Pricing policy Advertising/promotion/PR strategy Sales and distribution policy Customer service/support Major strengths Major weaknesses Position in product life-cycle

Figure 12.1 Competitive analysis proposition, pricing, promotional and distribution strategies of the competition and then try to identify their various market positions. In markets that are already mature and competitive, it may still be possible to build a successful growth business. It just takes more convincing of investors that the entrepreneur understands how and has the ability to execute.  Kim and Mauborgne’s (2005) book Blue Ocean Strategy gives examples of companies that have successfully done this by redefining existing markets, including Australia’s Casella winery, Cirque du Soleil and Curves, the women’s health chain. It introduces the concepts of ‘value innovation’ and the ‘strategy canvas’. These are techniques to look at the current industry and answer the following questions: • What is the industry doing now that could be significantly reduced or even eliminated without impacting overall benefit? • What is it doing poorly that is important to customers? • What features or service approaches would be valued and have not been introduced? • Is it possible to bring new customers into the market (as done by Casella’s [yellow tail], with ‘non-traditional’ wine drinkers)

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To the potential investor in a start-up, the entrepreneur must demonstrate not only the answer to these questions, but also that the venture has the appropriate solution and it can be executed.

Marketing strategy There are four basic marketing strategies that a company may adopt: • be the low-cost supplier; • develop a unique selling proposition (USP); and • focus on an existing market segment with either a USP or as the low-cost producer; • use value innovation to redefine a market and a winning USP.

The lowest-cost supplier is a market position available to only a few companies. If a company is the low-cost supplier to an industry, it then has a strong, sustainable, competitive advantage. Typically, the cost advantage comes from economies of scale, usually under-pinned by substantial technological advantages over the competition. Economies of scale refer to the ability of a large-scale business, particularly if it has considerable investment in capital equipment, to produce goods at a lower unit cost than the small business. Examples in Australia are brewing, aluminium and electricity production. For a small, growing company, competitive advantage created by economies of scale is unlikely. However, there is a competitive advantage that can be derived from being first in an industry; it is known as riding the learning curve. The learning curve refers to a discovery made in the aircraft industry during the 1950s. The cost accountants noted as a general rule of thumb that for each doubling of the production run the average unit cost of production over the total run fell by 20 per cent. Figure 12.2 shows the learning curve effect for a hypothetical product with an initial unit cost of $100. After about 4096 items are produced, the average cost of production has dropped to around $10 and the marginal cost (the actual cost to produce the 4097th item) is even lower. The learning curve has been shown to operate across a wide range of industries. The best known is the semiconductor industry. A company launches a new design that becomes popular and then rides down the learning curve ahead of the competition.

Average cost of production

market analysis and market strategy  139  100 90 80 70 60 50 40 30 20 10 0

1

2

4

8

16 32 64 128 256 512 1024 2048 4096 Number of items produced

Figure 12.2 The learning curve FIG1202.EPS

Developing a USP is probably the most common marketing strategy of the high-tech business, in part because of the difficulty of becoming the low-cost producer. If, by research and development and a clear understanding of its target market, a company can provide a product in the marketplace with genuinely differentiated and superior customer benefits, then it can acquire a large market. Examples of a USP strategy to dominate an entire market are rare. An example is the titanium pacemaker developed by Nucleus, but more prosaic examples include the Monier roof tile and the Westfield shopping centre. A USP need not just be a technical advantage; company positioning may also generate market leadership. One famous technique is to choose an unusual colour; Farley Lewis distinguished its cement from that of other companies by painting its trucks pink. A third strategy is to focus on a market segment or niche. By simply generating a new variable or concentrating on a particular segment of the market, a company can gradually establish a market position. The retail market abounds with examples of market niches developed by a focused marketing strategy. McDonald’s, Just Jeans and Knitwit are all examples of organisations whose initial marketing strategy was to focus on a product or a particular segment of a market.  The fourth strategy, also discussed above under market analysis, is to redefine the market through ‘value innovation’. This involves looking outside the current customer base to see what might persuade new customers to use the product category. It also involves looking at how the industry delivers the solution and how that can be dramatically improved, while at the same time reducing cost.

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New South Wales based Casella Wines [yellow tail] brand is an example of this strategy. Casella recruited the half-dozen American salesmen retrenched following the Southcorp-Rosemount merger in 2001. Intimately involved in the US market and familiar with the aggressive competition, this group designed a product to appeal to non-wine drinkers as well as drinkers, focusing on ease of selection, distinctive ‘fun’ (non-pretentious) labelling and presentation (it had a kangaroo on the label and staff in outlets were given Driza-Bones).  The price point, quality and taste were carefully selected to match this broader customer base, and costly advertising done away with. The results were spectacular. By 2005, [yellow tail] was the number one imported wine into the United States, with over 25 million cases sold.

Positioning Deciding on a positioning strategy is the first and most important step in developing a marketing strategy. Positioning refers to where a company places itself along certain axes by which it defines the market. Occasionally, a new product may be introduced to the market and incorporated in its positioning strategy will be a new dimension on which the competition will be positioned. A good example of this is the car industry. At one time, Ford dominated the motor industry with a market share of more than 80 per cent. General Motors, under the new leadership of Arthur Sloane, then developed a new positioning strategy introducing driver status. Against each of the models in the Ford range, General Motors positioned a slightly more expensive car fitted with some extra options to increase the status of the model. The strategy worked very successfully, and General Motors became the market leader. In the 1970s, as rising oil prices forced consumers to reconsider cost, the Japanese introduced the new dimension of value for money. In a similar way, Volvo created a new dimension of safety and positioned itself at the top end. Once the positioning strategy is established, the other components of a competitive marketing strategy—namely pricing, distribution, promotion and packaging—follow.

market analysis and market strategy  141 

Pricing After the positioning and marketing strategy, the next key decision is pricing. Pricing separates the successful businesses from the failures. The secret to pricing is to first analyse the competition and establish the range of prices, from lowest to highest. Pricing then becomes a question of solving the equation. Price (new product or service) = Price (lowest of competition) + F (price range) The value of the factor F can be estimated in a number of ways, but the simplest method is for you and your team to list and rank (by importance to the customer) all the features in the marketplace and then score your product on a range of one to ten. An even better strategy is to survey potential customers to get the ranking and your product’s score on each ranked feature. For example, let us assume that you wish to introduce a new car to the family market. You might rank the features as illustrated in the first column of Table 12.1. The maximum possible weight on any feature is the maximum possible score (10) multiplied by the importance ranking. The weight for each feature of your product is the importance ranking multiplied by your product’s score for each particular feature. To derive F you sum the weights for your product’s various features  (176) and divide that sum by the maximum possible total weight (390). In this example F = (176/390) = 45 per cent. You then carry out similar exercises for lowest priced competing car (priced at $20 000) and highest priced competing car (priced at $32 000) and get F scores of 30 per cent and 60 per cent respectively. You should thus price your product at the midpoint, say $26 000, as your F score is midway between the highest and lowest F scores. Pricing in this fashion could justly be regarded as an artificial calculation. On the other hand, it introduces systematic analysis into the pricing calculation. Pricing policy should also address: • add-ons; • inflation-based and other price adjustments; • discounts; • annuity income.

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Table 12.1 Pricing a new product Importance ranking (A) Fuel economy

Maximum possible weight

Product score (B)

Your product weight (A×B)

10

100

5

50

Safety

9

90

6

54

Four doors

8

80

0

0

Power steering

6

 60

10

60

Automatic

4

40

3

12

Power windows

2

20

0

0

Total

390

176

Add-ons refer to supplementary charges that can be justifiably added on without causing grief or embarrassment. Add-on charges are an economical way of adding to profit. Companies that have been in existence for a long time have generally developed several add-on charges. A good example would be the supplementary charges banks add on to a loan besides the standard interest charge. These charges can add substantially to the total interest bill. As you are intending to establish a company that will be in existence for some time, developing a range of add-on charges is excellent policy, provided it does not harm your customer relationships or impair your competitive position. Bank charges work for the banks because every bank charges them. Adjusting prices to reflect general price  inflation (or deflation), because of changes to your cost base or due to competitive moves is extremely common. Pricing is probably the most important marketing factor after positioning, but usually receives insufficient attention. One of the best business lessons that we have ever learned about business concerned a division of a large freight forwarding multinational which had just slipped into loss-making. It was decided to hold a management conference to agree on remedial policies to restore profits. The managers gave their individual presentations on how this could be done. The state managers wanted money for more salespeople, the marketing manager wanted more money for promotion, the operations manager wanted new trucks,

market analysis and market strategy  143 

and the administration manager wanted a new computer. After about six hours the managing director of the company, who is one of Australia’s most successful businesspeople, stood up, after having said nothing all day. He turned to the general manager, asked how much freight was carried a week, and received the answer, ‘4000 tonnes’. He then looked at the budget and said that the weekly budgeted profit shortfall was $8000. He suggested adding on $2 per tonne to the price and walked out. The decision was implemented and profits were restored. What the MD knew was that, while the price sensitivity of new customers is high, once a prospect is a regular customer the effort and cost to switch suppliers becomes significant and price sensitivity lessens. Successful businesspeople adjust their price schedules accordingly—always with an eye on the competition, of course. The other key aspect of pricing is discounting. In the computer industry it is said, ‘You do not have your first site until you have your first sale; but you can not get your first sale till you have your first site.’ This maxim refers to the need for a reference or demonstration site for your product, particularly if you are selling things such as enterprise software, capital equipment and outsourced services. A common strategy for companies with large budgets and positive cash flow is to set up and staff its own demonstration site. Small, growing companies cannot generally afford to do this. What the small company must do is discount. It is important that the discount is understood to be a one-off, special, never to be repeated offer. Entrepreneurs must gain from their initial clients as many non-financial benefits as possible, particularly case studies, written references, clearance for reference visits and testimonials (in writing and on video if possible). The final aspect of pricing policy is establishing an annuity revenue stream. What entrepreneurs and investors want is for the business to make money while they sleep. They want to establish a steady cash flow rather than rely on one-off sales. Consumer items that wear out such as razor blades and plastic pens (worldwide about ten billion are thrown out each year, 140 million in Australia alone!), maintenance contracts, software as a service and management fees are all examples of steady cash flow. Warehouse pallets are a good example of an average business converted into spectacular returns by introducing a weekly hiring policy. It is even better if the regular income is linked to the consumer price index (CPI). A good example is maintenance contracts for computer equipment, which start as an annual charge of 10–20 per cent of the purchase price and rise with the

144  raising the money

CPI. Over a five-year period the client usually pays more for maintenance than the initial purchase price.

Packaging Packaging is becoming an increasingly important part of the marketing mix. As the cost of sales staff and media advertising continues to rise, and the retailing and wholesaling industries continue to move to self-service supermarkets, packaging is becoming the silent salesperson. Packaging is the last part of the marketing mix a prospect sees before he or she makes a purchase decision. Industries such as alcohol and tobacco, which have government restrictions on advertising, are spending increasing amounts on packaging. Industrial products are also making increasing use of sophisticated design and packaging concepts. An example familiar to many people is the gradual increase in quality of the manuals for computer software. In the beginning, the manuals were often photocopies stapled together. Now they are sophisticated works of publishing which may cost over $100 000 to write and produce. Repackaging or a packaging difference may create a USP for a product that can often result in a telling competitive advantage. DBase was the first top selling database package for personal computers. It achieved its dominant position by innovative packaging. The package sold in a shrinksealed wrapper with a sample system on a separate disk. Prospective users, on payment of the package price, were given both the sample disk and the system disk with the guarantee that if the system disk was returned with the seal unbroken they would receive their money back. The manufacturer removed the risk of purchase with a simply administered system. The cost of the sample floppy disk, which the customer kept, was easily outweighed by the interest earned on the early receipt of cash. Packaging is also important when considering export markets. To achieve the necessary size and profits for a public flotation, it is usually necessary for Australian companies to have an export strategy. Cultural differences can spring some nasty surprises. Asians consider reds and yellows as colours of quality while Anglo-Saxons consider them tawdry. Southern Europeans like serif typefaces while Northern Europeans prefer Helvetica. While some brands have created a global image, such as the Coke bottle and the McDonald’s golden arches, other companies market

market analysis and market strategy  145 

differentiated products. In the United States, Campbell’s soups have a famous red and white label, immortalised by the pop artist Andy Warhol, but in the United Kingdom Campbell’s has positioned its products with a variety of labels.

Exports Due to Australia’s relatively small market, it is almost always necessary to develop an export strategy if the entrepreneur aspires to develop a large, fast growth company. One obvious target is the United States, with its population of 301 million and a gross domestic product about 20 times that of Australia’s, similar language and customs, and plenty of market research supplied by US television and products. However, there are differences—particularly in the banking, legal, and industrial relations systems. The United States is a fragmented market and should be regarded as 75 separate geographic areas, each equivalent in population to Sydney or Melbourne. In many cases, each area requires a tailored approach, as the variations can be startling. Two primary entry strategies are available: either buy a company or start up an office from scratch. The first strategy, while probably the most cost effective for most large companies, can be disastrous. A famous example is former petrol company HC Sleigh. Founded in the early 1900s, HC Sleigh was a listed company when it paid $20 million for 50 per cent of a US coal trading company, AOV. A few months later, AOV went into receivership. The concern about the effect on HC Sleigh’s profits depressed its share price and it was taken over by Caltex. Private companies are difficult to audit and analyse. Thorough due diligence is critical, but it can also be costly and time consuming. The fragmented banking system in the United States makes credit analysis more difficult, compounding the problem. Thus the second alternative, of setting up your own office, is probably preferable for many small companies. The question then becomes whether you use an American or an Australian to head the operation. Again opinions vary, but experience suggests it is better to use someone familiar with the company and the product to start up operations. There are of course excellent entrepreneurs and managers in the United States. The problem is that they are almost impossible to recruit. It is more likely that the Australian company will end up with a second-rate operator. Television and tourism have helped us all feel far more comfortable dealing with overseas

146  raising the money

businesspeople. Indeed, while it would be a mistake to promote aggressively the Australian characteristics of the business, it can certainly help to create corporate differentiation. Also, a visit to Australia by prospective customers can be a very effective sales weapon. The cost and time to enter the United States should not be under-estimated. A US office will require at least $500 000 in start-up funding and take at least twelve months to generate sales. The other export markets that are becoming popular are the Asian markets. The cost of start-up here can be considerably lower than in the United States. As a general rule, if the dominant language is English (such as in Singapore) you can set up a greenfields operation. On the other hand, for non-English-speaking cultures such as China or Thailand, it is far safer to set up a joint venture with a local partner.

Promotion and advertising For a new Australian consumer product, a major problem is the concentration of buying power in the retail industry. The emergence of buying chains has made new product introduction more difficult. Typically, in the grocery trade, new products are given only twelve weeks to prove themselves. Also, the retail chains have introduced a new-line fee to cover the introduction of new products. A common charge would be $250 000. In addition, at least $500 000 is probably required for the advertising launch. At least $750 000 and nearer to $1 million is probably the minimum marketing funding required to launch a new consumer product. Hershey, a company with an excellent reputation, tried to launch its chocolate products in Australia and spent $500 000 on advertising. The competitive Australian advertising budgets were estimated to be $6 million for Cadbury and $5 million for Mars and Rowntree Hoadley. The launch failed and retailers later said Hershey should have spent at least $3 million on advertising. These figures, combined with the knowledge that over 90 per cent of new consumer products wither and die within eighteen months, help explain why venture capitalists often reject investment proposals based on new consumer products. Large, well-established consumer products  businesses have seen successful buyouts, however, because they have had strong pre-existing brand recognition. On the other hand, consumer products that have a self-financing form of distribution are attractive. Direct mail is one approach, franchising is

market analysis and market strategy  147 

another. Franchising has become popular in Australia and now employs more than 600 000 people. In Australia, the domestic market is small so creating an adequately sized franchise network is more difficult than, say, in the United States. The size of the market in the United States means sufficient branches can be established so only a small royalty is required to cover central office overheads. The product must have sufficient gross margin to provide satisfactory profits for both the franchiser and franchisee. Only a few products, such as pizza and tax planning, have sufficient gross margins. Otherwise, franchisers must obtain their returns from either supply of the ingredients (Bakers Delight) or asset growth by leasing the premises (McDonald’s).

Partnering An increasingly common strategy to accelerate the growth of a start-up venture is partnering with larger firms. Having credible partners in place, like major reference customers, also greatly enhances the chances of a successful capital raising. Thomson’s (2006) book Blueprint to a Billion gives several examples of successful partnering in the US market to rapidly create $US ­billion turnover companies (he talks about ‘Big Brother Alliances’). These included IBM’s support for the introduction of Microsoft’s PC-DPOS (which became MS-DOS), Andersen and Microsoft’s support for Siebel and AT&T Worldnet’s support for Yahoo! Australian examples include Cox Media and Microsoft’s support of LookSmart and IBM’s support of Kaz Computing. The right partners can open doors, accelerate sales and significantly expand the perceived and actual resource base of the start-up. The wrong ones can divert product development, consume resources in bureaucracy, steal or leak intellectual property, damage relationships with joint customers through poor performance or cause cash flow problems. Some key considerations in choice of partners to enhance the marketing strategy are: • geographical reach or ‘footprint’; • value proposition to their customers (does it align?); • complementarity of products and skills; • their drivers and how they align with the venture; • reputation in the industry (good to be associated with?);

148  raising the money • ability to support joint customers; • cultural fit and chemistry between the principals; • trust.

Strategic partner relationships also need to be proactively managed. Confidentiality agreements, teaming agreements and formal alliances are typically documented. If partnering is a key element of the strategy, the business plan should allow for partner relationship management, training, technical support or joint promotional activity as appropriate.

The product life-cycle It is important to recognise that every market contains potential purchasers as well as actual purchasers, and at the time a new product or service is launched practically the whole of the market represents ‘potential’. Converting potential purchasers into actual purchasers takes time; it is often between five and 20 years before 90 per cent of the members of a particular group of people have adopted a new product. Within an established market, a new product will take a similar length of time to become generally recognised as a practical and efficient alternative to the established products. Over such a long period, the market itself changes: technology evolves, regulations change, some people die or become too old to participate in the market, or they migrate away from the market. At the same time, immigration and children growing up will increase the market size. Some people may become too poor to buy the products while others may reach a sufficient level of affluence to enter the market. A decision to enter a market for the first time, or to change to a new product, will often be sufficiently significant as to require considerable investigation and management resources. Inexperienced start-up entrepreneurs are hurt and bewildered to learn that their potential customers continue to buy old and inferior products. If they study those customers closely, they will find that they are ordinary people with many other demands on their time. Investigating a new product or service may be fairly low on their priority list. For most markets that have been studied, no more than 3 per cent, and often less than 1 per cent, of the potential purchasers targeted by advertising, point of sale and other promotional material, and sales ‘cold calls’ actually enter a new market or buy a new product in the year following the

market analysis and market strategy  149 

% Saturation

product’s launch. Apple’s iPhone is a significant exception, garnering over 19 per cent share of the US smart phone market in just one year. Most people do not have the time to make a careful personal investigation of a new market or a new product. Most, in fact, do their new product research vicariously. When a trusted friend or colleague has used a new product, and praises it, people who have not personally examined it in detail will become significantly more likely to buy it for themselves or their business. This ‘internal growth’ among users of a new product can amount to between 25 and 75 per cent of the growth in demand for a new product. It tapers off as the number of actual users rises and the number of potential ones falls. The combined effect of a few of the potential users responding to the marketing effort while many more respond to the influence of those who have already joined the market gives the product life-cycle its characteristic shape (see Figure 12.3). 100 80 60 40 20 0

1

2

3

4

5

6

7

8 9 Years

10

11

12 13

14

15

Figure 12.3 The product life-cycle FIG1203.EPS These facts must be taken into account when estimating sales in future years, and particularly when estimating the time it will take for a new venture to break even. Under some circumstances, a venture must be replanned at this point—if not cancelled. If, for example, a new product is unlikely to get more than a 15 per cent market share, and needs a market share of 12 per cent to break even, it probably never will. Figure 12.3 shows a product (or market) life-cycle for a fairly attractive product (such as an iPod). Note that although 97 per cent of the potential purchasers will be using the product fifteen years after its launch, in the first year fewer than 1 per cent of the potential users adopt the product and enter the actual market. The model used to produce Figure 12.3 is very basic, and more sophisticated models take into account factors like the entry of competitors and life-cycle price changes. The effort required to develop a life-cycle model is usually amply repaid.

150  raising the money

Entrepreneurs should note that the time to penetrate business or government customer markets can also be quite long, and the cost to do so should not be under-estimated. As mentioned, business and government customers want reference sites. One  venture capitalist  interviewed for this book felt new products needed to be ten times better than existing products because small incremental improvements to existing products are usually insufficient to overcome buyer switching costs.

13

Preparing a business plan: The financial analysis

In this chapter, we examine the techniques of financial analysis which demonstrate to potential investors that the entrepreneur understands the business. When they describe their business finances, many company annual reports and many businesspeople do so with a pie chart, similar to that in Figure 13.1. The chart demonstrates how much of every sales dollar the company must pay for labour and materials, interest payments and taxes. Usually the chairperson’s report contains some comment about how little is left for dividends and retained earnings. Retained earnings 4%

Dividends 4%

Material costs 24% Labour costs 40% Interest 6%

Other costs 18%

Corporate tax 4%

Figure 13.1 Typical division of sales dollar FIG1301.EPS

152  raising the money

Unfortunately, the diagram is misleading. It implies that in every dollar of sales there is an element of profit. The pie chart illustrates the misconception that the basic equation of business is the same as the profit and loss statement: sales – costs = profit.

Break-even analysis Break-even analysis uses a different and more realistic approach. Every business has two types of costs. Fixed costs are those costs that must be paid irrespective of sales. Examples are rent, utilities, management salaries, and so on. No profit can be earned unless the fixed costs are covered. Variable costs refer to those costs that vary according to sales. Examples are raw materials, manufacturing labour costs, transport and warranty provisions. The actual business equation is as follows: Sales – Variable costs = Contribution Contribution – Fixed costs = Profit The equation is often portrayed in chart form, as shown in Figure 13.2. As the sales increase so does the profit, as indicated by the rising profit line. The angle of the profit line depends on the contribution. The greater the contribution per dollar of sales, the steeper the gradient of the profit line. If sales are zero, the loss is equal to the fixed costs or where the profit line cuts the Y-axis. If there are sufficient sales so that the contribution equals the fixed costs, the business is at break-even (the profit is zero) and the break-even point is where the profit line cuts the X-axis. Profit 30 20 10 0 –10

20

40

60

–20 –30

Figure 13.2 Typical break-even chart FIG1302.EPS

80

100 Sales

the financial analysis  153

The first step in break-even analysis is to calculate the contribution rate. This is usually expressed as a percentage and defined as follows: (Sales – Variable costs) / Sales = Contribution rate The gross margin (sales less cost of goods sold) is often taken as a surrogate for contribution. The approximation assumes identical stock levels at the beginning and end of the accounting year. The break-even point is then calculated by dividing the fixed costs by the contribution rate. The break-even point may be expressed as a sales figure (‘We need $30 000 sales a month to break even’). If the business is dominated by a single product or has a standard measure of volume, the break-even point can be expressed in physical terms (‘We need to carry 5000 passengers a day’). A simple business may sell $50 000 worth of product a month, have a cost of goods sold of $30 000 and show a profit before tax of $4000. What is its break-even point? Sales $50 000 Variable costs – $30 000 Contribution = $20 000 Fixed costs – $16 000 Profit = $ 4 000 Contribution rate $20 000 = 40% 50 000 Break-even point Fixed costs = 16 000 = $40 000 Contribution rate 40% Break-even analysis can be used to predict profits. What would be the profitability at $60 000 sales per month? Using the equation below provides the solution: Profit = (Sales – Break-even point) × Contribution rate = (60 000 – 40 000) × 40% = $8000 Increasing sales by 20 per cent doubles the profits of the business. Breakeven analysis is a fundamental tool of successful entrepreneurs. They should calculate it every accounting period. Every business has a different breakeven chart. As shown in Figures 13.3 and 13.4, manufacturing companies typically have high fixed costs and high contribution rates, while retail organisations have low fixed costs and low contribution rates.

154  raising the money Profit 40 30 20 10 0 –10

0

10

20

30

40

50

60

70

80

90

–20

100 Sales

–30 –40

Figure 13.3 Manufacturing company break-even chart FIG1303.EPS Besides providing a tool for predicting profits at different levels of sales and understanding the dynamics of a business, break-even analysis can be a useful tool when deciding on business strategy. Increasing sales volumes, reducing fixed costs or increasing the contribution rate can increase profits. If each variable can be altered by 10 per cent with equivalent effort, then the calculations for one business would be as shown in Table 13.1. Readers should repeat the four calculations themselves to ensure they understand break-even points. In this simple example, the strategy of either increasing sales (by a new advertising campaign, say) or increasing the contribution rate (by reducing variable costs or increasing sales prices, for example) would be equally profitable. Improving the contribution rate has the added benefit of lowering the break-even point, however. Profit 30 Profit 40 20 30 20 10 10 00 –10 –10 –20

0

10 10

20

30

40

50 50

60 60

70 70

–30 –20 –40 –30 FIG1303.EPS

Figure 13.4 Retail company break-even chart FIG1304.EPS

80 80

90 90

100 100 Sales Sales

the financial analysis  155

Table 13.1 Break-even variations Base case

10% increase in sales

10% decrease in fixed costs

10% increase in contribution

Sales

$50 000

$55 000

$50 000

$50 000

Variable costs

$30 000

$33 000

$30 000

$28 000

Contribution

$20 000

$22 000

$20 000

$22 000

Fixed costs

$16 000

$16 000

$14 400

$16 000

Profit before tax

$4000

$6000

$5600

$6000

Contribution rate

40%

40%

40%

44%

$40 000

$40 000

$36 000

$36 364

Break-even point

While the above example is simple, calculating the effect of cost reductions on the break-even point is usually illuminating. The contribution rate can be increased in three ways: • increasing selling prices, which is probably the most common technique; • changing the product mix to increase the total contribution rate by replacing low-margin products with higher-margin products; and • decreasing variable costs by switching suppliers or introducing laboursaving equipment.

Self-financing growth rate Another key number for the entrepreneur to calculate and understand is the self-financing growth rate (SFG). This is the maximum rate at which a company can grow using its internally generated cash resources. Traditionally, entrepreneurs under-estimate the working capital required to fund their businesses. Calculating the SFG is a good way of understanding the working capital needs of a business. The calculation requires four steps:

156  raising the money • First work out the Operating Cash Cycle (OCC) for the business. • Establish the cash tied up ($T) in each OCC, both in the form of working capital and operating expenses. • Work out the cash generated ($G) for each OCC. • Then work out the SFG by the following formula: SFG = ($G/$T) × (365/ OCC).

The Operating Cash Cycle is best understood by considering Figure 13.5. In this simple example a distributor orders stock which is held and then sold. Cash tied up in inventory is calculated in COGS days, (COGS/365) while cash tied up in Accounts Receivable is calculated in sales days (Sales/365). The sum is the Operating Cash Cycle. The duration that cash is tied up is reduced by the Accounts Payable, again calculated in COGS days. This is known as the Cost of Sales Cycle. Operating Cash Cycle

Days of holding inventory Days of Accounts Receivable

Days of Accounts Payable

Inventory received

Payment for inventory

Duration cash is tied up

Goods sold

Payment received

Figure 13.5 The Operating Cash Cycle Let us take a simple example. The Operating Cash Cycle is 150 days and Accounts Payable are paid in 30 days; therefore the Cost of Sales Cycle is 120 days. In this example, we assume that operating expenses are paid over half the Operating Cash Cycle. Duration cash is tied up (in days) Accounts receivable 70 Inventory 80 Operating Cash Cycle (OCC) 150 Accounts payable 30 Cost of sales 120 Operating expenses 75

the financial analysis  157

The simple income statement is shown below. COGS is 60 cents in the dollar, while operating expenses are 35 cents. Cash generated on each dollar of sales is the profit of 5 cents. For simplification, we are omitting tax, fixed assets and depreciation. Income Statement Sales Cost of sales Operating expenses Total costs Profit (cash)

$ $ 1.000 0.600 0.350 $ 0.950 $ 0.050

The cash tied up in each sales dollar is calculated thus: Amount of cash tied up per sales dollar Cost of sales $ 0.600 × 120 / 150 or 0.800 = $ 0.480 Operating expenses $ 0.350 × 75 / 150 or 0.500 = $ 0.175 Cash required for each OCC $ 0.655 Cash generated per sales dollar $ 0.050 To calculate the SFG, there are two parts. First we calculate the SFG for one OCC and then we multiply that by the number of OCCs in one year. The product generated is the annual SFG rate: SFG rate calculations OCC SFG rate $ 0.050 / $0.655 = 7.63% OCCs per year 365 / 150 = 2.433 Annual SFG rate 7.63% × 2.433 = 18.58% This company thus has a self-financing growth rate of 18.58 per cent. To grow sales faster, it will need some form of financing injection.

Cash flow forecasts Break-even analysis is also useful for providing a format for cash flow forecasts. In every business plan, there must be a section on financial projections. A business plan without projections is like a body without a heart. The quality of the financial projections is of key importance to venture capital investors. The task for entrepreneurs is to prepare a valid set of projections. Presentation is also of paramount importance.

158  raising the money

Financial projections have three components: • monthly cash flows; • annual profit and loss statements (now to be known as statements of financial performance); and • annual balance sheets (now known as statements of financial position).

The monthly cash flows should extend for at least twelve months after the cash flow turnaround. It helps to plot a cumulative cash flow curve, as shown in Figure 13.6. Capital expenditure, set-up costs and working capital burn up cash, then as sales occur the cash flow turns from negative to positive. When laying out the cash flows, its best to label the months as Month 1, Month 2, etc., starting from the first capital injection. Otherwise you will need to constantly update the projections during the negotiations. The cash flow layout should consist of four sections:

Cash balance

• operating cash in (sales, royalties, etc.); • operating cash out (material, labour, rents, etc.); • capital expenditure; and • financing cash flows (debt, equity, interest and dividends). 120 100 80 60 40 20 0 –20 –40 –60 –80 –100

4

8

12

16

20

24

28

32

36 Month

FIG1305.EPS Figure 13.6 Cumulative cash flow curve

Operating cash in refers to cash received. Cash received comes from sales or government grants and not from financing. The key is to first make a sales estimate and then, using a lag of two to three months, estimate the debtors. Most entrepreneurs under-estimate the debtors requirements. It

the financial analysis  159

is worth noting the actual figures in sales-days for some groups of listed companies. A sales-day is the annual sales divided by 365. Average debtors typically vary between 40 and 60 sales-days (see Table 13.2). Table 13.2 Working capital ratios in sales-days for listed companies Group

Stock

Debtors

Creditors

Builders’ suppliers

55

51

36

Chemicals

88

56

28

Food manufacturing

56

38

37

Paper and packaging

70

52

28

Retail

49

4

22

107

62

29

Textiles

Operating cash out is calculated in several steps. The first step is to work out the labour and material requirements for the variable-cost section of the operating costs. This will vary from business to business. However, it is worth noting some stock levels and creditors for certain businesses. Typical ratios are 60 sales-days of stock held and 35 salesdays for creditors. Step two is to work out the cash flows of the fixed costs such as management, sales administration, research and development. Tax payments should also be calculated. Taxable income will be equal to net operating cash flow less depreciation and provisions. Tax is typically paid nine months in arrears, but recently has varied from Budget to Budget. The third group of cash flows is capital expenditure. You need to estimate the property, plant and equipment you will require for your business. Much of this may be leased under operating leases and may fall under operating cash out. If you plan to make fixed asset purchases, you need to forecast the cash outflows. After calculating the capital expenditure cash flows, the next step is to prepare the financing cash flows. The usual technique is to first calculate the cash flows as if the financing were 100 per cent equity and no dividends. Then introduce debt financing into the model (for a start-up, borrowings are not likely until some time into the future). It is necessary to do an iterative calculation, for interest will reduce the taxable income and in turn reduce the rate of repayment of debt.

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For a buyout or a start-up, the cash flow forecasts are critical. In the case of the buyout, it determines the ability to service debt, and hence how highly the company can be geared. In the case of the early-stage business, it indicates the time to reaching a cash flow positive state. You should build your forecasts in a model that lets you alter key assumptions and show the sensitivity to the changes. For buyouts, the cash flow forecast is also a vital tool for assessing the level of debt that can be serviced.

Profit and loss forecasts After completing the cash flows, the entrepreneur needs to prepare profit and loss accounts and balance sheets. The business plan should contain a maximum of five years’ figures. Two years should be summaries of past results while three years should be projections. If past results are not available, then you only provide the forecasts. One format for the pro forma profit and loss statement is: Sales – Cost of goods sold = Gross profit – Selling, general and administration = Earning before interest and taxation – Interest = Pre-tax profit – Tax = Post-tax profit

Balance sheet forecasts One format for the pro forma balance sheet is: Current assets + Fixed assets + Intangible assets = Total assets Current liabilities + Long-term liabilities + Shareholders’ funds or equity = Total liabilities and equity

the financial analysis  161

Forecast ratios Then a number of ratios should be calculated. The key ratios are detailed below.

Net margin This percentage is calculated by dividing the post-tax profits by the sales. Anything over 10 per cent is suspicious. The average for the S&P 500 for the past 50 years has been between 5.5 and 8.5 per cent. For S&P 500 technology companies, the average has been about 10 per cent, sometimes a little above this level.

Gearing This is generally expressed as the ratio of total debt to shareholders’ funds, and is a measure of financial risk. Anything over 100 per cent is regarded as high for an earlier stage company. For buyouts, because they tend to involve larger, mature companies with stable cash flows, gearing is often much higher, frequently 200 per cent or more.

Stock, creditors’ and debtors’ ratios These are collectively known as the working capital ratios. They should be calculated in terms of sales-days or annual sales divided by 365. Anything below 60 sales-days of stock, below 50 sales-days of debtors or above 40 sales-days of creditors is probably unrealistic.

Return on equity The return on equity equals post-tax profits divided by shareholders’ funds expressed as a percentage. The return on equity should be above 15 per cent. That is the minimum; to attract venture capital or angel backing, your business model should deliver even higher ROE.

Interest cover This ratio is defined as pre-interest cash flow divided by interest payments. If the interest cover falls below two, the financing risk of the business is too high. This is a critical ratio for buyouts, along with gearing.

Annual sales/employee This ratio should be calculated monthly but expressed as an annual figure. To calculate it, you need to prepare a workforce planning chart that

162  raising the money

shows the monthly growth in staff. The monthly sales figures from your cash flow forecasts are then matched with the monthly workforce totals. You should calculate the sales per employee for other companies in your industry or for companies with similar business models and benchmark your own estimates against the results. The figures will vary depending on the industry and the business model. Microsoft, despite having more than 79 000 staff in 2007, had an average of $647 000 per employee. ResMed averaged $265 000 per employee in 2007. Telstra averaged $425 000 per employee in 2007. BHP Billiton averaged $1.2 million per employee in 2007. Among the Fortune 500 in 2007, the pharmaceutical industry averaged $400 000 per employee, as did telecommunications. Medical products and equipment averaged $300 000 per employee, as did computers and office equipment, and semiconductors and other electronic component makers. Do your benchmarking and if your figures fall outside the normal range for your chosen industry, your workforce estimates are probably too low, or your sales growth estimates are too high.

Contribution and break-even point These two ratios should also be calculated on a monthly basis for the business. As a check, you should also include detailed manufacturing cost calculations for the two or three most popular products.

Conclusion As indicated previously, such calculations would have been very timeconsuming and expensive before the introduction of personal computers. With the advent of spreadsheets, they are now easy to prepare and should take two to three days at most. Moreover, if your financial estimates are available on a spreadsheet, you can change or modify your model relatively effortlessly. Early-stage companies may struggle with what the future financials might look like. Find some listed companies in similar sectors targeting similar customers. Calculate the key ratios for those comparable companies and use them as a guide for your business when it reaches a steady state. For buyouts, analysis of comparable companies can also be very valuable, but with buyouts there is always an operating history to look back upon as a guide for forecasts. One mistake entrepreneurs make is to project at a detailed level too far into the future. Remember the plan should fit into a briefcase. Including

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pages of spreadsheets will try the patience of most investors. One page for annual profit and loss statements, balance sheets and ratios, combined with two to three pages for cash flows and workforce estimates, is often enough. The back-up documentation should be available but not included. On the other hand, key assumptions in the estimates should also be stated in the financial section. Samuel Goldwyn once said it is difficult to prophesy, especially about the future. If there is a consensus developing about forecasts, it is that to try to make them for a ten-year period is impossible—just budgeting for eighteen months ahead is difficult enough. Entrepreneurs should have their minds fixed on two key dates: first, how long will it take before the business turns cash-flow positive; and second, in what year will net profit after tax exceed $3 million? The financial analysis should provide a good indication of those two dates.

14

Preparing a business plan: Organisational and operational issues The organisational and operational issues of importance to investors comprise the final significant part of a business plan. These include the management team, board, operations strategy, recruitment and staffing plan, implementation plan, risk management, protection of intellectual property and employee ownership of shares.

Management team Every venture capitalist and private equity investor interviewed for this book placed extremely high importance on the presence of a quality, experienced and ethical management team. So whether you are operating an early-stage venture or planning a buyout, a key task is to have a management team organised. The ideal management team should include people with skills in marketing, sales, partnering, finance, administration, operations and product development. Typically, some necessary skills are missing but usually a start-up needs at least three committed individuals. There should be someone who understands and can sell to the market; there should be someone who can develop and manufacture the product; and there should be someone who can handle finance and administration. As important as having key individuals on board is ensuring relatives and friends are not freeloading off the company. Both the management

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and the board of the company should comprise competent people who are interested in increasing the net worth of the business. The best indication of quality of management is a track record in the industry with experience of start-ups. A good example of this would be the Sock Shop, a UK retail chain that specialises in hosiery. In the first four years of operation, the company set up 59 small shops. In the fourth year, turnover and net profits were $35 million and $3 million respectively. The company floated after three years when net profit exceeded $1 million. The management team is a husband and wife. The wife began her career in the typing pool of Marks and Spencer, the largest retailer in the United Kingdom, and worked her way up to become the chairman’s secretary. She left to help start the Tie Rack, a chain of speciality tie shops, where she met her husband, a chartered accountant. In the eighteen months they both worked at the Tie Rack, the number of stores went from zero to fifteen. This team of two together had the three key skills of sales, operations and accounting and also a track record in the industry. Many investors and venture capitalists rejected their business plan. After four years, the company had a market valuation of over $125 million. As mentioned previously, the management team should be aligned in their interests of building a successful business with the aim of eventual capital gains. This applies to both buyouts and start-ups.

Board The board and, if appropriate, the advisory board, play an important role, particularly in early-stage companies. ResMed used an advisory board of world-recognised specialists in sleep treatment and related conditions to reinforce its positioning as a technical leader and as a source of ideas on new products and treatment approaches. A well-constructed board for an early-stage company can build brand value, provide key contacts and introductions to customers and be an important sounding board on strategy and issues about which the CEO has no prior experience. Board members need to be proactively encouraged to take this approach and consulted regularly, typically on a weekly basis. As indicated previously, a good mix in the early stages is three to six members, including a CEO of another successful firm in a related sector,

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a senior executive of a strategic partner, ‘value adding’ investor, a key ­customer and one or two executives from the business.

Operations strategy The operations strategy sets out how the business will be run. It addresses questions such as: • key assets—for example, patents, know-how, plant, exclusive sourcing of key components; • key operational capabilities and gaps (objectivity is vital here); • activities that will be performed in house and why; • activities that will be outsourced or provided by partners, who will perform them and the arrangement, including protection of IP and safeguards against late delivery or poor quality; • where and how a competitive advantage will be built over time—for instance, in marginal cost, quality, flexibility, turnaround time, delivery or support; • proposed inventory and cash flow management; • product development; and • staffing and resourcing.

It is important to start from a realistic view of current assets and strengths, focus on a small number of key factors (e.g. design, cost per unit or delivery time) and compensate for critical gaps through partners and outsourcing arrangements. As the business grows, additional resources will be acquired, new products developed and critical activities can be brought back in house if appropriate. The operations strategy, product roadmap and staffing plan should be set out in tabular form, typically with a detailed two-year horizon and a more general description of the strategy for Year 3 onwards.

Implementation plan The business plan must include an implementation plan. This should start with a statement of the two or three key objectives the company will accomplish in each of the next two to three years. The plan should then contain a reasonably detailed operational checklist of the various steps that are going to happen in each calendar quarter. If these objectives are displayed in chart form showing the start date and duration of each activity, so much the better.

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Risk management There should be a section on the key risks for the business and how they will be managed. These may be technical (e.g. the likelihood of product development being unsuccessful or delayed), regulatory (such as FDA approval being required for a new drug) or market related (customer rejection of a new way of being serviced). They may also be competitive— the wise entrepreneur gives some thought to how significant competitors will react to the venture’s plans. Examples of competitor responses include market spoiling tactics like FUD (spreading fear, uncertainty and doubt about the entrepreneur, the company or its products), blocking market entry through exclusive channel contracts or pre-emptive legal action. There may be legal restrictions and regulations or problems with unions. Other difficulties may result from the manufacturing process. Aquaculture businesses, for example, must consider issues of food supply, temperature, energy costs, disease and predators. After an initial session where the executive team ‘brainstorms’ these risks, they should be narrowed down to those that might significantly impact the business. The remaining (high and medium impact) risks should then be summarised in a table, together with the strategy for overcoming them or reducing their impact. This is an extremely productive management tool and very important for dealing with prospective investors, who will come up with probing questions in these areas during the presentation and due diligence stages. It does not look good if management appears naive, not having thought of a key risk and how this might be addressed.

Intellectual property The implementation section should address the ownership of intellectual property. Intellectual property refers to those intangible assets a company owns which are a result of invention or creative thinking. Many federal laws cover the protection of intellectual property. Among the more important are the various patents, copyright, design, trademarks and trade practices Acts. The protection of intellectual property is a vital aspect of most highgrowth businesses. Expert advice must be sought, but we provide some basic information in the paragraphs that follow to give you a starting point for discussions with your legal advisors.

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The patent is the best known form of intellectual property protection. Patent applications are valid if the invention is new, not in the public domain, and applies to a new substance, machine or process. Patents are expensive to obtain and usually cost $2000–3000 per country. A worldwide patent could cost more than $300 000. Thus inventors may choose only to patent their invention in certain countries. To keep a patent, the holder may have to prove the invention has not been in the public domain. Otherwise the patent will not hold. There have been some unfortunate examples, such as the invention of monoclonal antibodies, where the desire of the academic to publish meant that patent protection was refused. Another problem with patents is that, although governments grant patents, they do not enforce them. Enforcement rests with the patent holder, who must go to court to stop infringements. It is the court that enforces patents. Another drawback with patents is the time taken to process the patent application. Typically, the first step in getting a patent is to lodge a provisional specification, which is a brief description of the invention. The date of lodgement of the provisional specification is known as the ‘priority date’, which a court will use to establish claims. Within twelve months the applicant must lodge a complete specification with descriptions and drawings, otherwise the provisional application will lapse. Once the complete specification is lodged and up to a maximum of eighteen months after the priority date, the patent office publishes the complete specifications to allow the public to inspect and to object. Within five years of lodging the complete specification, you must request examination by the Australian Patent Office which, if it is satisfied the invention is ‘new’, will grant the patent. The patent stays in force provided the annual fee is paid for sixteen years from the date of lodgement of the complete specification. Another problem is that, for some products—such as medical ones­ —sixteen years is insufficient time to complete testing, launch the product and recover costs. Indeed, a major industry has developed in the United States for the generic production of those popular drugs whose patents have run out. To speed up the patent process, there is a lower order of patents, called innovation patents, which allow the inventor to patent just one part of an invention. An innovation patent allows the entrepreneur to protect each stage of development long before the complete research project might be completed, thereby reducing some of the commercial

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and financial risks. Similarly, innovation patents have a life of eight years so they may be useful for inventions that are expected to have a relative short life, such as computer software. Innovation patents can be granted quickly, sometimes as quickly as 30 days. A common strategy is now to go for an innovation patent and extend it to a full patent if the product becomes a commercial success. Another problem with patents, especially with the advent of electronic databases, is that on publication the invention is in the public domain. Hence many companies now avoid patents and rely on other techniques for protection. While a patent is no guarantee of uniqueness, it is wise for entrepreneurs to carry out a patent search. A patent attorney or entrepreneurs themselves can do this at the Patent Office. It is not a difficult task and the Patent Office can be very helpful. The advantage of the patent process is that it can be used as a negotiating tool if the entrepreneur or inventor decides the more profitable course of action is to license the technology. The inventor first lodges a provisional patent and, in the twelve months before lodging a complete specification, negotiates with several licensees. As a potential bargaining weapon, the inventor can threaten to put the invention in the public domain so nobody has unique licensing rights. Because of the limited timespan of protection for patents, sometimes intellectual property is better protected by copyright. Copyright protects the material form but not the idea itself. Computer programs, company manuals and silicon chip designs are examples of items that may now be subject to protection by copyright. Copyright rests with the author of a work except if they are an employee, in which case it rests with the employer. Protection typically lasts for 50 years after the death of the author. Copyright prevents copying of the original material form, such as an instruction manual, whereas patents provide a total monopoly which stops either production or use of an invention or process. However, as copyright protection arises when the work is produced and costs almost nothing, copyright protection is often sought because there is no delay, as with patents. Designs and trademarks are not regarded as vital for high-growth business. They are for buyouts, where often a trademark (which can last forever) may be a key asset of the company. Because patent registration means publication, more and more companies are using the protection provided by trade secrets. Many companies

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ask their customers, employees and suppliers to sign confidentiality agreements, either explicitly or as a term in a supply contract. In any trade secrets action, part of the onus of proof is on the prosecutors, who must demonstrate they have made reasonable efforts to keep the product or method secret. While patents may excite some investors, most investors prefer intellectual property to be protected by secrecy arrangements. What granted patents do provide to the investor is a limited proof of uniqueness. The preceding commentary is just a guide, and entrepreneurs and investors must seek specialist advice when establishing the best means to protect intellectual property.

Employee compensation Employee compensation is also a vital aspect of high-growth companies. It has evolved into a highly specialised field because of the legal and tax rules that govern the structuring of compensation. Entrepreneurs and investors must seek legal and tax advice prior to designing and implementing staff compensation plans. Your business plan must cover the way you plan to pay and provide incentives to your team. Thus structures such as Employee Stock Ownership Plans (ESOPs) and employment contracts should be covered. ESOPs are one mechanism to provide your key employees with the opportunity to create wealth should the company meet success and eventually realise a profitable exit event such as an IPO or a trade sale. As mentioned, there are extensive tax and legal matters to be considered regarding employee share ownership, so seek advice as you construct this part of your business plan. A properly structured ownership plan for staff can often be a powerful incentive for them to work hard to increase the capital value of the company. A second key aspect in the employment compensation area is executive employment contracts. Experience demonstrates that such contracts generally favour the executive far more than the company. If entrepreneurs need the security of a contract and are insufficiently confident of their job, can investors be confident about the business? Equity should be a sufficient tie and adequate reward. As a result, in the venture capital world employment contracts are rare. In most cases, everyone is an ‘at will’ employee, essentially meaning they can be let go at any time for any reason. Seek legal advice of course, but the general rule is that it is

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probably best that the company policy, set at board level, should be to not have employment contracts. Employees should be given simple offer letters outlining their basic terms of employment, including provisions on confidentiality and assignment of inventions.

15

Choosing a venture capitalist

Once a company has been formed, a business plan prepared and one or two successful businesspeople attracted as board members, a platform from which to raise money has been established. The next step is to contact high net worth individuals or venture capitalists and organise a presentation. Entrepreneurs should remember that they are on a selling exercise—what they are selling is part of the company. For consideration, entrepreneurs are obtaining cash plus intangible costs and benefits. The intangible benefits include the networks and experience of the investors and the credibility of having a well-regarded investor in the share register. The intangible costs include more rigorous corporate governance, regular board meetings and other disciplines more akin to public companies. The money invested will usually be coloured by the investor’s reputation and knowledge of the sector. Investors with good reputations as either a successful venture capitalist or business builder in the same sector are invaluable. Gordon Bell advises ‘make sure that person can offer more than textbook advice. The more revolutionary the business idea, the more financiers struggle to understand it.’  Lack of understanding of the domain of the venture can mean failure to understand the value proposition and an early rejection, a high-risk premium being put on the cost of capital or investor inability to add value

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after the capital is raised. As mentioned earlier, the venture capital game is also a continual round of fundraising. Consequently, entrepreneurs should expect support from early investors in raising subsequent funding. Picking the right fund or HNW investor is very important. Entrepreneurs must establish their character and the relevance of their experience. One simple test with venture capitalists is to see whether the venture capitalist is an investor member of the Australian Private Equity and Venture Capital Association Limited (AVCAL). The list of investor members is on the AVCAL website (www.avcal.com.au). Another useful resource is ­Private Equity Media’s Australian Venture Capital Guide. The easiest way to find out about a venture capital company is to go to its website. The website should provide at minimum a description of key staff, investment philosophy and the investment portfolio. The website should also enable you to determine how much of the funds are invested and how much are available for new investments. Venture capitalists typically invest around 75 per cent of a fund and aim to keep 25 per cent in reserve and for fees. If the website does not contain this information, send an email requesting it. Websites of venture capital companies, besides providing an indication of the funds available, also usually contain a summary of individual investments. From reading it, entrepreneurs should be able to develop a feel for the type and size of investments. If the average investment is $3 million and you are seeking only $1 million, then you may have a problem. The website will also have a list of current and previous investee companies. Entrepreneurs can contact the managing directors of the investee companies and find out what the venture capitalists are like as investors and partners. Venture capitalists, if they become interested in a proposition, should spend a lot of time checking the entrepreneur’s references. There is no reason why entrepreneurs should not act similarly. Your lawyer, accountant or other advisors may have personal contacts in a venture capital firm. You should be able to arrange introductions through these channels if you have chosen your advisory team well. Similarly with high net worth individuals, researching their background in the industry is important. Today there are internet search engines specifically designed to find people information, so always check the web. Also, check media releases and the history of companies with which they have been associated. If possible, speak to the MDs of companies they

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have been involved in to get a reference on their style of engagement and their ability and willingness to add value to the business through contacts, partnerships and relevant industry experience. Another key criterion for both high net worth individuals and venture capitalists is distance. The further the business is from the money, the smaller the probability of gaining funds. The more successful of the American venture capitalists, especially when they are expected to be the lead investor, refuse to consider any business where the head office is located more than 90 minutes’ travelling distance away. Similarly, the bulk of the portfolio of HNW networks is local and in a sector of which they have knowledge. Venture capital requires hands-on involvement, and being too far away can be a knockout. Some Australian venture capitalists have set up US offices to stay close to investee companies that move to North America. Some US investors have set up offices in China and India to be close to those rapidly growing markets and have a presence near potential investee companies in those countries. Very few investors try to manage investments over long distances. Most venture capital company websites will have an email address through which to submit business plans or executive summaries. This channel should be your last resort. It is far better to get a personal introduction if you can. Perhaps the most important factor is the stage and type of the investment. Taking a seed or early-stage information technology proposition to an early-stage biotechnology fund or an MBO fund is a waste of time. You look foolish and lazy and your reputation will quickly be tarnished if you do not do your research. Entrepreneurs are encouraged to adopt a focused approach to seeking venture capital. The Australian venture capitalist community still has an informal network, and a scattergun approach by the entrepreneur can backfire. Most venture capitalist and many HNW investors regard themselves as hands on, and the most common form of interaction will be at board level. Entrepreneurs should find out early who is going to sit on the board, what is their experience in business, and what has been the experience of other entrepreneurs with them as directors. Entrepreneurs should also establish how often they would have contact with the venture capitalists. Ideally the investors should talk to the entrepreneur at least once a week and visit, say, once a fortnight. If an investor is ­sitting on the boards of twelve companies and nominates someone else

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to maintain contact, it is a warning to the entrepreneur that there will be little direct contact. If they like your business proposition, the first meeting will probably be at the office of the venture capitalist or in an agreed neutral location with the HNW. If the investor prefers to visit the entrepreneur first, that can be taken as an encouraging sign about the calibre and level of interest. The entrepreneur should have prepared a short (fifteen-minute) PowerPoint presentation on the company, covering the mission statement, staff, the market, competition and financial requirements. The presentation will effectively be a show and tell. The best technique is to have either an overhead presentation or a set of slide copies bound into a booklet. Entrepreneurs should remember the rule of six: ‘No more than six lines per slide, no more than six words per line’. If the investor asks questions at the end of the presentation, that is a positive sign. However, the entrepreneur should remember the objective of the presentation is to get the investor to read the business plan. Many ventures are now using videos; however, in our opinion ­videos turn off an experienced investor just like business plans prepared by accountants do (customer testimonials on video may be useful, however). Your prime objective is to get a first meeting and during that meeting establish your credibility with the investor and for them to establish their credibility with you. Further meetings will then get down to negotiation of the deal, and that is the subject of the next chapter.

16

Negotiations with investors

Negotiation is often compared to a game of poker. At first glance, the odds would appear to heavily favour the investor. The venture capitalist or HNW has the money. The investor can walk away from the game and still have the money. The venture capitalist in particular is repeatedly dealing with entrepreneurs, so his or her negotiating skills are continually being honed, while the entrepreneur seldom meets with investors. On the other hand, entrepreneurs should remember that while a venture capitalist may see many deals, few merit investment. If your proposal attracts the venture capitalist, then you have crossed the first hurdle. Furthermore, entrepreneurs can use the same weapon monopoly sellers have always used—the threat of a counter-offer. If the venture capitalist is aware you are discussing your proposal with other investors, it can speed up and help complete the negotiations. It is useful to note the characteristics of good (defined as tough) negotiators. Good negotiators typically: • open with a very high but realistic demand; • make a few small concessions but no large ones; • decrease their concessions as negotiations continue; and • are undisturbed by threats of deadlock but are conscious of methods of avoiding deadlock.

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In venture capital negotiations, the first key variable is the pre-funding valuation placed on the company before injecting funds. Valuations are discussed more thoroughly in Chapter 18 but the key equation, assuming all money invested stays within the company (the investors will subscribe to newly issued shares), is: funds invested Pre-funding valuation = – funds invested % of company owned For example, a company with an issued capital of three million shares issues a further one million shares for $500 000. Then: $500 000 Pre-funding valuation = – $500 000 25% = $1.5 million It is important for entrepreneurs to realise there is no single true valuation of a private company. The valuations of public companies can vary substantially, as any reader of the financial pages who has followed takeovers would be aware. For private companies, the range can be even greater. However, while the range may be wide it is not infinite. Entrepreneurs should aim towards the high end of the realistic range. Moreover, there are many other negotiating issues besides valuation. While the business plan (which may be considered as the opening offer) may omit these topics, they will be negotiating points. Whatever structure the business plan proposes will almost certainly be modified. Venture capitalists seek several financial objectives in a deal. These objectives are generally met by the structure of a deal. Structure refers to the number and type of shares issued and the mix of equity, debt, options and guarantees given. Every business plan contains financial projections—venture capitalists and the more experienced HNWs know from bitter experience that the likelihood of entrepreneurs meeting projections is low. Experienced investors will focus on key milestones and assumptions underlying the projections, such as time to complete a prototype, gross margins achievable (versus industry norms), distributor margins, time to get FDA approval for a drug or the assumed length of the sales cycle in businessto-business (B2B) markets. They may probe hard to find out who the first customers are (actual names and why they would want the product) and

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seek validation. As Rick McElhinney of the Founders Forum puts it, ‘the entrepreneur must be able to manage (defend, adapt and overcome objections to) the numbers’. This can in no circumstances be left to a consultant to do, even if the consultant wrote some of the business plan. In the expectation that the company will fail to meet the forecasts, venture capitalists often suggest that they take a bigger share of the company at the start but have options granted to entrepreneurs related to performance. To counter this proposal, the entrepreneur may suggest that options over part of the entrepreneur’s shares be granted to the venture capitalists if the performance is lower than projected. Another concern of the investor is that, although the company may grow and prosper, entrepreneurs may change their objectives and decide to stay as head of a private company rather than lead the company to an exit by IPO or trade sale. If this change of plan occurs, the investor will have capital tied up in the company with no opportunity of recovery. Consequently, venture capitalists and the more sophisticated HNWs often seek to invest in the form of redeemable preference shares, so they have the opportunity to redeem their original investment. Some venture capitalists choose a hybrid debt/equity instrument where the debt may be converted to equity if the company goes public or is sold privately. Examples of these hybrid instruments are convertible notes or a subordinated loan with options. Entrepreneurs should seek to bank the investment as equity. While they will continually be seeking rounds of equity, they may need to use debt as bridging finance between rounds. A key ratio for lending institutions is the debt-to-equity ratio. The enterprise will find it difficult to borrow if there is already excessive debt on the balance sheet. Once the valuation and structure are agreed, entrepreneurs should obtain a letter of intent or term sheet. This is a two- to three-page ­document that contains the amount and type of investment, a list of the representations and warranties required, and the affirmative and negative covenants. Entrepreneurs can search the internet for example term sheets to obtain a sense for the typical content, but it is important to be aware that different jurisdictions will have different legal requirements. The representations and warranties are defined in the shareholders’ agreement. A shareholders’ agreement is an important document for clarifying the terms under which funds are provided and, in the case of HNWs, the role—if any—that the HNW will play as an advisor, coach, board member or introducer to prospective customers and partners.

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Typical formal requirements are evidence of incorporation, schedules of leases and assets, latest audited accounts, ownership of intellectual property, schedules of insurance, and so on. On behalf of the company, entrepreneurs will then disclose the state of the company; the disclosures are attached as appendixes to the agreement. These documents take some time to prepare, and asking for what is required earlier rather than later lends a sense of urgency into the negotiations. The affirmative covenants are a list of actions entrepreneurs agree to carry out as long as the venture capitalist is an investor in the company. Common requirements are monthly board meetings, strategy reviews, regular financial statements, payment of all government taxes, regular filings and maintenance of company records, preparation of an annual budget, and so on. The negative covenants are a list of actions entrepreneurs will not do or allow to occur without the approval of the investors. Common terms are increases in salary of key executives, purchase or lease of capital equipment above certain limits, acquisition or merger with another company, and changes in capital structure. These three areas of warranties, affirmative covenants and negative covenants should all be regarded as negotiable. Entrepreneurs should not be averse to asking why a clause is included. They will gain credibility with investors if their objections are thoughtful and sensible. Board composition is often a contentious topic. It is well worth spending some time on it because it will play an important role in developing the company. Small flexible boards that can add genuine value to a business in the early stages of development are desirable. David Thomson, in his book on high-growth companies, Blueprint to a Billion, identifies a common structure for those to be: two internal staff plus one CEO of another growth company, one investor, one reference customer, one strategic ‘Big Brother’ partner, one community member and two others. For the highest growth companies, the ‘other successful CEO’ and alliance partner were the most common features. Thomson’s book has some excellent principles, but is analysing companies that have already made it to, or are close to, $US1 billion in turnover. Our observation from experience is that three to six members is more common in the early stages of NTGFs. A good mix is one successful other CEO/HNW with relevant domain experience, one venture capitalist, one strategic partner and two executives from the firm (typically the

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CEO and either the COO or VP Sales and Marketing). Advisory Boards are also common, and can add significant value in the early stages to build market credibility and further leverage contacts and industry knowledge. Entrepreneurs should aim at having a right of veto of appointment and should strive to have a balanced board and balanced voting power. A growing business typically goes from crisis to crisis. These crises tend to erupt at Board meetings, and having inexperienced external directors who understand neither the technology nor the market can be disastrous. Another negotiating point is the payment of legal fees. This is a common procedure in the United States and is also attempted in Australia. In fact, a company in Australia is unable to pay for the legal fees owing to the Corporations Law which prohibits companies from purchasing or aiding in the purchase of their shares except in special cases. Venture capitalists may ask entrepreneurs to pay the legal fees or make some other form of payment as advisory fees. As a minimum, entrepreneurs should put a cap on the fees paid. Somehow discussions tend to be shorter if both parties are paying the bills instead of just one. On completion of the term sheet negotiations, the lawyers will draft the shareholders’ agreement, generally working from your particular venture capitalist’s standard document. Here entrepreneurs have to accept the golden rule of business: ‘He who has the gold makes the rules.’ Nevertheless, you and your legal counsel must inspect the document and list, in order of priority, the key clauses to negotiate and those susceptible to concession. Lawyers tend to treat all points of issue as material while the commercial reality is that perhaps only 20 per cent are of commercial importance. One common technique of negotiation is to adopt a tough stance on all points and, if you think it necessary to concede, do so on a point of minor importance. The shareholders’ agreement should generally follow the outline of the final term sheet. You should, as an intelligent entrepreneur, have accounts audited by a reputable accounting firm. Investors asking for a further audit should be told that will be fine as long as they pay for it. Warranties are a key part of the shareholders’ agreement. The investor will ask entrepreneurs to make a series of statements about the company, such as that no government taxes and duties are outstanding, the bad debt provisions are adequate, there are no law suits against the company, and so on. Investors rely on the word of entrepreneurs, and the shareholders’ agreement is the formal crystallisation of this. Many entrepreneurs

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become unduly concerned by the warranties. First, they should remember that once they have made the disclosure and venture capitalists subsequently invest, then the venture capitalists will have no recourse. Disclosure actually protects entrepreneurs more than venture capitalists, and the policy should be to disclose everything. The tactic entrepreneurs should adopt is to try to ensure that included in each of the warranties is a disclaimer—something along the following lines: ‘The entrepreneur has taken such fair and reasonable action as a businessperson would take to ensure, etc.’ Entrepreneurs should then take fair and reasonable action. With bad debts, for example, instead of just warranting that the provisions are adequate it is better to warrant that for the past three years bad debts were $X representing Y per cent of debtors, as of ‘a date’ the debtors’ list showed the following debtors as more than 90 days due. Furthermore, on telephone contact all the 90-day debtors indicated payment would be made in 30 days. Entrepreneurs should get hold of the list of required warranties early and start acting on them as soon as realistically possible. While the list of required warranties is gradually becoming standard, there are still significant differences among investors. Other matters for negotiation regarding warranties and representations are materiality and date after which there is no recourse even if the investor identifies a defect. You do not want the investor raising a breach of warranty five years after their investment was made. Also worth considering is representations and warranties insurance. Investors may require this because the ability to take legal action for a breach of warranty is useless if the defendant has no financial resources to pay damages. By now you may be wondering whether the activity outlined in this section is worthwhile. Entrepreneurs should expect to spend at least six months, and up to a year, on preparing a business plan, meeting with venture capitalists, answering the due diligence questions and negotiating a shareholders’ agreement. The time initially taken and then repeated annually is what makes the financial controller—who should be a qualified accountant—an important member of the initial entrepreneurial team. Most business textbooks stress the need for such an individual, particularly when the company employs more than a dozen people. A typical rationale is the need for a business to have accurate reporting and cash forecasting systems. While such requirements are mandatory, the main reason for employing a financial controller for a high-growth company is the need to have one person focused on raising the next

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round of finance. While much of the negotiations are commercial rather than legal, we recommend that investors and entrepreneurs seek expert legal advice to support and document their respective negotiations and outcomes.

Building net worth Entrepreneurs should remember how to generate tangible net worth. Net worth, or shareholders’ funds, is defined as assets less liabilities. One objective of business is to increase the net worth of the company. Indeed, many successful entrepreneurs have used a steady annual increase in net worth as their fundamental business objective. The failure of many businesses to remember this objective is a common reason for their business difficulties. There are good ways and bad ways to create net worth. One way to increase net worth is to increase assets. A typical technique of many high-tech companies is to capitalise research and development instead of writing it off against profit. Another common technique is to create some intangible asset such as intellectual property. Most people in the financial community are aware of such techniques of balance sheet improvement and will automatically remove such intangibles from the list of assets. Tangible net worth is what counts. Another technique is to reduce liabilities; for most businesses, leasing does this. Leasing can be effective, but entrepreneurs should remember wide variations can occur in the marketplace. Annualised interest rates can vary widely, and in some cases leasing can be very expensive, so it pays to shop. The growth in net worth that investors will be seeking is an increase in shareholders’ funds through profits reinvested as retained earnings. A good business operates on a post-tax margin of  10 per cent. To add $2 million to shareholders’ funds will require $20 million in sales. Ask most entrepreneurs whether they would prepare a 30-page proposal, go through 20 meetings and negotiate a 30-page agreement for a $20 million contract, and the answers would be very keen ‘how? who? and when?’ Ask the same entrepreneurs to prepare a 30-page business plan and negotiate with financiers to invest $2 million and many will say it is too difficult. Their issue is that they know how to sell the product but don’t know how to sell the company. Highly successful entrepreneurs,

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however,  know how to sell their company and find that raising equity is the easier task. What is required is the ability to learn and speak the language of the financier.

Advisors Another method of raising funds is to hire an investment banker or financial advisor. Many companies offer their services; however, few are satisfactory. Advisors can help in preparing a memorandum and may establish a realistic valuation. They can usually generate the first meeting with investors through their range of contacts. This can be useful if you are trying to attract institutional money. Financial advisors are useful during negotiations. They can be more aggressive negotiators, and any stigma or bitterness should stay attached to them. All sorts of companies are now involved in financial advisory work, ranging from accountants to the retail banks. Entrepreneurs should decide upon their advisors using the same criteria for choosing any service organisation: reputation, people and price. Contacts are important, especially when raising finance. Fundraising is selling. When choosing a financial advisor, ask them to sell to you. Ask the advisor for three recent references and details of three recent deals. Finally, get some feeling for price. Typically, fees are either on an hourly basis (the accountants) or on a fee-for-success basis. Some are on a combination of success fee with an upfront fee or retainer. Entrepreneurs should at least get an estimate for the job and ask for a ‘cap’ if hourly rates are involved and a time limit if retainers are part of the contract. With a fee for success, the advisor takes a fee if the fundraising is successful. Fees vary but US rates are 5 per cent for the first million, 4 per cent for the second and 3 per cent thereafter. Entrepreneurs should be aware that a fees-for-success basis is riskier for the advisor. However, a successful advisor should gain more rewards. Entrepreneurs should also be aware that investment bankers will sometimes ask for both an upfront retainer or time-based charges, and a fee for success. Some upfront fee or retainer may be appropriate if the advisor is assisting with the preparation or review of the business plan, information memorandum, financial model, and so on, as these activities would other­wise need to be done in house by paid employees. For buyouts, advisors are often essential to help the entrepreneur and management distance

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themselves from the conflicts that usually arise when taking over a company where they are employed.

Options Entrepreneurs should also treat options with care, although they can be a most useful weapon when raising finance. Most entrepreneurs do not realise options have both an intrinsic value and a time value. The intrinsic value is easy to understand—it is the difference between the buy-in price of the option and the actual price per share. For example, if you have an option to buy shares at $1 (known as the strike price) and the present price is $1.50, then the option has an intrinsic value of 50 cents. The time value is more difficult to define. As an indication of the time value one can look at the exchange traded options in the newspaper. The value of an option varies according to many factors, including interest rates, share price expectations, share price volatility, time to expiry date, and the ratio of current price to strike price. Options have a time value. Typically this will gradually erode as the option expiry date draws nearer, declining steeply in the final months. As an example of option value, take the price of an exchange traded option for ANZ Bank on 12 June 2008 whose strike was $23.50 and the current share price $19.92. The option was well out of the money; however, as can be seen in Table 16.1, the longer the time to expiry, the greater the price of the option. All too often, entrepreneurs give away options when they should act as another source of funds. Table 16.1 An example of option value Time to expiry of option

Percentage of current price

1 month

0.9%

6 months

4.4%

11 months

7.9%

Buyouts Until now, we have been discussing how to raise equity capital for a highgrowth company. Raising money for a management buyout uses many of

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the same principles, but is complicated by the greater number of players. Typically you have the vendor, the management, equity investors, debt lenders and mezzanine investors. For a management buyout, you almost certainly want a financial advisor. However, to maintain credibility your advisor should also be willing to invest some equity in the buyout. The advisor will help the entrepreneur to manage the relationships and ease the conflict of interest that exists when a management team wishes to take over the business of their employer. The tax and financing aspects of buyouts are complex and current legislation affecting buyouts in Australia is constantly being modified. It is critical for a buyout that the structuring be done in the most tax-effective manner. Furthermore, during a buyout, because of the number of different parties, allegiances keep changing. Negotiations are similar to the diplomatic negotiations that occur when Australia’s state and federal governments meet for the annual Premiers’ Conference. Management may agree with the vendors that the warranties required by the investors are too strict, and the next day side with the institutional investors against the lenders, who maintain that debt-to-equity ratios of the proposed structure are too high.

Conclusion Negotiations are a complex process. The time spent on them and the stress they engender should not be under-estimated. But initial sound negotiations followed by good documentation will reduce the negotiating load during later rounds of investment. It is best to seek expert advice to assist with your negotiations and the final documentation of the terms that have been agreed upon.

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Part IV

Investing the money: What the investor must do

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17

Screening criteria and due diligence

It is vitally important for entrepreneurs to understand the motivations and method of operation of investors and how to leverage and apply their funding wisely. In this and the next four chapters we follow a single deal through the venture capital investment cycle. This cycle goes through five stages: 1 screening and due diligence; 2 valuation; 3 structuring and completion; 4 post-investment activities; and 5 exits.

The last part of the book looks at Australian companies that have used venture finance successfully. It also identifies common characteristics of successful NTGFs.

Screening criteria Chapter 2 advised entrepreneurs to analyse a market by remembering the economists’ dictum of keeping one eye on demand and the other eye on supply. Similarly, investors should keep one eye on buying and the other eye on selling. Unfortunately, most non-professional (and many

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professional) investors develop a squint and prefer the excitement of purchasing and spending money to the strain of selling. Investors should examine their investment in terms of potential buyers of the company. The two most rewarding takeout mechanisms for the venture capital investor are the stock market and the corporate investor. As a general rule, the venture capital investor will get a greater return from the stock market. While both techniques are examined in more detail in Chapter 21, the simplest rule to remember is that both groups want ­profits—and preferably a profit after tax of at least $3–5 million. It follows that the first question venture capitalists should ask is whether the proposed investment can generate $3–5 million in profit after tax in a reasonable time (say, between three and seven years). The investment task then becomes twofold. First, venture capitalists should carry out an initial screening to establish whether the business can reach $3–5 million in post-tax profits. If the answer is positive, the second stage, known as due diligence, establishes the risk of failure. The first stage of initial screening is to review the business plan and determine whether or not it is worth meeting the entrepreneur. Investors must qualify the prospect to try to establish whether it is worth meeting. Investors should have a grid or questionnaire to screen deals. One way is to use the simple mnemonic MAMECH to help you remember how investors typically qualify an investment prospect: • market size • advantage • management team • endorsements • capital requirements • history

Market size If the market is too small, then no matter what happens the company will never be able to produce the necessary profit. As a rough rule of thumb, it is impossible to generate profits of $3–5 million plus from a market smaller than $100 million. Market share and product penetration rates rarely increase at more than 3–5 per cent a year. Thus it will be difficult to build a market share up by greater than 20 per cent within five years. Net profits after tax for most businesses rarely exceed 10 per cent. The S&P 500 has averaged net profit margins of between 5.5 per cent and 8.5 per cent

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for the past 50 years. Thus, if the potential market is less than $100 million, venture capitalists should pass. Generally, venture capitalists should be seeking out potential markets of at least $500 million. In some cases, with start-up companies which have new products and business models, the market may be difficult to quantify. The effort to do so will be very worthwhile because if the potential market is very large the investment becomes increasingly attractive.

Advantage The next question concerns the significant competitive advantage of the business. Normally the advantage is some product or technology edge, but there may be others, such as a new business model, method of marketing, channel relationship or access to capital. It helps if the technological edge is proprietary. As mentioned earlier, protection provided by patent is limited. Products protected by design, copyright or confidentiality agreements are preferred. It is useful to have an accurate costing of the R&D. Generally, R&D represents 1–3 per cent of the total lifetime turnover of a product (in pharmaceuticals, R&D investments are generally even higher). Take a product that is projected to have annual sales in the next eight years of, say, $1, 3, 6, 10, 10, 6, 3 and 1 million, or $40 million in total. Something between $400 000 and $1.2 million should have been spent on R&D. If not, there is probably an inconsistency in the product sales projections. Investors should remember that single-product or invention companies frequently fail. To succeed, a business needs a core technology or capability from which it can generate a host of products. The best situation is where these are complementary products addressing the same or a similar set of customers.  Revenue growth is a good indicator of whether the company is keeping up with technology advancements. If a company is not achieving top-line growth of greater than 15 per cent per year, it might well be slipping behind its competitors.

Management team The management team is the next variable, and is typically the most significant consideration by far for HNW investors and venture capitalists. As Lisa Nolan of Strategon has put it, ‘97 per cent of our (HNW) investors said this was the final factor in writing a cheque. This includes a commitment to bringing in the best people as required.’

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Typically the team will consist of an entrepreneurial leader and two to three cofounders or key managers. Successful entrepreneurial teams come in all shapes and sizes; however, there are some defining characteristics. The team need to be able to convince the investors that they know their market and the execution of their business model intimately. This means a deep understanding of the customer (including the ability to name and describe them in the case of a B2B product or service), the problem or need being solved, how urgent it is (life threatening is good in this context), and how best to get to and communicate the offer to the customer. It means a realistic understanding of market channels, partnerships required and sales cycles. An unrealistic view of sales cycles is one of the biggest red flags. HNW and venture capitalist investors in particular place emphasis on the character and integrity of the entrepreneur and core team. As Peter Farrell of ResMed puts it: ‘Ethics plus integrity plus smarts and the ability to execute. Execution is 1, 2, 3.’ Investors try to form a view of the integrity of the team because they know that any business plan is at best a rough guide to how a business will actually be run. They want to know, for example, that if a milestone is missed or a significant issue comes up in the business this will be promptly and accurately communicated to the board. Also, if the business looks like it is going to be successful, they do not want to suddenly receive a minimum takeout offer which subsequently turns out to be far too low. One common quality of successful entrepreneurial teams is an abundance of energy, which can best be gauged by meeting them. Entrepreneurs need to be enthusiastic about their business, their products and their markets. The only thing more contagious than enthusiasm is the lack of it. As David Greatorex, HNW and serial investor in start-ups, puts it: ‘The team, motives and passion are our key focus, not the product.’ Investors also want this energy to be focused and not dissipated chasing rainbows. As Roger Allen of Allen & Buckeridge put it, when describing their decision to invest in Seek.com: ‘We liked their laser-like focus on one category. They transformed recruitment, a large and mature business, by focusing on the online business while the existing major players (like Fairfax and Newscorp) were trying to juggle both online and print’. Another essence of the successful entrepreneurial team is persistence. Again and again, entrepreneurs have overcome obstacles by a combination of tenacity and fox-like cunning. Investors often gauge the level of persistence by asking entrepreneurs to tell their stories, asking them about

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lessons they have learnt and mistakes they have made. Some examples are provided in Part Five. Another common attribute is fluency. Business plans are valuable to investors because they show something of how well the entrepreneur can communicate. If entrepreneurs cannot communicate with investors, how can they communicate with customers and employees? A characteristic of successful entrepreneurs is their ability to set realistic goals and achieve them consistently. Nearly all successful entrepreneurs follow the management axiom of planning the work and then working the plan. Most admit that events modify the original plan and goals change. Nevertheless, conscious goal-setting is a common management style of successful entrepreneurs. Entrepreneurs also think like owners rather than managers. While many multinational companies exhort managers to treat shareholders’ money as if it were their own, few actually do. Many managers worry about profit but do not have to worry about cash as there are credit departments and treasury operations to take care of that function. Owners, on the other hand, are driven by cash flow. If there are insufficient funds in the company, they will not pay themselves. They are always looking for the cheapest option and ways to reduce outward cash flow. Owners travel at the back of the plane, multinational managers at the front. Investors should be seeking entrepreneurs not only with high IQ, but also with high OQ, or ownership quotient. While gauging the character, focus, ability to execute, persistence, fluency, goal-setting and ownership quotient of an entrepreneurial team is difficult and subjective, it is possible to measure members’ financial commitment. There is debate among venture capitalists as to whether the commitment should be everything or substantial, but there is no doubt it should be significant. If investors do not see a financial commitment from the entrepreneur that represents a significant part of his or her assets (known in the game as ‘hurt money’) they should wonder whether the investment will succeed. In a buyout, the required financial commit also varies, but in the United Kingdom a sum of two to three times salary is sometimes used as a rule of thumb.

Endorsements The next step is to deduce from the plan the quality of approvals the company and the concept have received. Some endorsements are better

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than others. Support accompanied by the receipt of money, such as a sale to a large customer or investment by a reputable institution, is better than an expert’s report obtained by payment of fees. The best endorsement is one given by a large, technically competent buyer who has bought the product. A qualified investor who has invested equity in the project provides another good endorsement. If neither is available, venture capitalists must look to other endorsements. Again, the quality of these can vary. Future investors are happier if a successful and respected businessperson is either a director or, preferably, a non­executive chairman, or if a partnership has been established with a major player in the industry. On the other hand, it has been our experience that technical and market research reports by experts have limited value. Unfortunately, as many investors in high-technology floats have realised, the predictions of experts often fail to occur. Many experts have only limited knowledge of the marketplace in which the company operates. Reports prepared by management consultants or auditors tend to have the same defect.

Capital requirements The next step is to establish whether the capital requirements of the business are reasonable and within the investors’ limits. It is important to establish exactly how much entrepreneurs need and in what form. Investors should be sensitive to the total amount of capital exposure. As a rule, Australian entrepreneurs tend to under-estimate the funds required. Of the favourite rules of thumb applied by Peter Farrell of ResMed, also an HNW investor, is ‘the four by two rule: it always takes four times as long and twice the money or the other way around’.

History Finally, investors should have in mind the history of the company and the principals. The company should provide the latest copy of the accounts with the business plan. Failure to do so is suspicious. A business history of persistence, innovative marketing campaigns and a fierce dedication to controlling costs signals a good investment. The track record of the management team becomes even more important where there is no business history, as is often the case with a start-up.

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Typical reasons for rejection After one meeting and a skim of the business plan, investors should be able to reject the plan or decide that the company is worth further investigation. The finance industry describes the further examination as due diligence. The most common reasons for rejection are: • The market is too small. • The market is large but the company has insufficient competitive advantage. • The financial projections lack credibility. • The entrepreneur/management team is either inadequate or considered over-optimistic. • The capital requirement is too small or too large. • The pre-funding valuation by the entrepreneur is too high or the investor believes the required return objectives will not be met. • The investment falls outside the guidelines of the fund either because of stage, location or type of industry.

Some investors linked with government programs or special exemptions have additional investment criteria. Early-stage venture capital limited partnerships (ESVCLPs), for example, are prohibited from investing in companies that are property based, or have more than $50 million in assets. Valuation, the subject of the next chapter, is the one potential rejection variable it is possible to change. Valuation is a movable feast. Investors should wait for entrepreneurs to value the company first in the small hope of under-valuation. Once this valuation is given, there is no reason for investors not to reply back with their own estimate without prejudice. It is rare for an entrepreneur to value his or her company less than an investor. When this does occur, it is typically the investor who is later proven wrong. If venture capitalists do consider a proposal worth examining further, they should draft an internal paper on the proposal using the headings above. The completed document should be read again the next day. Venture capitalists employed by a venture capital management company would distribute the paper among their colleagues, who would discuss the proposition in the weekly investment committee meeting and jointly establish whether they should go on with due diligence. If the sentiment is still positive, the next step is to proceed to meet the entrepreneur and begin preliminary due diligence.

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Due diligence Investing is a tradeoff between risk and reward. The reward side of the equation depends on the valuation and structure of the deal, which are covered in the next two chapters. Due diligence establishes the level of risk inherent in an investment. There are seven risks investors should analyse when carrying out due diligence: • development; • manufacturing; • market; • management; • financing; • valuation; and • exit risks.

The information required to establish these risks comes from a variety of sources and typically takes at least one to two months of effort to collect. It will usually take two to three months in chronological time to complete the due diligence task.

Development risk Development risk is the risk that no product, only ‘vapourware’, will be or has been developed. Contrary to the popular notion, venture capitalists rarely invest in products yet to be developed. Typically, less than 20 per cent of venture capital funding goes to Series A rounds. A Series A round is generally the first institutional investor funding round in a company, and follows the initial money invested by the founders and angel investors. The bulk of venture capital is invested in later rounds from Series B onwards. What may attract an Australian venture capitalist to a start-up ­proposal is an exceptional management team, large market potential and substantial commitment of government funding.  How well the intellectual property is protected depends on the product life-cycle. Human biotech products typically have gestation periods of at least ten years until they get to market. Patent protection and knowing that the proposed business does not infringe any current patents is critical. On the other hand, if product life-cycles are short, as occurs in the internet industry, speed to market is the critical factor.

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Venture capitalists must try to establish whether there is a potential new or outside development that will prevent the firm making the target post-tax profit of $3–5 million. If the significant competitive advantage of the company is based on technology, investors should ask independent experts whether they have the technical expertise within their investment team. While technical or academic experts may be helpful, a better alternative is to try to contact recently retired chief executives in the industry. Because of their experience, these individuals have a wealth of information about the market and product development cycles. Moreover, they think in strategic terms and can often provide useful insights about the industry. While it is difficult to try to predict the technological future of a company, investors should try to obtain a history of developments in the product category for the past ten years. Typically, product cycles range from between three to five years on release to the market. Venture capitalists will usually require, at minimum, a working proto­ type installed on trial at a customer’s site. If, however, they decide to invest in R&D, it is worth remembering some statistics. For the period 1979–85, the federal government funded a number of large-scale R&D projects under a scheme known as the Section 39 Public Interest Program. The program invested $53.6 million across 29 projects. The program ­initiators, concerned that public funding would result in commercial success and possibly enrich companies, biased the program towards projects that were in the public interest. Nevertheless, several astute entrepreneurs arranged funding of some major projects which developed into successful businesses. The program was later the subject of a report that noted, among other things, that the typical project took twice as long as originally estimated and overshot the cost budget by about 33 per cent. The common reasons for the time delay were the inability to either recruit the right staff or get the necessary equipment. If the company has built up sales to, say, $10 million what is then important is the annual budget for R&D. A consistent R&D effort is more important for a technology company than any other and it should be spending around 5–10 per cent per year.

Manufacturing risk If the company has developed a prototype, the next step is to establish whether it can commercially produce the product. The most common reason for rejection of proposals based on life sciences such as bio-technology

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or aquaculture is excessive manufacturing risk. Even the most experienced farmers have crop failures due to poor weather or disease. A similar problem occurs with companies based around a new form of advertising. The entrepreneur typically may have invented a sign that uses new technology such as holograms or computers. The profits, based on the number of advertisers who will flock to use the new medium, look terrific. Unfortunately, the company is unable to obtain sites on which to place the advertisements. Another manufacturing risk is risk of supply. Currently, many Australian companies are struggling to find skilled staff in many fields, like engineering, due to the country’s skills shortage. Investors should establish whether there are any critical components supplied only by a single source, including people. Another problem in Australia is the supply of certain types of labour. Cheap and illegal Mexican labour has built Silicon Valley. There are few chip plants around Boston. Government restrictions or legal changes are another risk. Investors must obtain warranties or proof, if they are investing in a manufacturing business, that the necessary government approvals have been secured or may be secured without difficulty. Government restrictions in Australia, while not onerous, are numerous and compliance is expensive. Similar difficulties arise when trying to export electronics and communications products overseas. Venture capitalists will bear manufacturing risk if they believe there is a guaranteed market. For many commodity and primary produce products, the market is definite and the selling costs are minimal. If you can produce the product, you can sell it. Even so, investors should understand the dynamics of the market, especially the price history. Moreover, once the manufacturing facility is built, the company should be the low-cost producer. As an example, CSR can produce sugar at less than 10 cents per kilogram. No matter what happens, it is the world’s low-cost producer and it can usually make a profit—even in times of over-supply and depressed prices. Even if the company is manufacturing the product, investors still need to do due diligence. They should take the bill of materials for two or three major products, establish the product cost, and then calculate the gross margin. If the gross margin is below 50 per cent, then it is unlikely that the company will produce adequate profits. Good manufacturing businesses have gross profit margins of over 50 per cent and successful investments have gross margins of between 60 and 80 per cent.

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Market risk Venture capitalists prefer not to bear either development or manufacturing risk. They do expect to bear the market and management risks. The marketing risk is the risk that there will be inadequate sales for the product. Among the key issues investors should address are the size, growth and expected market share of the company. This can be challenging where a company has created a disruptive product that will change existing market dynamics. Entrepreneurs are by nature optimistic, and their optimism is reflected in the way they perceive the size of the potential market and the potential market share. The size of a market and its growth rate are usually difficult to establish and investors must spend time trying to ascertain both figures independently. One problem with Australia is that the market statistics are limited. On the other hand, the United States keeps comprehensive statistics and sometimes a guess may be made by interpolation. For example, if you know that annual US frozen yoghurt consumption is 3.62 kilograms per capita, you may estimate the total potential Australian market as 20 × 3.62 or  72 million kilograms. Government studies, particularly Productivity Commission reports, are another source of information. These reports usually contain a comprehensive industry analysis. In addition, the reports generally list the major competitors and experts in the industry. Another public source of information is import/export statistics. These are obtained by a visit to the Australian Bureau of Statistics or its website (www.abs.gov.au). Currency fluctuations may distort the figures, but they still provide a useful guide to the size and growth rate of a market. The statistics are comprehensive and reasonably timely. Industry associations may also provide estimates of market size. Industry association executives can provide a wealth of information about the industry and should be contacted. Association executives are often familiar with the entrepreneurs in an industry and can provide independent corroboration of many details. Another source of information is the media. The easiest way to access the media is to use a computerised search facility. There are now companies that prepare abstracts of articles and books and then load the abstracts into computers. By entering a key word and time period, users can obtain a listing of article abstracts for the subject. After reading the abstracts, they can then choose those articles they think will be of interest.

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Customers are a further source of corroboration. Investors should talk to at least six customers and establish their views about the product and the company. Talking to customers should also help establish the competition, the buying criteria, the reputation of the executive team, and so on. Another tip for investors is to write out a summary immediately after a telephone interview. If not, they will find later interviews will overwrite it in memory. Finally there is the internet. Many companies have put the equivalent of an electronic brochure on the World Wide Web and this can provide useful information. Also, you can access many of the articles archived by trade journals and business publications. Using the internet search engines is a simple operation and the user is generally overwhelmed by the amount of information available. There are several other characteristics of markets that investors like to see besides size (greater than $500 million) and growth (greater than 20 per cent per year). A key one is the potential for high gross margins (typically above 50 per cent). The ability to earn high gross margins from the beginning of the business is one of the characteristics identified by David Thomson (2006) in Blueprint to a Billion. They help the business to ride inevitable bumps in the market without having to seek additional capital. They allow it to consistently invest in R&D, product and market development rather than the ‘boom–bust’ approach that happens in many early-stage companies where margins are narrower. Another is low promotional cost. High advertising costs are a barrier to entry, causing immediate difficulty. Products or services that do not require advertising are preferred because they do not attract competition so easily. Advertised consumer products readily attract competition. Take, for example, the first wine coolers, which were a mixture of white wine and fruit juice. While the initial launch products gained large market share, over 40 competitive products appeared within six months. Venture capitalists also prefer many competent buyers who are homogeneous. It is important to market a basic, easy-to-use product, which can simply and easily be tailored by the customer. Products that require substantial after-sales service or tailoring usually result in marginally profitable companies. An ideal product/market nexus is an item that sells for $2000– 50 000 to industrial buyers and includes some element of repeat business. If selling to either industrial buyers or to distributors, it is important to understand the industry norms with regard to credit terms. Also, the

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quality of the revenues should be checked by looking at the credit history of the five largest clients and also plotting the debtors ratio in terms of days’ sales outstanding (DSOs). A company may be trying to boost sales by booking as ‘sold’ shipments for which it will not be paid for several months. On average, DSOs should range from 45 to 60 days. If the trend is increasing, the company has to work harder to make the sale. Preferably, there should not be any significant institutional barriers to sales. Examples of such barriers are Underwriting Laboratory approval in the United States for electronic goods, drug approvals by the Department of Health, and telecommunications authority approvals for connecting new products to public communications networks. If significant regulatory hurdles exist, such as with pharmaceuticals, there should be a clear plan to obtain approval and the management team should have had prior success with obtaining regulatory approval. High regulatory barriers suggest the need for a much larger market opportunity to compensate for the risk and burden of obtaining approvals. When analysing a market, investors should distinguish between flows and stock. Tourism, for example, comprises travel to and from the destination and activity while there. For carriers such as airlines, the crucial measure of the market is flow. For hotels, the size of the market depends on the stock of visitors. The stock is the average flow multiplied by the average length of stay. The flow is easy to measure and length of stay may be obtained by survey. This leads to anomalies, such as the flow of Japanese tourists to Australia and Australian visitors to Europe being roughly the same but the stock of Australian visitors in Europe being five times greater (driven by the longer average length of time Australians stay in Europe). Thus many hotels which are being justified on the basis of increased tourism flows will probably be initially unprofitable because of low stock. Another example of flow and stock is found in banking. Deposits and withdrawals are flows, whereas the account balance is the stock. Stockbrokers make commissions on the volume and value of trades (flow). Most fund managers make the bulk of their revenue from the amount of assets under management (stock). One key to business success is to convert the revenue from a one-off stock sale into a regular cash flow. The Chep pallets division of Brambles is a good example of this process. Pallets could be sold from stock, but by renting them Brambles obtains an even and steady cash flow. The

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emerging market for software as a service is another example of the conversion of a one-off sale into a regular cash flow. Once investors have decided on the size of the market, they can take the sales projections in the business plan and calculate the market share. A first-year market share greater than 1–2 per cent and a market share within three years of greater than 10 per cent are danger signs. Most companies do not gain 25 per cent market share in three years. If they do, the market is generally too small. It is worth noting that, in today’s knowledge-intensive markets, capturing substantial market share quickly and early is sometimes essential to success. In these cases, the investor needs to carefully evaluate the proposed strategy, cost of execution and probability of success.

Management risk Management risk is the risk that management may fail to effectively execute the business plan or adapt to changing conditions, or have interests that conflict with those of the investors. Again, the best technique of establishing this risk is the interview. Ask the entrepreneur for at least six references. The selection is usually informative. After asking referees how long they have known the individual and how often they meet, the real interview starts. The key questions to ask are set out below. • What are the entrepreneur’s three strongest characteristics? • Does the entrepreneur have a track record of making profits in the industry? • Can you relate any experiences where the entrepreneur showed persistence and originality in overcoming problems? • How does the entrepreneur perform under stress? • What do you think are the entrepreneur’s goals in life? • How well does the entrepreneur manage other people? • Does the entrepreneur finish projects or leave them incomplete? • Would you have any doubts about the entrepreneur’s integrity? • Would you invest in the business if you were given the opportunity? • Who else knows the individual and could give me a reference?

In addition, you should also do a credit check on the company and its directors by using a well-known agency such as Dun & Bradstreet or Veda Advantage. It is critical to establish the ethics and honesty of the management team. What investors are trying to discover is whether the entrepreneur and his or her associates have the combination of ethics, drive, intelligence

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and persistence to succeed. Investors should have their antennae ready to detect any signs of lack of integrity. If there is the slightest doubt about integrity, investors must walk away from the deal. It is doubtful whether the referees supplied by entrepreneurs will provide an indication about integrity, but friends of friends often do. The best referees are those who have both worked with the individual concerned and know the investor sufficiently well to be frank. The credit-checking agencies are other sources of information and should be used. About one deal in 20 has a whiff of scam about it. What distinguishes the professional investor from the amateur is not so much the ability to pick winners, but the ability to minimise losses. It has been our experience with references that the entrepreneur either checks out well or a feeling of doubt begins to develop and then becomes stronger. It rarely is a marginal case. The market and technology can seduce investors, who then disregard lukewarm approval. They may not bother to check references. But they should obtain positive endorsement from the reference-checking and not 50/50 statements. A good measurement of management effectiveness is the operating margin (pre-tax profit over sales) of the business. If it is declining or falls below 10 per cent, it means the company is discounting to make sales, expense controls have slipped or gross margins are falling. Another good measure to examine is the inventory level. If the stock intensity (stock level per dollar of sales) is rising and the business is one where inventory is only valuable if it is sold quickly, then the investor should be concerned. Some companies achieve stock intensities of 10 cents, which is equivalent to ten stock turns per year. The best reference of all is track record. People who have been successful and made money for investments or employers tend to be able to repeat the process. What investors like to see is an entrepreneur who has gained experience as a general manager for a profit centre of a multinational corporation. He or she should know about performing to budgets, reducing costs and generating sales and profits, and should have developed management skills but think like an owner. This will occur if the entrepreneur has also started or owned a business. Most of all, venture capitalists want serial entrepreneurs. These are people who have a track record of starting and selling businesses. Real entrepreneurs begin their business careers early. Bill Gates started his first business when he was sixteen.

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Management risk is regarded by venture capitalists as the most important risk to assess. Venture capital may be regarded as backing long shots compared to backing favourites (blue chips). There is no question that irrespective of the horse (the product), the horse race (the market) or the odds (financial criteria), it is the jockey (the entrepreneur) who fundamentally determines whether the venture capitalist will place a bet at all. —Professor Ian MacMillan, Wharton Business School

Financing risk Financing risk is the risk that, when the injected funds are used up, the company will be unable to raise further funds. As stated earlier, the venture capital game regards fundraising as an annual event. The financing risk may manifest itself in several ways. If the cash burn needed to develop the product or build the factory is faster than projected, the equity raised may be used up too quickly. Also, sales may occur later than projected. Finally, either the variable or fixed expenses may be under-estimated. Venture capitalists can quantify the financing risk by producing on a personal computer their own cash flow model of the investment using a spreadsheet. They should use a spreadsheet with graphics capability, then they can play around with the model, increasing the expenses, lagging the sales, and so on. They should develop their own sensitivity analysis for the company. For example, each month the launch is delayed will burn $30 000 of cash flow. By using a cumulative cash flow graph, investors can develop a feel for the realism of the entrepreneur’s projections and try to establish whether the business will reach a cash-flow break-even point before it goes broke. The next task is to produce pro forma balance sheets and income statements, and then calculate key ratios. There are a number of packages available to ensure consistency between the cash flows, the profit and loss accounts and the balance sheets. Investors should first calculate the after-tax and gross margins and compare them to industry averages. Far too many business plans contain ridiculous estimates of net profit margins. Figures over 10 per cent for after-tax margins are likely to be over-optimistic. Recall that the S&P 500 average net profit margin for the past 50 years has been between 5.5 per cent and 8.5 per cent, but varies considerably by industry. Expenses as a percentage of sales should also be calculated. If investors cannot find industry averages, as a rule of thumb R&D should

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be 5–10 per cent (higher for pharmaceuticals), administration should be 8–10 per cent and marketing expenses should be 10–25 per cent. The next set of ratios calculated should be the asset intensity ratios. Benchmarking the entrepreneur’s forecasts against industry norms is essential. Manufacturers rarely have asset intensity ratios less than 33 cents, wholesalers seldom beat 20 cents. Debtors typically run 45 to 75 sales-days, as does stock. Also the debt-to-equity ratios should be calculated to see if the company is over-geared. As a general principle, total debt should not be greater than net tangible assets. Finally, the ratio of preinterest cash flow to interest payments should be calculated. A growing company should have a buffer of at least twice the interest payment. Finally, investors should calculate the sales-to-employee ratio. The poor business plan generally contains too many people at the beginning and too few people at the end. A good target figure for the sales/employee ratio for a manufacturer is between $150 000 and $200 000, while for a wholesaler it should be twice that. These ratios vary widely by industry, and the astute investor will benchmark the entrepreneur’s forecasts against industry averages. After the cash flow and ratio analysis, the final tool of financial analysis is break-even analysis. The calculations have been discussed in Chapter 13. One good test of entrepreneurs is to see whether they have calculated the break-even point for their business. What is important for investors to calculate is the desired income point, which is the amount of sales required to generate a desired income. The formula for calculating the desired income point is: (fixed costs + desired income) Desired income point = contribution rate Contribution is equal to sales minus variable costs. The gross profit margin is often taken as a surrogate for the contribution rate. For most businesses, the variable costs are few. For example, in a restaurant the variable costs are food, drink and credit card charges. Investors must establish accurate fixed costs and then determine what prices will be necessary to achieve the desired income. Many new businesses often price their services or products too low. On the other hand, if the market is one with a high degree of price sensitivity, then investors could have problems. Market share will need to be captured quickly if the product is one that is easily imitated, and pricing should reflect this objective.

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Investors need to be comfortable with the funds required and how they are going to be used. They should then try to establish the profits and performances of the company in one year’s time in the event that everything goes to plan and in the event of things going wrong. Then a valuation for the company can be developed, using the techniques discussed in the next chapter. From the projected valuation, investors should then establish the risk of not being able to raise further funds. Once investors have established the risks involved in a project, they can balance the risks against the estimated reward. As a general rule, investors should not accept more than two risks in an investment. Any more are likely to lead to capital loss. Entrepreneurs should assess how many risks they are asking potential investors to bear. If it is more than two, they should reconsider the business plan and identify ways to further reduce the risks.

Valuation risk Valuation risk is the risk that the investor pays too much for the investment. The subject of valuation is discussed in more detail in Chapter 18, but there are some checks that the investor can do to gain comfort. First, is any money ‘leaving the ring’ or are all of the funds being raised staying with the company? If funding is going into the entrepreneur’s pockets, the investor should be suspicious. As a general rule, first-in last-out applies to fundraising and returns for the entrepreneur. On the other hand, if the entrepreneur or other investors are investing money at the same company valuation as other investors, that is a positive. Venture capitalists are judged on their returns and over-valuation can be expensive. Take, for example, two investments, one made on a post-funding valuation of $6 million and the other at $10 million. The venture capitalist exits on a valuation of $30 million in five years. The first investment provides a return of five times the original investment in five years or a pre-tax internal rate of return (IRR) of 38 per cent. The second investment gives a three times return in five years or an IRR of 25 per cent. Venture capital fund returns above 30 per cent are rarely achieved, and will certainly be accompanied by institutional investors providing more capital to the venture capital fund manager.

Exit risk This is the risk the investor will not be able to exit the investment within three to five years. Most venture capital funds are terminating funds with

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a ten-year life span. Typically, the manager has five years to make investments and then harvests the investments over the next five years. What venture capital investors fear most is the inability to exit the investment and therefore be trapped with a ‘living dead’ investment. This is an investment that is breaking even or making insufficient profits to list or sell to another party. There are certain industries that constantly make low or inconsistent returns to investors. Freight forwarding, textiles, fashion, new product retailing and franchising, and agriculture are examples of industries that investors find it difficult to consistently make good returns from or exit easily. Accordingly, investors do not value these businesses very highly. Besides avoiding investor-unfriendly industries, investors can reduce the exit risk by structuring the investment to include some form of exit by either a put option or a redemption mechanism. The redemption can often be done over time—say, three to five years. Typically investors do not make much of a return but at least the capital is regained. The threat of a redemption will often cause the entrepreneur to come up with innovative forms of exit or replacement investors.

18

Valuation

Once investors decide that the investment proposal will serve a sufficiently large market, has significant competitive advantage, and at minimum has a competent and commercial entrepreneur, they must value the proposition. When deciding on the valuation, investors must distinguish between the post-funding and pre-funding valuations. The difference is best described by an example. Assume a company with 100 000 issued shares decides to make a new issue of 20 000 shares at $50 per share to raise $1 million. Then the post-funding valuation is 120 000 × $50, or $6 million; the pre-funding valuation is 100 000 × $50 or $5 million. Another way is to calculate the post-funding valuation by percentages and then deduct the cash remaining in the company to calculate the pre-funding valuation. For example, if an investor, after an investment of $1 million cash which remains in the company, owns 40 per cent of the voting capital then the post-funding valuation is $1 million/0.4 or $2.5 million. The pre-funding valuation is then $2.5 million less $1 million or $1.5 million. If, on the other hand, 50 per cent of the cash ‘leaves the ring’, then the pre-funding valuation increases to $2 million. Many inexperienced entrepreneurs fail to recognise the difference between pre-funding and post-funding valuations, which can sometimes be exploited during negotiations. Many fail to look at the value of their company or think in terms of share price. They tell themselves they do not

valuation  209

want to give up more then 40 per cent of the company, and the company needs $2 million. Thus they fix the pre-funding value implicitly at $3 million, even though it has no bearing on reality. Investors may need to explain the concepts of pre-funding and postfunding values, unless of course the entrepreneur is experienced in dealing with venture capitalists or has read this book. Investors should ask the entrepreneurs what their company is really worth before an injection of funds. It is even better to ensure they think in terms of share price. For example, if a company has 150 000 shares on issue and its board considers the current (pre-funding) share price to be $3.25, the company is valued at $487 500. As the company grows and funds are injected annually, the entrepreneur and other members of the management team are cognisant of the need to increase the share price and to do so in a commercially appealing fashion. How much the investment ‘steps up’ in value as it passes from stage to stage depends on the industry (and the company, of course). Table 18.1, while several years old, gives the reader a flavour for the step-up factors for various industries in the United States. Table 18.1 Step-up levels for various industries Valuation by Industry and Stage ($millions) Start-up Development Shipping Profitable Computer hardware Average deal size

$4.1

$5.5

$4.8

$5.9

Average pre-funding valuation

$4.1

$11.2

$20.4

$47.6

Average post-funding valuation

$8.2

$16.7

$25.2

$53.5

1.37

1.22

1.89

Step-up Computer software Average deal size

$2.3

$3.1

$3.4

$5.3

Average pre-funding valuation

$3.0

$7.4

$14.1

$29.5

210 INVESTING THE MONEY Average post-funding valuation

$5.3

Step-up

$10.5

$17.5

$34.8

1.40

1.34

1.69

Telecommunications Average deal size

$2.7

$4.5

$4.2

$5.2

Average pre-funding valuation

$2.2

$8.3

$17.8

$34.6

Average post-funding valuation

$4.9

$12.8

$22.0

$39.8

1.69

1.39

1.57

Step-up Health care Average deal size

$2.6

$5.3

$4.4

$3.3

Average pre-funding valuation

$2.8

$16.2

$18.5

$41.4

Average post-funding valuation

$5.4

$21.5

$22.9

$44.7

3.00

0.86

1.81

$2.2

$3.3

$3.3

$2.5

Average pre-funding valuation

$2.1

$6.9

$13.0

$33.6

Average post-funding valuation

$4.3

$10.2

$16.3

$36.1

1.60

1.27

2.06

Step-up Industrial equipment Average deal size

Step-up Semiconductors Average deal size

$2.6

$5.4

$6.2

$6.2

Average pre-funding valuation

$2.2

$13.8

$29.2

$52.0

valuation  211 Average post-funding valuation Step-up

$4.8

$19.2

$35.4

$58.2

2.88

1.52

1.47

This way of calculating the pre-funding valuation will help negotiations involving start-ups or where the company has a limited history of sales or earnings. It is difficult to put a pre-funding valuation greater than $500 000 on any start-up unless entrepreneurs are able to put money on the table from their own pockets, other investors or government schemes. Pre-funding valuations greater than this require extensive justification. It is, of course, very important for entrepreneurs to remember that values do not always step up. In the Fenwick and West LLP 2008 first-quarter survey of venture deals in the San Francisco Bay area, 19 per cent of financings were down rounds and 9 per cent were flat rounds. Another rule the Australian venture capital investor should consider adopting is not investing in expansion deals at a pre-funding valuation greater than $10 million or early stage pre-funding valuations greater than $5 million. Higher valuations require extensive justification and should generally apply only to companies that are near to a public listing. A valuation greater than $10 million is usually too high for an early-stage business, and probably has inadequate growth potential to justify the risk involved.

LBOs On the other hand, the valuation for an LBO should be considerably higher and is highly impacted by market conditions, particularly the availability and cost of debt. Assume the exit mechanism for an LBO is predicated to be a public offering. If the minimum valuation acceptable to institutions is $30 million, the leveraged buyout valuation should be similar. Both investors and entrepreneurs should note as a general rule that, in an LBO, investors should pay no more than seven times earnings before interest and taxation (EBIT) and aim at a valuation of five times EBIT. Thus LBOs usually require minimum EBIT of $4 million. As the EBIT for a mature company is usually 7–10 per cent of sales, the minimum range of turnover for an LBO is about $40–50 million. The risks are greater for buyouts of small businesses with lower EBIT; therefore lower EBIT multiples in the range of three to five times should be applied. Smaller

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buyouts (EBIT $1–4 million) can successfully be backed by investors, but they are more difficult to gear and growth becomes a vital factor in driving exits and investor returns. It is quite challenging to rapidly grow a highly geared business because fast growth tends to require significant incremental capital to fund the increased capital expenditure and working capital requirements. The public stock market has established several ways of valuing a company which can apply to private company investment. Nevertheless, there are some important differences to consider in tandem with the methods of valuation.

Net assets Another way to value a company is to use its net worth (assets less liabilities) and then adjust it for under-valued or undisclosed assets. This approach is most commonly used to value investment or real estate companies, and should be used in the valuation analysis of LBOs. For any investment, an investor must always calculate the net assets per share, net tangible assets per share, and the price-to-book value ratio. Many people dismiss asset valuations for high-growth companies as irrelevant. On the other hand, many new companies include intangible assets on their balance sheet. One class of intangible asset is the revalued asset. Typically the revalued asset is either a revaluation of intellectual property or a marketing licence. From the asset revaluation, it used to be possible in Australia to issue bonus shares to the existing shareholders. Such issues are no longer possible, but the revaluations are still done to try to add value to a company. As the board of directors carrying out the revaluation and entrepreneurs seeking funds at the highest valuation are often closely associated, any investor should treat such revaluations with caution. Professional institutional equity-investment managers generally remove intangible assets unless there is a history of profits and sales as justification. Examples of acceptable intangible assets are newspaper mastheads, broadcasting licences and long-standing brand names. Venture capitalists and private investors should follow the professionals. If the price-to-book ratio is greater than one or the net assets contain significant intangibles, then the investor must demand justification. They can turn the asset valuation method to their advantage. They should

valuation  213

calculate the pre-funding valuation, subtract the net tangible worth of the company and ask the entrepreneur to justify the difference. The difference can only be one of two asset types: identifiable intangibles and a residual amount, commonly called goodwill, which comprises unidentifiable intangible assets. What value you put on identifiable intangibles is a matter of contention. However, let us take the extreme example of an invention that will attract a licence fee of 2.5 per cent and that has expected annual sales of $1 million. The life of such a product will be ten years, which in today’s environment is a long product life-cycle. If we apply a discount rate of 12 per cent, then the net present value of the licence is $141 255. Venture capitalists are looking for big winners but few individual products achieve $10 million in total sales. Thus, when one sees licence valuations of several millions in new companies, the directors— probably unintentionally—are implying product sales of several tens of millions. This requires a very large market and a very strong value proposition for customers. This is exactly what investors are seeking, but careful due diligence is required here. When trying to establish the value of an intangible asset, the valuer must seek to determine the cash flow that the asset will generate. Who would really pay that value for the asset? Is it transferable? How long will the intangible asset hold its value? Patents, for example, have a limited lifespan and are only of value if the holder has the power to fight the infringer in court.

Price earnings (P/E) ratio The most common valuation technique used by investment analysts for listed industrial stocks is the price earnings ratio (commonly known as the P/E ratio). One calculates the P/E ratio in two steps. First calculate the market capitalisation of a company by multiplying the number of ordinary shares on issue by the last sale price for a share. Then divide the market capitalisation by the total earnings due to the ordinary shares on issue. Earnings due to shareholders are generally defined as profits after tax. Implicit in the P/E ratio is the assumption that earnings will be maintainable over that period, or will substantially increase. For example, a company with a net profit of $3 million on a P/E of 10 is expected to earn a similar figure (or more) for at least the next ten years. Investors should be aware of several traps with P/E ratios. First, net profit is a post-tax figure. Far too many Australian entrepreneurs show

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complete ignorance of P/E ratios and apply them to pre-tax figures. Moreover, it is easy to distort the earnings figure. One popular technique is to treat extraordinary profits as ordinary profits. Another method is to use a lower than standard corporate tax rate. When carrying out a valuation, the investor should eliminate extraordinary profits such as asset sales and one-off royalties, and profits earned from interest-bearing deposits, and use the normal tax rate. The profit should also be adjusted for non-arm’s length transactions and non-recurring expenses, provide for normal salaries and eliminate cost subsidies that are not sustainable. The objective is to establish a normalised profit figure. The earnings figure should also be calculated after deducting the payment of any preference dividends and minority interests. If a company does not fully own a subsidiary, then it cannot claim 100 per cent of the profit the subsidiary may make. The accounting convention for minority interests is to first claim 100 per cent of earnings and then deduct that profit attributable to outside shareholders. The average P/E ratios for all listed stocks and each major sector (financials, consumer discretionary, etc.) are published in the print and online financial media. These are useful figures and every investor should be familiar with the current multiple for their industry sector and comparable companies both in Australia and abroad.

Adjustments for private companies While the publicly listed P/E ratios are important, they cannot be applied indiscriminately to private companies. First, the publicly listed P/E ratios apply to portfolio interests (not controlling stakes) but contain a premium for liquidity. The premium ranges from 25 per cent to 50 per cent over private company shares. A good example was Macquarie Bank, which prior to listing ran a grey market in its shares on the last Wednesday of each month. When Macquarie Bank announced that it would seek public listing, the grey market price increased some 50 per cent in anticipation of a listing. Second, the market requires a company to prove itself and develop a history of improving earnings. A newly listed stock is not brought to the market at a P/E equal to the prevailing ratio, but at a discount—typically of about one-third. Again, when Macquarie announced to the market it was going to exceed its prospectus forecasts, the market—in a stunned reaction to this unusual event—increased the share price by some 50 per

valuation  215

cent. To incorporate these two factors of limited liquidity and lack of earnings history, investors must discount the P/E ratio by about two-thirds for private companies. Thus, over the past 20 years, investors in a private company would have used a P/E range of from three to nine depending on market conditions. If entrepreneurs point to merger or acquisition transactions as the basis of their valuation proposals, a further adjustment is required. Take­ over offers generally involve a premium for control that is above the normal trading values for portfolio interests in companies. These premiums are quite specific to the particular buyer because each buyer will have different views on potential synergies and cost savings in the combination with the target business. In Australia, control premiums have ranged from nil to more than 50 per cent. For example, the 2008 initial offer by Westpac for St George Bank represented a control premium of 28 per cent. It is not appropriate to use takeover valuations for valuing equity stakes that are less than controlling, which would be the case for most venture capital investments. In buyouts, consideration of a control premium may be appropriate as the investor in buyouts is often (but not always) taking a controlling stake in the business. In applying P/E and other ratios to value a business, investors and entrepreneurs must also be careful to match P/E ratios with correct earnings of the proposed investee. If using a listed company P/E ratio based on historical earnings, the historical earnings of the investee must be used. If using a P/E ratio based on the next twelve months’ forecast earnings, the next twelve months’ forecast earnings of the investee must be used. The problem with using P/E ratios with many private or newly started companies is there are no profits. Two approaches have been developed in the United States: using either an estimate of future earnings or a priceto-revenue ratio.

Price-to-sales ratio The price-to-sales ratio is an easy multiple to understand (it is the ratio of market capitalisation to annual operating revenues), and is a common calculation for publicly listed stocks in the United States. It was a common valuation method during the tech bubble, and is commonly used as a cross-check to other valuation methods today. As a rule, US investors look to buy on price-to-sales ratios of around 50 per cent and would regard

216 INVESTING THE MONEY

a ratio of 300 per cent as a maximum. The earnings-to-sales ratio varies between about 3 per cent and 8 per cent for most industrial companies. These ratios imply a minimum P/E ratio of 6 to 16 and a maximum ratio between 37.5 and 100. The private company investor who uses the priceto-sales ratio technique should aim at a ratio of one-third and not pay more than 100 per cent of revenue.

Future maintainable earnings The estimate of future earnings approach is probably the most common method described in the venture capital textbooks. The calculation involves taking an earnings figure in, say, three to four years’ time, multiplying it by some price-to-earnings ratio, and then discounting the value back using a discount rate to a net present value. Investors using this method must make three decisions: 1 What P/E ratio should be used? 2 What discount rate should be used? 3 What time period should be used?

The prevailing interest rates and the stage of the investment combine to determine the discount rate. Interest rates over the last ten years have shown as much fluctuation as equity prices. What the investor must do is use a market-sensitive, long-term, risk-free rate. The easiest to use is the ten-year Commonwealth bond rate, which is published in the financial section of most major newspapers. The question then becomes which multiple to apply to this risk-free interest rate to reflect the risk of the investment under consideration. The multiple must vary according to the stage of the business because the risk varies accordingly. Using the definitions stated earlier in the book, there are three stages in the growth of a company: Table 18.2 Growth stages in a company Stage

Description

Sales

Profits

Multiple

I

Seed/start-up

No

No

7–9

II

Second stage

Yes

No

5–7

III

Development stage

Yes

Yes

3–5

valuation  217

The gross multiple is then varied according to the size of market, ­significant competitive advantage and quality of management team. The second decision is in which year to apply the P/E ratio. Earlier in the book we set as a screening criterion of whether the business was capable of earning at least $3–5 million post-tax. The year this occurs is the time to apply the P/E ratio. However, the $3–5 million in net profit must be based on a fully applied tax rate and should not be when the profit ­figure is favourably distorted by carried-forward tax losses. Let us now look at three examples and assume the appropriate ASX sector P/E ratio was 18 so the applied IPO exit P/E ratio was 9, reflecting the investor’s assessment of an appropriate private company and illiquidity discounts. This also falls in the P/E ratio range of small and large capitalisation IPOs over the past few years of 9 to 13. Assume the ten-year Commonwealth bond rate was 6 per cent.

Case 1 A start-up company is seeking $5 million and projects earnings of $10 million in five years. The market is large, advantage is average and the management team is excellent. Apply a discount multiple of 8 to the ten-year bond rate, giving a discount rate of 48 per cent. The estimated value in five years is nine times $10 million or $90 million. One plus the discount rate is 1.48 which, raised to the fifth power, is about 7. The net present value of $90 million discounted at 48 per cent over five years is about $13 million, so $5 million should buy about 38 per cent. It is not unusual for start-up (Stage I) capital injections to acquire up to 50 per cent of the company.

Case 2 A Stage II company is seeking $2 million, projecting $3.25 million earnings in three years. The market is average, advantage is significant and the management team is average. Apply a discount multiple of 7 or 42 per cent. The value in three years is our estimated P/E ratio of nine times $3.25 or $29.25 million. One plus the discount rate is 1.42 which, raised to the third power, is about 2.9. The net present value of $29.25 million discounted at 42 per cent over three years is $10 million, so $2 million should buy about 20 per cent. A second-stage business is more advanced

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and has some track record, so it is not unusual to see a higher valuation at this stage.

Case 3 A development stage company with a current net profit of $5 million is seeking $5 million of growth capital, projecting $10 million net profit in two years. The market is average, advantage is significant and the management team is good. Apply a discount multiple of five to the bond rate for a discount rate of 30 per cent. The estimated business value in two years is nine times $10 million, or $90 million. One plus the discount rate is 1.30 which, raised to the second power, is 1.7. The net present value of $90 million discounted at 30 per cent over two years is about $53 million, so $5 million should buy about 10 per cent. Someone familiar with the financial markets might regard the discount rates used as excessively high. In mitigation, venture capitalists offer two explanations. First, the investments are long term—typically at least three and more often at least five years. It is very difficult to predict what market conditions will exist five years into the future, hence the prevailing P/E ratio in five years may vary substantially. So, although a venture capitalist may have built a diversified portfolio, the portfolio still suffers from substantial systematic risk. Moreover, studies have shown the volatility of a venture capital portfolio to be more than twice that of the share market index. Second, while liquidations do occur in the listed market, they are relatively uncommon. By contrast, the average venture capital portfolio may have up to a third, if not half, of the portfolio written off. Most venture capitalists target a return of 20–25 per cent to investors. Accordingly, to achieve those returns and given that half the portfolio is going to be written off, the other half of the portfolio is going to have to generate 40–50 per cent returns. If the venture capitalist decides to use the discounted earnings approach as a means of valuation, he or she should remember that the entrepreneur might use the strategies set out below. • First, it is likely the future projections will be over-optimistic because the greater the future valuation of the company, the less equity they will have to sell to raise their venture capital. • The public offering will be proposed earlier rather than later because the shorter the holding period for the investment, the less equity will need to be sold.

valuation  219 • Expand the company as quickly as possible before raising venture capital because the longer the entrepreneur can wait, the lower the required rate of return and the shorter the holding time to harvest.

Other valuation methods The third method of valuation is to use comparable company results or industry standards. In many industries, there are rules of thumb such as multiples of weekly revenues for restaurants, multiples of litres pumped for gas stations, subscribers for cellular telephone companies, beds for hospitals, hectolitres or cases for beer and wine, and so on. Unfortunately, many of these multiples are only available for stable industries and the ratios generally favour the seller. Many entrepreneurs often quote US figures. These are figures for listed companies, which as noted before will be about two to three times the value for a private company. Also, the size of the US market reduces the business risk. Industry standards have limited appeal as a valuation method for the private company investor but they can be useful as a cross-check of valuation. While all these forms of financial valuation are in the venture capital books, venture capitalists often use a different approach. To offset the risk of the investment, they look for high returns. Typical expectations are five times the original investment in three years to ten times in five years. These objectives equate to compound annual growth rates of 71 per cent and 58 per cent respectively.

Impact of dilution Venture capitalists also realise the fundraising never stops and each year brings a new injection of equity. As discussed previously, these rounds are commonly called Series A, Series B, Series C, etc. Hence a method they commonly use is to try to establish both a reasonable time and date for the exit and work backwards. This is sometimes referred to as the Stage Financing Model, or Multi-Stage Financing Model. This is best demonstrated through an example. Let us say a university department has been carrying out research over the past three years and so far has received some $1 million in funding. It contacts an early-stage venture capitalist and together they develop a business plan that shows it will take some $10 million over the next five years to commercialise and roll out the

220 INVESTING THE MONEY

product. The venture capitalist believes that in five years the company will achieve $7.5 million profit after tax and will IPO at a multiple of ten times for an IPO value of $75 million. The venture capitalist then creates the stage financing model showing the financing amount required each year and the expected IRR that the new venture capitalist will require for that round. At the commencement of the first year, a venture capitalist will invest $2.5 million and wants a 54 per cent IRR (based upon an assumed ten-year Commonwealth bond yield of 6 per cent and a discount factor multiple of nine times). The future value of $2.5 million in five years at a 54 per cent rate of return is $21.7 million. Capital of $3 million needs to be raised by the start of Year 2, and the investor is expected to require an IRR of 42 per cent (based upon an assumed ten-year Commonwealth bond yield of 6 per cent and a discount factor multiple of seven times). The future value of $3 million in four years at a 42 per cent rate of return is $12.2 million. At the start of Year 3, $4.5 million of capital is required and it is expected that a venture capitalist will require an IRR of 30 per cent per annum (based upon the assumed ten-year Commonwealth bond rate of 6 per cent and a discount factor multiple of five times). The future value of $3 million in three years is $9.9 million. In order for the Series A venture capitalist to get $21.7 million from an IPO exit worth $75 million, they naturally require an ownership stake of 28.9 per cent at the time of the IPO ($21.7 million divided by $75 million). Similar calculations are made for the Series B and Series C venture capital investors, resulting in a required ownership breakdown at the exit that looks like the pie chart in Figure 18.1. We now have a picture of what the final ownership pie needs to look like, as calculated by our knowledge or estimates of the IRRs that subsequent investors will require for the risk they are bearing and the estimates of timing and amount of the future funding rounds. These same factors can be used to determine the dilution of ownership that will occur after each of these funding rounds. Series A and the founders/management will be diluted by the $3 million in Series B and the $4.5 million in Series C, because more shares will be issued to accommodate these new investors and they will take up ownership at the ‘expense’ of the earlier investors. That is a price we must pay to get the additional funding. Here we must introduce a term known as retention, which in this example is simply 100 per cent less the Series B and Series C ownership stakes at exit, being

valuation  221

Series A, 28.9% Founders/Management, 41.7%

Series B, 16.2%

Series C, 13.2%

Figure 18.1 Required ownership stakes at exit 100 per cent minus 16.2 per cent minus 13.2 per cent, or 70.6 per cent. The Series A investor’s required ownership at exit (28.9 per cent) is now divided by the retention (70.6 per cent) and the result is the ownership they require at the time of their investment (40.9 per cent). If Series A investors are investing $2.5 million for a 40.9 per cent ownership stake, the post-funding value must be a respectable $6.1 million ($2.5 million divided by 40.9 per cent) and the pre-funding value must be $6.1 million less the amount invested of $2.5 million, being $3.6 million. Similar calculations can be made for Series B and Series C, the results of which are shown in Table 18.3. Table 18.3 The stage financing model Ownership required at investment date

%

Premoney

Postmoney

Series A—Ownership required at investment

40.9

$3.6

$6.1

Series B—Ownership required at investment

18.7

$13.0

$16.0

Series C—Ownership required at investment

13.2

$29.6

$34.1

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The founders and management are being diluted each round as depicted below: Founders/Management Stake: Before Series A 100.0% After Series A 59.1% After Series B 48.0% After Series C 41.7% In this example, the founders and managers own a healthy 41.7 per cent worth $31 million in a listed company with a market capitalisation of $75 million. The model indicates the venture capitalists can earn the rates of return that they require, so this appears to be a viable transaction for all parties. For this to work, the company needs to be very successful and everything needs to go to plan. Of course, life is not a smooth trajectory and what is known as a ‘down round’ can occur where, instead of the valuation rising, it declines. Down rounds in the United States occur in about 20 per cent of funding rounds while flat rounds occur in about 10 per cent of funding rounds. One of the more famous down rounds in venture capitalist history was Federal Express in the United States. The share prices on the four rounds were $47.75, $204.17, $7.63 and $0.63, and the founders ended up with 0.7 per cent of the company. But then 0.7 per cent of $12 billion is not a bad reward. All these methods of valuation are valid and will lead to a range of values. Ultimately, the investor and entrepreneur must remember that the valuation is the price at which people are willing to invest and it is a subjective figure. If no deal is done, no actual valuation has been achieved. On the other hand, there are several reality checks investors can apply before investing. One question is to ask whether they would be able, with a reasonable amount of effort, to sell their newly acquired holding and break even or make a small profit. If not convinced, then they should not invest. Another reality check is to work out the implied compound annual sales growth required from the investment (see Table 18.4).

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Table 18.4 Implied annual compound growth rates Ozzie Trier

Internet Dreamer

Current annual revenues

$3.5m

$0.5m

Post-funding valuation

$6m

$2m

Expected IRR

40%

40%

Expected time in years

5

5

Valuation at exit time

$32.27m

$107.56m

Expected P/E ratio

15

15

Expected profits

$2.15m

$7.17m

Expected net profit margin

10%

10%

Expected turnover

$21.51m

$71.71m

Compound annual growth rate

44%

170%

Table 18.4 contains two examples: Ozzie Trier and Internet Dreamer. Ozzie Trier has $3.5 million of revenues and obtains a venture capital investment of $2 million at a post-funding valuation of $6 million. The venture capitalist hopes for a 40 per cent IRR and to exit in five years, leading to a valuation of $32.3 million. Given an expected P/E of 15, net profits will be $2.15 million which, if then divided by the expected net profit margin of 10 per cent, leads to expected sales in five years of $21.5 million. To achieve this result, sales must compound at 44 per cent per annum. The reality check is that the best sales growth that Microsoft ever achieved over a five-year period was 53 per cent and for Dell it was 66 per cent. The next example is the Internet Dreamer. These were typical numbers that venture capitalists were receiving during the dot.com boom of 1999–2000. As can be seen, the required compound sales growth was 170 per cent, which is out of touch with reality. This simple reality check can save investors considerable sums of money.

19

Structuring the deal

If investors decide a proposal is believable and the valuation is such that the rewards outweigh the risks, the next step is to structure the deal. First we shall discuss the objectives of the entrepreneurs and investors, followed by a description of the tools of structuring, and finish with a discussion of other structuring issues investors should address. As mentioned previously, structuring is a highly specialised activity impacted by both commercial needs and the requirements of the law and tax regulation. Expert advice must be sought and our comments here are only of a very general nature to provide entrepreneurs and investors with a starting point for discussions with their advisors. Due diligence of the business opportunity and agreeing on the valuation appear to take up most of the time, but the structure of a deal is probably more important. Good business prospects have been ruined by improper structures; similarly, entrepreneurs or investors have not received their just reward from business success because of poor structure. We have already stated the rules of the investment game, but it is important to repeat those relevant to structuring: • The common objective of both parties is to build an enterprise generating sufficient after-tax profits so institutional investors will invest in a public listing.

structuring the deal  225  • Building such an enterprise will require a series of funding injections. • The reduction in the rate of capital gains tax and limited liability rules make the private company the most attractive business organisation in most situations. • The financing task is finding sources of unsecured debt and equity.

Differing objectives The first step in determining the investment structure is to realise that the objectives of investors and entrepreneurs differ. Entrepreneurs’ wishes are simple: they wish to give up as little equity for as much cash as possible. Surprisingly, it is a mistake for the investor to take the opposite view and try to get as much equity for as little cash as possible. If the cash amount is too small (and usually entrepreneurs under-estimate the cash requirements), then the business stalls because another round of funding must be started. On the other hand, if the business is over-capitalised, entrepreneurs may purchase luxury cars and lease space in expensive offices. Every farmer knows too much water as well as too little can kill a crop— the amount of funding is as important as the implied valuation. Second, if initial investors take too much equity, later dilutions may result in too little equity residing with the entrepreneurs, who will lose motivation. Venture capital investors should have different goals. They should be seeking the return of their capital with an adequate reward for the risk taken, combined with the ability to share in the gains on an equitable basis with the entrepreneurs if the business becomes a success. Private investors and entrepreneurs should also carefully evaluate their motives when investing. Both the investor and the entrepreneur should be seeking to achieve a return by an exit event within a reasonable timeframe. If that objective is not jointly held, or if entrepreneurs are uncomfortable with sharing ownership, then the entrepreneur should seek other forms of funding or simply limit growth to the self-financing growth rate. The alternatives often substantially reduce the gain but also significantly reduce the pain. It is also important to understand that objectives may change over time. The young entrepreneur may come to realise that the business will not grow large enough to list publicly and be content to draw a healthy salary, join the Rotary Club and seek election to the local council. The investor will then own illiquid private shares with no buyer until the incumbent CEO/founder decides to retire.

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The enterprise may fail to meet the original projections. Investors then seek capital recovery and need to ensure that they regain their capital before the entrepreneur does. Investors should also consider obtaining a note from entrepreneurs to repay any investment—if not now, then at some time in the future. As a matter of principle, entrepreneurs must have some hurt money at stake. Asking them or their family to recognise a future obligation to repay former backers is not unreasonable. Times change, and while one enterprise may fail another may be very successful. On the other hand, investors occasionally find an entrepreneur who has failed in an enterprise but whose creditors or lenders did not lose any money. Even better, the entrepreneur paid them back even when not obligated to do so. Investors should back such an individual almost without question. In summary, venture capital investors are not looking to gain as much ownership for as little money as possible. What they are trying to accomplish is capital return, with some capital gain for either indifferent or marginal performance or significant capital gain if the enterprise prospers, while acknowledging the risk that all their capital may disappear. Venture investors typically seek a minimum of five times their investment. Investors in buyouts of mature companies usually require a slightly lower return, as the risk of investing in mature companies is generally lower than for early-stage businesses. To produce the appropriate returns, venture capitalists and buyout investors may use various tools.

Mezzanine financing Venture capital financing is mezzanine financing. The term ‘mezzanine financing’ is best understood by regarding the choice facing the corporate financier as a multi-storey building. Debt financiers in their search for collateral prefer debt to be secured with a fixed charge against a specific company asset. This debt is at the top of the building and is senior to all other payments at the time of liquidation. Beneath the top floor could be a secured lender with a floating charge over assets. Then there may be unsecured lenders, who rank behind the secured lenders if the company goes into liquidation. Often unsecured lending is done by a negative pledge. This refers to certain financial ratios, which the company agrees not to breach. The most common ratios used in a negative pledge are gearing and interest cover. Gearing is the ratio of debt to shareholders’ funds.

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Interest cover is the ratio of earnings before interest and tax to interest paid. Typical target values are below 100 per cent for gearing and above 3 for interest cover. Buyouts are much more highly geared, as discussed in the earlier chapters. On the bottom floor of the building are the ordinary shareholders. The original shareholders usually subscribe to shares, typically at a value of 50 cents or $1. Later investors subscribe at higher valuations. Ordinary shares have voting rights plus the right to receive ordinary dividends. Dividends are paid out of the after-tax profit and are usually paid semi-annually. On the stock exchange, where shares are traded, there could be confusion about whether the buyer or seller is entitled to a dividend. The confusion is eliminated by setting an ‘ex dividend’ date whereby shares traded after that date are ‘ex’ (without) the dividend, denoted by XD after the share’s name. Shares traded before that date are traded ‘cum’ (with) dividend. Mezzanine finance,  sometimes called hybrid securities,  refers to financing between the top floors of debt and bottom floors of equity. The three most popular forms of hybrid securities are convertible notes, subordinated debt with options and redeemable preference shares.

Convertible notes Convertible notes (sometimes called convertible bonds), as the name implies, are a loan for a fixed period at a fixed (but possibly floating) rate of interest. The holders of convertible notes have the right to convert them to ordinary shares at specified dates in the future. If the conversion does not occur, the loan is paid off at maturity. The conversion is at any time, at the option of the lenders. Entrepreneurs and investors should seek tax advice about the tax implications of interest payments and interest income. Sometimes financiers recommend convertible notes as a form of financing for initial seed capital. Convertible notes are sometimes a good financing method for projects that might take several years to be profitable but where the costs and time of development can be predicted with a reasonable degree of certainty. The lower cost to the company during the development stage converts to a higher cost when the project is profitable. However, for this type of project financing (say, a building or a mine), experience provides a reasonably good estimate for development costs, so it is easier to calculate the funding requirements. It is quite common for angel investors to propose that the first round of funding be a convertible note where the conversion price is set at a

228 INVESTING THE MONEY

percentage (say, 70 per cent) of the initial Series A fundraising. Using a convertible note avoids setting a valuation for the company which, in the first round, is probably going to be fairly low and difficult to determine. Even if the convertible note converts into the eventual VC Series A at a discount (or also has warrants included), the argument is made that the amount of dilution suffered by the founder in the convertible note is less than the dilution suffered by setting the valuation low in the seed Series A. This assumes that the valuation at the time of the seed financing will increase at a rate greater than the discount/warrant coverage on the convertible note. Also, the legal documents for a convertible note are simpler than for Series A. The potential time and cost savings could be advantageous to both the entrepreneur and the investor, so it is worth considering this instrument and seeking the appropriate legal and tax advice to make an informed decision. However, there are some problems. Convertible debt investors have the perverse incentive to want the valuation of the company in the eventual venture capital Series A to be low, so the investors and the venture capitalists have a greater percentage ownership of the company after the venture capital Series A round. Debt investors will usually want aggressive terms as, unlike equity investors, they believe that if the business plan does not work they should get their capital back. Typically debt investors will require the company to grant a security interest in all of the company’s assets, personal guarantees from the founders, drastic measures upon an event of default, and so on. It is not uncommon for debt investors to suggest some onerous terms. For venture capital funding, each company will have different needs and the funding estimates will always be wrong. The essence of venture capital is to raise funds in tranches. The problem with convertible notes is they deter the financiers for the next round. Debt lenders regard convertible notes as debt and refuse to lend because the gearing ratio will be too high or the interest cover will be too low. On the other hand, equity investors will immediately convert the convertible note to equity, and calculate the earnings per share post-dilution. The equity investors will usually think the convertible noteholders have too sweet a deal and demand a lower price. But the convertible notes can be useful in leveraged buyouts where later fundraisings are not envisaged.

structuring the deal  229 

Subordinated debt/options The subordinated debt/options combination suffers from the same deficiencies as the convertible note. Major shareholders typically use subordinated debt for fiduciary or other reasons when they do not want or need to take any more equity as an asset but only want to have debt. A good example would be a venture capitalist already at the 50 per cent ownership level of a company needing to inject further funds into an investment. However, company options can be a most useful form of incentive for both investors and entrepreneurs. A company option is the option to take up (buy) a new share from a company at some future date at a fixed price known as an exercise or strike price. Options are attractive to investors as an equity sweetener. Thus a company can often obtain equity by attaching to a new issue of shares either an option or part of an option as a ‘sweetener’. Options of this type should not be free but should be used to raise money. Company options are useful to motivate entrepreneurs and the employees. Options can be tied to the performance of a company. A typical employee share scheme allows the company to issue between 5 and 10 per cent of shares to employees. By issuing options tied to profit performance, investors achieve both the profits to repay their capital and a more equitable split between the investor and entrepreneurs. Expert advice must be sought when considering option plans for employees.

Preference shares Because of the difficulties outlined above, the most popular form of venture capital financing is the preference share. Preference shares rank above ordinary shares for claims on assets, earnings and dividends, but below creditors and lenders. Preference shares usually have a fixed dividend rate attached, unless they are participating preference shares, in which case they may also participate in ordinary dividend distributions. Venture capital investors consider convertible redeemable preference shares to be an excellent instrument. If there is success, the ability to convert to ordinary shares means investors may participate in any public listing or other profitable exit event. In the event of failure, the preference shares take priority over the ordinary shares. If the investment becomes a ‘living dead’, with moderate but insufficient earnings to list, investors may be able to redeem their shares and recover their original capital, provided there is sufficient cash or borrowing capacity in the company to finance the redemption.

230 INVESTING THE MONEY

To motivate entrepreneurs to achieve a public listing, venture capitalists use financial incentives. One technique is to attach a high preference dividend to the shares after a period of, say, four years, so that if listing does not happen the company’s profit will all go to the investors. Even more attractive to investors is to make the dividend payments cumulative—if a preference dividend payment is missed, the dividend accumulates and is paid when the company has sufficient profits. Another method is for the investors to have attached to their shares a put option to the entrepreneur or have an enforceable company buyback. The company options discussed earlier were call options (i.e. the holder has the right to buy stock in the future at a fixed price). Put options give the holder the right to sell shares at a certain price. Buyers of put options treat them as an insurance policy. Sellers of put options believe the company value is going to rise continuously, which a priori is what entrepreneurs believe. Another structuring technique is to divide the investment into two or more separate segments. For simplicity, assume the entrepreneurs have the option to redeem one-half of the investment at twice the entry price and that the second half is redeemable only by the investors. The entrepreneurs will then try to generate sufficient profits to redeem the first segment, as it will increase their ownership percentage. For example, say a company has 20 000 shares on issue and it raises $1 million by the issue of 10 000 ‘A’ class shares and 10 000 ‘B’ class shares at an issue price of $50 per share. The redemption price of the ‘A’ class share is $100. If the entrepreneurs then have the company redeem the ‘A’ class preference shares, their ownership will move from 50 to 67 per cent. The advantage of preference shares, particularly if they are convertible, is that corporate financiers regard them as equity rather than debt. This means entrepreneurs can then raise debt finance and obtain government grants, where a common requirement is that any grant given be matched dollar for dollar with equity.

Other structures For start-ups, there is often a need for staged funding, with the injection of further funds depending on the results of the previous stage. A fastgrowing company may be compared to a mining start-up where, say, $1 million is wanted for a broad exploration of a claim. If a strike occurs, a further $2 million is raised for precise definition of the ore body and project planning. If the body proves suitable for drilling, then $7 million

structuring the deal  231 

will be needed over two years to start production. If Stages I or II produce negative results, the funding stops. The structure sometimes adopted for start-ups is partly paid or contributing shares. In the above example, the company could issue ten million partly paid $1.00 shares in annual tranches of 10 cents, 20 cents, 35 cents, and 35 cents. In a public limited liability company, the shareholder must pay the calls, so the financiers invented no liability (NL) companies, whereby shareholders do not need to pay any uncalled amounts. Partly paid shares are also a way of providing ownership to entrepreneurs. The partly paid shares are often entitled to full dividends, but voting power depends on the amount paid on the shares. Then, as the company grows and is successful, entrepreneurs and their employees use the dividends to pay out the remainder of their contribution. The problem with partly paid shares is that, in the event of liquidation, the remainder of the unpaid capital could be called up. A possible structure to solve that problem is to have the partly paid shares held by a $2 company that can default. Earn-outs, put options, and redemption tied to profit performance are all important structuring techniques, and the investor should consider them. Arthur Lipper (1984), in his excellent book Investing in Private Companies, quoted a typical US guideline whereby if investors put up all the money they should get 100 per cent of the equity. The stake the entrepreneurs ultimately own depends on the speed at which they pay back the investment. Repayment in one year means the entrepreneurs get 80 per cent, in two years 60 per cent, and in three or more years 40 per cent. Earn-out structures should relate to market conditions and any formula should be tied to market conditions. A valuation based on a P/E of 5 would have appeared low in 1997 but reasonable in 2001. Earn-outs may be structured either by the redemption of preference shares or by the issue of new contributing shares. Astute entrepreneurs sometimes reverse the earn-out mechanism to a giveback. In this structure, if the entrepreneurs fail to perform, they give up equity. The problem with an equity giveback is that the investors may end up owning more of a lemon. In all cases of structuring, investors and entrepreneurs should work out their primary commercial goals and seek legal and tax advice to establish a structure and the documentation to achieve those commercial goals with appropriate protections.

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Other investment terms As indicated in Chapter 16 on negotiations, the documents used in venture capital funding are the letter of intent or term sheet, and the shareholders’ agreement. The term sheet should contain the structure of the deal and a summary of key clauses. The key clauses in the term sheet for venture capitalists, besides the usual warranties and covenants, are: • key person insurance; • right of co-sale if the entrepreneur obtains a buyer for all or some of his or her stock; • pre-emptive right of first refusal on the issue of any new shares; • agreed exit mechanism; • board seat and right to monthly reports and cash flows; and • remedies in the event of non-compliance and impending liquidation.

There are some other clauses that are matters of debate. One important issue is employee contracts. Experience has shown that employee contracts favour employees, and seldom benefit the company. Many venture capitalists would recommend against signing service agreements. A service contract can be useful if the buyer of a company wants the previous owner to stay around and run the company for one to two years while the buyer learns about the business. Often, however, the training period is shortened by mutual consent. Another important topic is the issue of guarantees. One description of a guarantor is a fool with a pen in hand. While many people regard the secret of venture capital as picking winners, the essence is more one of limiting losses. Venture capitalists should be prepared to lose all the capital they have invested in a company. They should not be required to lose more. It is better to put up the whole amount of risk capital as some form of voting equity. Similarly, entrepreneurs often request a debt/equity mix. Venture capitalists should regard all the funds they provide as risk money. Other parties should provide debt funding. If venture capitalists must provide debt, it should be as a convertible note or have call options attached. Anti-dilution provisions are another common subject of negotiation. These provisions prevent the dilution of a shareholder’s stake, even if further funding is required. The classic example is where the entrepreneur

structuring the deal  233 

wants to have inserted in the shareholders’ agreement that his or her shareholding can never be diluted below 30 per cent. Investors should avoid these like the plague. On the other hand, seed stage investors often request anti-dilution clauses. Again, these should be avoided. In venture capital deals, where there will be several rounds of funding, seed investors should remember such clauses will be a big negative to future investors because such clauses cause the dilution effect to fall on the remaining parties. Future investors would have to seriously doubt the business acumen of any individual who would agree to such a clause. Moreover, because future investors will demand similar anti-dilution protection, not only is it a special slice of the pie that cannot shrink, but over time the slice begins to expand! On the other hand, a clause frequently required by venture capitalists is down-round protection (this is sometimes referred to as anti-dilution protection, but it differs from that described above). This clause says that if the next round of venture funding is at a lower share price, investors in the previous round will have bonus shares issued so that the previous fundraising will be at the new price. This means that, in the event of a down-round, the venture capitalist for that round will not have to make a writedown in its portfolio. Say a venture capitalist investor has invested $2 million at $5 per share and so has been allocated 400 000 shares. The next round is at $2.50 which means the venture capitalist would have to take a writedown of $1 million. However, if the venture capitalist has downround protection it would be allocated another 400 000 shares for nothing and not have to make a writedown. Entrepreneurs should insist, however, that down rounds do not last more than one round. A clause most investors should consider including in a shareholders’ agreement is the Mexican standoff, or call/put clause, especially when there are just a few parties with roughly equal ownership. Investors may be given the right to buy out the other parties. However, under a Mexican standoff, the other parties typically have the right to turn around and buy the offerer’s interest at the same price. As the parties may not have similar wealth, often a long offer period is imposed (about six to nine months) to allow the less wealthy party to raise finance. The reason this clause is useful is that it keeps all parties honest. Entrepreneurs who are close to a business may realise the company is going to suddenly increase in value. They may try to buy out their present investors, conveniently forgetting the importance of their original contribution. Such a clause in

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the shareholders’ agreement will always make one party stop and think before offering too low a value.

Documentation Finally, investors in a private company transaction must never allow themselves to be hurried. It is all too easy to buy; it is far harder to sell. When negotiating the shareholders’ agreement, it is worth remembering that whoever controls the documentation is in the more powerful position. Everyone says a contract, once signed, should go into the drawer and only be pulled out if something goes wrong. The investor should remind himself that Murphy was a venture capitalist. Something will go wrong and the agreements, Constitution and other documents will appear. Investors need to ensure—and here lawyers are essential—that their interests are protected if something goes amiss. No investor should ever hand over a cheque unless he or she has co-signed a shareholders’ agreement with the entrepreneur, which both the investor’s lawyers and the investor have agreed is a satisfactory protection of the investor’s interests. In the United States, lawsuits between entrepreneurs and venture capitalists are common. Supposedly New South Wales ranks second to Orange County, California in terms of litigation. Accordingly, it is likely that lawsuits will become more common. There has already been one case heard against a venture capitalist in New South Wales over purported misleading and deceptive conduct. The entrepreneur alleged that the venture capitalist, during eight months of protracted and exclusive negotiations, continually made assertions that the financing would be forthcoming. In the end, the financing did not eventuate and the entrepreneur stated that if the venture capitalist had not engaged in misleading conduct he would have closed down his local operations and headed for the United States and tried to attract American venture capitalists. On the specific facts of the case, the court did not find the conduct sufficiently misleading or deceptive nor did it find the certainty proved sufficiently that the entrepreneur would have achieved a successful US capital-raising strategy. However, the courts left it open for other cases to enter a claim for damages where it could be shown that a clear link existed between investor misconduct and investee loss of opportunity. In this case, the venture capitalist allegedly shifted from no tranches to eventually multiple tranches, and it went from not requiring the entrepreneur to put more hurt money in to requiring

structuring the deal  235 

a significant infusion of personal capital. The court did find in favour of the entrepreneur for approximately $400 000 of damages incurred in continuing to operate the business when he would have walked away from the potential investor and shut down. A common suit in the United States is for a rejected entrepreneur to sue a venture capitalist for breach of confidentiality when the venture capitalist later invests in a similar business. One such case has already started in Australia. Investors and portfolio companies should always operate within a cloak of confidentiality. If a non-disclosure agreement is signed, it must contain a termination date. A new form of venture litigation that has started in the United States is tortious interference. This can occur when one venture capitalist offered, say, a role in a syndicate, goes ahead and does the transaction on his or her own. In another case, a business sued a venture capital firm for tortious interference after one of its portfolio companies poached a specific team of experts from the business, the logic being that the venture capitalist has aided the portfolio company in the poaching and, having deep pockets, the venture capitalist was a prime target for the lawsuit. In conclusion, it is vital to get the deal structure right, so entrepreneurs and investors should not rush the process, should think carefully about their commercial objectives, and should seek legal, tax and other expert advice to support their negotiations and documentation of their agreements.

20

Post-investment activities

Lead venture capitalists usually take a board seat upon completion of the investment. High net worth (HNW) investors may also do so, though some prefer to be involved only on advisory boards. The contribution of venture capitalists may be over-stated, usually by venture capitalists themselves, especially when they make a successful investment. The Greeks best summarised the attitude when they said: ‘Victory has many fathers but defeat is an orphan.’ The management of the businesses in which venture capitalists invest usually has limited financial skills; venture capitalists provide a level of experience that previously was only available to clients of merchant banks and stockbrokers. Indeed, it is the combination of entrepreneurs’ and HNW investors’ business skills and venture capitalists’ financial skills that provides much of the added value. Whether board representation is a management support activity or a perk of the job is arguable. It has been our experience that when a board seat is offered in a high-growth company which has had a significant injection of equity, the queue of people willing to make the noble sacrifice of serving as a director is longer than one might expect. Venture capitalists who sit on investee boards must be prudent. They must be careful not to be perceived as someone who will override their obligations as board members in favour of the interests of their venture

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firms. They need to disclose potential conflicts and, if necessary, remove themselves. Venture capitalists and portfolio companies should always operate within a cloak of confidentiality and keep the information they find out about one another’s operations to themselves unless authorised to release it to the broader business community. Should it transpire that a venture capitalist unwittingly or intentionally released specific intellectual property that was subsequently received by a competitor and used to the portfolio company’s disadvantage, then the venture capitalist has not only harmed the investment, but has damaged its reputation and is also potentially exposed to a law suit for damages. One of the better definitions of the venture capitalist’s role is in Peter Drucker’s (1985) stimulating book Innovation and Entrepreneurship. He defines the three key elements supplied by venture capitalists as follows: • focus on the strategic plan; • focus on the people; and • focus on the financial needs of the company.

Focus on strategic plan Businesses succeed on the whole not because the executives come up with the perfect plan, but because they decide on one course of action based on sound commercial principles. Management then executes the plan without distracting itself with outside activities. McKinsey and Co. is probably the world’s most reputable strategic management consultancy. It deals regularly with the chief executives of the largest private and public organisations. The principal of a McKinsey office was once asked for the secret of its success. He replied that it was a matter of first establishing with the chief executive of the client organisation the three most important tasks for the next twelve months. The second step was to convince the chief executive not to spend any time on anything else. The final step was to reinforce the advice by charging a fee of $100 000 plus. Entrepreneurs, as a general rule, are energetic people and easily distracted. Venture capitalists need to ensure that a strategic plan is formally produced every year. It need not be a long document, and much of the content will be repeated year after year. Nevertheless, four of the most

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useful tasks a venture capitalist can perform for an investee ­business are: • defining what business the company is in; • applying Porter analysis to the company and industry; • redefining the mission statement; and • setting just three corporate objectives for the following twelve months.

Strategic plans should be formulated every year as part of the budgeting process, and after face-to-face contact with the more important customers. The role of venture capitalists is to ensure that this task is done and then followed through. The Romans used to place a slave behind a successful general as he was riding through the city on a chariot in a triumphal procession. The slave would continually whisper in the ear of the general, ‘Remember you are a mortal’. In the same way, venture capitalists should repeatedly be whispering in the ear of the entrepreneur, ‘Remember the strategic plan—are you increasing the return to yourself and your shareholders?’ A big advantage of personal computers is that they make it easy to update last year’s plan. Many entrepreneurs fail to realise that the fundraising never stops. The secret is to put the fundraising on a systematic, rather than ad hoc, basis. A fundamental tool for success is an up-to-date formal business plan stored on a computer. Where investors can be of significant help is in acting as a devil’s advocate about the business plan. Active venture capitalists probably see five or six business plans a week. After a while, they develop a feel for a likelihood of success. In this way, they compensate for a weakness of the smaller organisation—the lack of management depth. Large organisations have the management resources available to examine potential concepts thoroughly before making a decision. Weaknesses are rooted out, and usually non-viable concepts are rejected. Major failures rarely occur; their scarcity accounts for the publicity received when they do.

Focus on the people One golden rule of venture capital is that, given the choice between an ‘A’ class product with ‘B’ class people, or a ‘B’ class product with ‘A’ class people, one should choose the latter. Surveys of venture capitalists again and again report that the most common reason for rejection of business

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plans was inadequate management. This can vary from low leadership potential in the lead entrepreneur or management team to lack of industry experience, the poor track record of the entrepreneur or management team, poor marketing/sales capabilities in the team and poor organisation/administration capabilities in the team. Drucker makes focusing on people a key task for venture capitalists. Much of the venture capitalist’s job consists of meetings and interviews with a variety of people. They can act either as a screener or as a second opinion before hiring key staff. It is a principle of high-growth companies that they should over-hire. Over-hiring means the companies must recruit people who can handle more complex and sophisticated roles in three to four years’ time. Most important of all, the five key positions in the company—namely, the general manager, the chief marketing officer, the chief financial officer, the chief operations/technical officer and the chief legal officer—must be filled with able executives. The best executives are those who have had profit-centre experience with a division of a multinational company or who have been key managers in a prior successful start-up or buyout. Small start-up companies often lack status. A venture capitalist or HNW with a high profile can be helpful in supplying credibility for such a small company. An established name serves to reassure both the recruiting agents and potential recruits. Entrepreneurs should remember that it is not how much money is invested but who is investing that is often more important. It is also important to recognise that the needs of a start-up business change rapidly. The founders of the company may not always be the ­people to run the business in the medium or long term to maximise its return to shareholders (including, of course, the founders). The wise entrepreneur will listen to the views of experienced members of the board on this issue. As Adrian Giles, a founder of Hitwise (which brought in a professional CEO to run the business) stated: ‘You have to avoid the founder syndrome. Appoint good people to run the business. You as a founder can then work on it rather than in it.’

Focus on the financial needs of the company The investor can assist the company to implement the best practices of larger companies. Here, venture capitalists can be of particular value in

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ensuring proper monthly accounting records are kept and monthly cash flow forecasts and annual budgets are prepared, and assisting in further rounds of funding. Besides the actual investment made, venture capitalists must help the company source extra funds and lines of credit. Venture capitalists must dedicate some time to dealing with the bankers of the company. They should be able to arrange debt financing to act as bridging between rounds of equity. Venture capitalists can also help with the public listing. The procedures of underwriting, choosing a broker, preparing a prospectus and carrying out Australian Securities and Investments Commission (ASIC) and stock exchange negotiations are unfamiliar to entrepreneurs and typically only done once, while venture capitalists generally have experience of several listings. One of the keys to the game is understanding that the company, if successful and growing, will need funds continuously, and these should be raised by successive rounds of equity. In Silicon Valley, the companies have this process down to an art form and the chief financial officer, as soon as he or she has raised one round, immediately starts organising the next. Funds are traditionally raised on an annual basis. The intelligent entrepreneur uses the annual fundraising process to maintain a balanced ownership structure by attracting new investors to each funding round so that no one investor completely dominates the voting rights. Entrepreneurs will often ask the initial investors to make a followon investment. The question often becomes one of either injecting new funds or pulling the plug. As a rule, if investors cannot attract a new party to co-invest in the next round, they themselves should not invest. This is another example of how syndication acts as an independent means of setting a valuation. Besides raising cash, investors can also be of help in saving cash. It is fundamental to the success of a company that a culture of conserving cash prevails. One maxim is to ‘lease the pencils’. Three-monthly cash forecasts must be prepared every month, and debtors and stock watched closely. Venture capitalists should take an active role in preparation of cash forecasts, and in asset and liability management. The other key financial role of venture capitalists is in introducing ratio analysis. ‘Sell more’ and ‘Keep costs down’ are useless statements. Aiming at $200 000 sales per employee and keeping overheads below

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20 per cent of turnover, just as your competitors do, are good examples of measurable objectives. Good venture capitalists should practise what they preach and prepare a monthly monitoring sheet. This is a simple spreadsheet that shows monthly actual results for income, balance sheet items, and cash flow and budgets. A number of key ratios are also calculated, along with the monthly break-even point. Using a spreadsheet package makes this an easy task. Moreover, if the package has a graphics capability, it is easy to produce graphs for demonstrations at board meetings. Venture capitalists perform several other functions. The legal protection of intellectual property is a difficult area, unfamiliar to many lawyers and often overlooked by small business. Licensing agreements, patents, trademarks and so on are expensive to arrange and venture capitalists could help save on legal costs and prevent costly mistakes. A key task is ensuring that all consultants who act for the company sign consulting agreements which pass to the company the title for all inventions and designs made while employed by the company. Investors, particularly experienced HNW investors, can provide support in sales presentations to key suppliers and clients. If they can fulfil the role of emphasising the plan, the people and the finance, their contribution to the success of a business will be both significant and satisfying.

Open some doors The HNW individual or venture capitalist should also open doors for the venture, where their professional position is not compromised by doing so. HNW individuals who are former successful entrepreneurs typically have significant personal networks, and these can be critical for the venture to gain access to a key customer or strategic partner at the right levels. HNW entrepreneurs with the right experience can also make a significant contribution via executive mentoring and participating in strategy reviews with the executive team. A common characteristic of the successful companies in Part 5 was that they did this on a regular basis, typically communicating with their HNW board members on a weekly basis.

21

Exit mechanisms

Ultimately, investors must look to exit from their investment. In this chapter, we examine in detail three primary possible exit mechanisms: public listing, selling out to a third party and releveraging. We assume the investor has built into the shareholders’ agreement and share structure the fourth mechanism, which is redemption of original capital. Finally we consider some other capital recovery strategies. As indicated in Chapter 19, although at the beginning both parties may have sought public listing as an objective, the company may not grow to the size expected because the market is not of the size projected. The company will now join what venture capitalists call ‘the living dead’. Suppose that after five years the company is producing $300 000 a year in after-tax profits and that the venture capitalists had earlier bought one-third for $1 million. With the potential for just $100 000 of dividend income, they would be looking at a yield of 10 per cent and the entrepreneur would be looking at receiving two-thirds of the profits as dividends or $200 000 fully franked dividend income. While this is a reasonable return, it is inadequate to cover other losses in the venture capital portfolio. The investors are locked in with nowhere to go. If, however, the investors have put into the shareholders’ agreement a no-dividend policy and forced redemption of investors’ capital, they can at least get their capital back and go play the game somewhere else.

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Public listing We previously established that an initial public offering, or IPO, is the primary exit objective. As a general rule in favourable market conditions, the public pays more for a company than any other source. The IPO is also a potential source of additional growth capital for the business. In this section, we examine the ways a company can go public. There are effectively two methods: the public offering and the backdoor listing. We will not try to describe them all in detail, but will point out some of the key decisions. The key to the public listing is the prospectus. Promoters now have to prepare and register a prospectus with the Australian Securities and Investments Commission (ASIC). A prospectus must contain all information that investors and their professional advisors reasonably require and reasonably expect to find in a prospectus for the purpose of making an informed assessment of assets and liabilities, financial position, profits and losses, prospects, and rights attaching to the securities. If the prospectus is found to contain errors or misrepresentations, the promoters face both criminal and civil liabilities, which are quite severe. The net liability not only includes the company and directors, but also those entities which previously could exclude themselves, such as promoters, stockbrokers, underwriters, auditors, bankers, solicitors, and professional advisors and experts. The idea is that these individuals will now pre-vet the prospectus and the ASIC registration should just be a rubber stamp.

Public offering One of the more unpleasant aspects of capitalism has been the history of wheeler-dealers raising funds from the public for various projects. The net result has been to convert the capital of the investors into income for the wheeler-dealers. The regulatory authorities in most countries have introduced laws to ensure that public offerings of shares are accompanied by a document known as a prospectus. This document should contain sufficient adequate and reliable information so the investor can judge the present financial condition of the company and its potential. The various people and parties involved in preparing a prospectus have duties of disclosure and of care. Furthermore, the Australian Securities Exchange (ASX) has its own listing rules and regulations which should be referred to when planning

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the exit. These are the rules covering the number of shareholders, profit history, types of shares allowed and so on. Chapter 6 covered public listings as a source of growth capital and contains a table summarising the basic listing requirements. As mentioned in Chapter 6, the minimum spread of shareholders is 500 persons and each must hold a share parcel to the value of at least $2000. This imposes a minimum capitalisation of $1 million on the company. In addition, the company must satisfy the profit or asset tests. For the profit test, the company must have had a pre-income-tax aggregated operating profit of at least $1 million over the past three full financial years. It must have had unqualified audited accounts for three full financial years. It must have been in the same predominant business activity for a minimum of three full financial years. Finally, the company must have had a pre-income tax operating profit of at least $400 000 for the twelve months prior to the lodging of a prospectus. These are minimum requirements but are indicative of exactly the type of company venture capitalists and entrepreneurs should be trying to build—striving, of course, to create a company large enough to attract institutional investors into the share registry. The asset test is typically used in two cases, an investment fund or a start-up business. The investment fund requirements are fairly simple. The fund must have net tangible assets of at least $15 million after deducting the costs of fundraising. A start-up business must have net tangible assets of at least $2 million after deducting the costs of fundraising, or a market capitalisation of at least $10 million. After the fundraising, less than half of the total tangible assets (after raising any funds) must be cash or in a form readily convertible to cash. If half or more of the entity’s total tangible assets (after raising any funds) are in cash or in a form readily convertible to cash, then the prospectus, product disclosure statement or information memorandum must have clearly stated business objectives and include an expenditure program to meet 50 per cent cash maximum rule. Say, for example, a start-up company raises $2.3 million, and the cost of its capital raising is $300 000. The ASX would normally require it to have expenditure commitments for an additional $850 000 (which, combined with the $300 000, is half the $2.3 million raised). Note that the ASX would normally not treat inventories and receivables as readily convertible to cash. It may comfort those about to start the initial public offering route to remember that others have trod the path before. The ASX had more than

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440 IPOs for the 26 months from 1 January 2006 to 11 February 2008, nearly seventeen floats every month or one or more every two days. Of these, over 240 had a market capitalisation of $20 million or less. While many listings were small in size, the sheer volume reflects the demand for IPOs by the 100 or so operating brokers in Australia, as well as the retail and institutional investor community. This demand gives venture capitalists the opportunity to exit. The two problems with IPOs are cost and timing. Typically, a float costs between $500 000 and $750 000. To make it worthwhile, a company should be seeking to raise at least $10 million cash. What is called the IPO window can open and close depending on the financial appetite of investors. The average of seventeen IPOs each month from 1 January 2006 to 11 February 2008 should be contrasted with the average for 12 February to 15 June 2008. For the latter four-month period, there were 29 IPOs or just seven per month. In the first quarter of 2008, the United States had the lowest level of venture capital-backed IPOs ever recorded. The rate of IPOs slowed with the end of the bull market which was in part caused by the US sub-prime crisis and subsequent tightening of credit availability around the world. In Australia, there is also seasonality in IPOs caused by the need for three years of audits. As most companies end their annual accounting period on 30 June, most firms aim to list from September to November. As has been stated several times, the goal of both the entrepreneur and the venture capitalist is a public listing to achieve the greatest capital gain. Consequently, the company should already have appointed reputable auditors and solicitors. The first critical step after deciding to float the company is to appoint an underwriter as well as legal, tax, accounting and other professional advisors. Underwriters guarantee that the funds required will be raised at a specific time and under specific terms. The underwriter must take up the balance, referred to as the shortfall, of any amount sought and not raised. Appointing an underwriter is most important and should not be left to chance or personal contact. As in most purchase decisions, the buyer should contact at least three underwriters and ask why the company should choose one over the others. The first criterion of choice is the after-market support the underwriter can provide. Listing is not just a means of raising money or profile. It also provides negotiability for stock. If the underwriter cannot convince

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the entrepreneur that it will provide after-market support by promoting the company to the investing institutions and private clients, the entrepreneur should look elsewhere. Therefore, it is probably better to ensure that the underwriter is a stockbroker, or a stockbroker is intimately involved. To measure the after-market support, ask the underwriter to provide the price and volume history graphs since listing of at least the last three stocks it has underwritten. Attracting investor interest for the listing of an unknown company is not easy, and the underwriter will usually price the issue at 15–20 per cent under the expected market price to ensure IPO takeup and after-market support. This pricing often results in profits after trading commences, which are known as ‘stag’ profits, in contrast to the bulls and bears of the stock market. If the price falls after the issue, one may assume the underwriter has lost credibility in the market but it is also possible that the market itself was in a nervous or pessimistic state. While entrepreneurs and investors should strive to maximise the value of the IPO, they must remember that new shareholders are joining the registry and the subsequent performance of the company, its listed shares and after-market support from the broker are critical to generate ongoing appeal of the company to share market investors. Besides the price–volume graphs, the company should ask to see the latest three prospectuses and ask which institutions subscribed to the issues. This will provide some measure of how the market views the underwriter. The stockbroking industry has fairly high staff turnover, and institutions tend to follow individuals. It is also necessary to establish which representative of the underwriter is going to be advising on the issue and what his or her experience is. IPOs are not difficult, as the listing figures above attest, but there are some horror stories of companies failing to list on schedule owing to oversight caused by lack of experience and thousands of copies of prospectuses being shredded. Another criterion is the financial capacity of the underwriter and its ability to meet a shortfall. In times of boom, capital strength is overlooked, but when there is a correction it becomes important. It is necessary to understand that underwriting is a risky business. While the fees appear high compared with the work done, every so often an issue takes a bath and the shortfall is large. The cash flow in underwriting consists of a stream of reasonable profits interspersed with the occasional large loss. All underwriters understand this problem; they try to delay signing the

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underwriting agreement as long as possible and insert as many escape clauses as they can. On the other hand, if there is a market correction but the expected shortfall is a small part of its capital base, it is likely that the underwriter will still go ahead. If, however, the shortfall is a large part of its capital base, then the underwriter will pull out of the agreement. The company has limited redress; suing an underwriter will not gain the support it will ultimately need from the financial community. Finally, the company should try to establish the fee structure and terms of the issue. Typical underwriter fees, including brokerage, range from 3–5 per cent, but they can go higher for speculative issues. Once the underwriter has been chosen, work can commence. The underwriter should immediately prepare a timetable and a list of the parties involved. The current prospectus rules mean that, with focused effort, an IPO can take about three months. Australia is perhaps the fastest and least expensive country in the world to achieve a public listing. The company must appoint an executive responsible for the various documents and the roadshow presentation. This is usually the financial director or the company secretary. The company will need to draft the marketing part of the prospectus. It will need to ensure the necessary board resolutions and shareholders’ meetings occur. The investigating accountants must complete their report on time. As a full audit must be completed no more than six months prior to listing, many companies list in the third quarter of the calendar year following the 30 June close. The company should appoint someone to maintain the share register. Finally, the executive responsible must organise the preparation for the roadshow. This refers to the visits to and by institutional investors and major private clients at the time of selling the issue, which is after registration of the prospectus and before listing. A key IPO decision is the pricing and structure of the issue. Each IPO is different. The typical price for shares has ranged from 20 cents to $1. However, in the United States under the NASDAQ rules, shares that trade under $1 for three months are delisted. This has led to an American perception that a company is ‘tainted’ if its share price is below $1. This can be deleterious to the company if it is seeking overseas clients or distributors. Accordingly, some companies are now looking to list at prices above $1. VeCommerce, an Australian listed company that was developing applications in Natural Speech Language Recognition, for example, carried out a 10:1 consolidation so that its share price would be above the $1 psychological level.

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Another important factor is the free float. This refers to the amount of shares freely available at the time of listing. Typically brokers want a minimum of $15 million. This often provides the venture capitalists and the entrepreneurs with the opportunity to sell some of their shares and take at least a partial exit. Because an IPO is new, exciting and technically fascinating, many companies fail to use it as a marketing weapon. The prospectus can be a most useful sales aid, yet it is surprising how many prospectuses fail to contain such simple details as the locations and telephone numbers of the company’s branch offices. Moreover, the executives should make sure they reserve sufficient shares for distribution to clients and suppliers. Stockbrokers do not just do underwritings for the fee income. If the company is successful and a stockbroker becomes known as the broker for the stock, it will earn far more in commissions. Even more importantly, if it can provide stag profits for its clients it will generate loyalty for new deals. Newly listed companies should also use the loyalty created by stag profits by placing shares among their clients, employees and suppliers.

Backdoor listings One of the benefits of capitalism is that failed companies eventually lose their value and resources are allocated elsewhere. On every stock exchange there are listed companies that have lost their original means of producing profits and have slowly lost all value. What remains is a shell. The present shareholders have their scrip at the bottom of a drawer or on the wall. Basically, listing by the back door consists first of buying up to 19.9 per cent of the shell in order not to breach the takeover provisions of the Corporations Law. A shareholders’ meeting is held to allow a consolidation of capital of the shell company so that the net tangible assets per share will roughly be equal to the par value of the share. On completion of the consolidation, the shell company then issues as consideration a sufficient number of new shares in exchange for all the shares of the target company. The new issue requires majority approval of the shareholders other than the acquirer and his or her associates. Usually the incumbent shareholders are so happy to see something positive finally happening to the company that they approve the resolutions with alacrity. To ensure the consideration is fair and reasonable, the authorities require an independent expert’s valuation of the acquired company.

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A backdoor listing is a form of reverse takeover in which a smaller company, by issuing shares, takes over a larger company. Typical shells have a market capitalisation of $300 000 or less and the acquired companies will be valued at $5 million upwards. A successful IPO is the king hit in venture capital. Entrepreneurs and investors alike should strive to build a company that can be listed and engage expert advisors to assist with the listing.

Selling out to a third party and share buybacks Another alternative to the IPO is selling out to a third party. Acquisitions occur far more often than IPOs as a form of exit. Large companies, particularly those with mature products and steady cash flows, prefer to buy profitable companies rather than build up businesses from nothing. A mature listed company, in order to maintain its stock price, must show steady growth in earnings. Starting new entities is risky and expensive, especially if management uses equity to fund the start-up. On the other hand, buying an already operating and profitable company generally entails less risk (certainly different risks, including integration). More­ over, the purchase can increase earnings per share if the purchase is done by debt and the pre-tax profit of the business is greater than the interest costs. Even if the purchase is financed with shares, provided the P/E of the purchase is less than the P/E of the acquiring company, then the earnings per share of the acquiring company will generally increase. The other third-party sale method becoming increasingly common is the leveraged buyout. While fast-growth companies are not typically LBO targets, if the business growth has topped and cash flows are stable, then the company may well be a candidate. A share buyback is another option. The founders and incumbent venture capitalists may agree that borrowing to finance a buyback of shares of the company is the best form of exit. For example, Macquarie Investment Trust exited Neverfail Spring Water via a specific buyback of MIT shares funded by bank debt. The timing of trade sale of an investee company is as important as the timing of an IPO. The investee company should still have potential for growth so it is always better to sell a business on the rise, rather than one that has peaked or where the market has become too competitive. An enterprise that has proven its technology platform in Australia and that has secured market position in Australia and Asia is particularly attractive

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to US and European multinationals looking both to move into Asia and seeking new products to take into the United States and Europe. This is sometimes called a ‘third-leg’ acquisition. Other reasons that a company may wish to acquire an investee company include: • acquiring people, skills or intellectual property (particularly likely in the IT and high-technology sectors); • ability to integrate the investee business into other operations; • desire to inject new life into the business through different management, investment or processes; • a competitor desiring to increase market share and gain critical mass (industry rationalisations can be very profitable); • customers wishing to move upstream in the supply chain to ensure supply and reduce costs; and • suppliers moving downstream wishing to control market share.

However, while acquisitions should make strategic sense, it is well to remember that it is people who buy companies. There is always emotional content in any company purchase. The intangibles are generally more important than the tangibles. Analyses have shown that some 80 per cent of acquisitions perform poorly. Consequently, the buyer must be assured that profits and gross margins will continue to grow. Buyers gain confidence from a healthy backlog of orders and proposals.

Trade sale issues and considerations When acquisitions don’t work out, management in the acquiring company not infrequently tries to find causes other than their own lack of analysis or ability to integrate the acquiree into their operations. Sometimes this turns into litigation, as happened with a company in which one Australian venture capitalist had an interest. A year or so after the acquisition, a key customer was lost and the acquiring company in the United States sued management and the sponsoring venture capitalist. While the action was unsuccessful, it tied up significant amounts of time of both the venture’s previous management and the venture capitalist. Market timing is another critical issue. The first is the market for the company’s products or services­—is it thriving and growing? The second aspect is the market for similar types of businesses. An active and bullish

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stock market will tend to increase both merger activity and acquisition prices. The final marketing stage is to consider the time of year. If the business is seasonal, then you will be much more confident discussing the company’s prospects when the management accounts have shown a solid six months of profit. For example, the corporate financing activity in Never­fail Spring Water always occurred in March and April after the strong summer results. Acquisitions were always targeted in August and September when the target companies would have weak cash flows and reserves. Many acquisitions are based on gaining the capabilities of a management team. Indeed, we have seen more than one acquisition justified solely on the cost and time of recruiting a similar management team. Accordingly, contracts and compensation plans must be in place to ensure an orderly changeover. One technique is to give management members options so that if the transaction goes ahead they will make serious money. The private company should try to create a market by talking to more than one buyer. Far too often a business accepts the first offer. By creating a market, the shareholders will have a better chance of obtaining a fair and reasonable price. It is best to approach several buyers simultaneously, with potential bidders invited to make offers for the business on the basis of the selling memorandum. A clearcut timetable is then imposed, giving a period for negotiations and a deadline by which offers (subject to contract) must be received. It is probably best to use an agent­—particularly one with overseas connections and the technology to ensure as wide as possible a market is developed. Selling a business is similar to selling a house. Real estate agents would rather get a smaller fee on a fire sale rather than no fee at all. A good method of obtaining fair value is to ladder the fee. For example, if you think your company is worth $10 million, say you will pay the agent 0.5 per cent for the first $10 million, 3 per cent for the next $5 million and 30 per cent for any amounts received over $15 million. Using a laddered fee can do wonders for the ‘independent valuation’ your expert will provide when you begin negotiations. Another tactic is to make sure the recurring profits are as high as possible. If the company has been supporting a loss-making branch, it should close the branch. Long-term investments in areas such as MIS and R&D should be deferred. All interrelated activities such as inter-company loans should be cleared up. Accounts should be audited at least three years prior

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to the sale and physical stocktakes done regularly. Surplus cash should not be left in the company. The company should take out options on renewing any leases. Many businesses lose much of their value if their lease is about to run out and is not renewable. If there are any assets in the business that are not of real use, they should be disposed of. As many large companies do not like to have property on the balance sheet, it may pay to sell the property and rent it back under an arrangement that will continue when the business is sold. A problem with a company sale is confidentiality. If information about a potential sale leaks out, employees and customers may begin to get nervous and competitors may start spreading rumours about the financial stability of the company. Just as the venture capital investor is aware that the structure of the deal is as important as the valuation, so when selling a company the terms may be more important than the price. A key determinant in any sale is the effect of tax and professional advice should be sought before entering the sale process. Tax considerations usually determine whether the sale consists of assets or shares. One benefit often proposed for asset sales is that the acquiring company does not take over the liabilities of the acquisition. While this is generally true, an asset acquirer will still need to negotiate with clients, suppliers and employees. Often clauses are inserted in distribution and maintenance agreements that allow termination if there is a change of ownership, but these are rarely enforced. A typical request by purchasers, especially if the deal is an LBO, is some form of vendor finance, typically a promissory note. A seller’s note may be structured in a number of ways. The bank providing the debt will want delayed payment of principal and the purchaser will want a low rate of interest. However, a seller’s note may be the concession that makes or breaks a sale. It is important that professional advice is taken, particularly with regard to the capital gains tax and interest expense implications. Another potential problem with share sales and vendor finance involves the prohibitions in the Corporations Law against companies providing financial assistance for acquiring their own shares except in specific circumstances; therefore, expert legal advice should be sought when structuring vendor finance arrangements. Another common request is for the entrepreneur and/or management to stay with the company for several years and the purchase price to be adjusted according to either future earnings or revenue. While profit is the

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usual criterion, both parties may find it preferable to agree on revenue as a basis for valuation. However, if profit is the basis, it is common for the seller to reduce all forms of long-term expenditure, be it capital equipment, product or market development, replacement stock and so on. Because most sales will be shares rather than assets, representations and warranties will be needed from both the entrepreneur and the venture capitalist. Make sure that the offer memorandum that is usually prepared by the broker does not contain any items that either the entrepreneur or the investor is unwilling to warrant. Here venture capitalists, with experience on the other side of the table, should ensure fair and reasonable terms for all parties. Also, purchase agreements will usually contain some form of non-compete agreement based on some mixture of location, product and time. While the non-compete domain can be set quite widely, it will be difficult to uphold in court. Both stock and asset sales are complicated transactions, due to the tax implications. The past decade has seen changes in company tax every year, and many areas of the Tax Code require rulings from the authorities. Also, the laws will change over time, so all parties need professional advice. One reason for using a reputable auditing firm is that it should have expert tax partners. Another is the possibility of the fourth exit mechanism, receivership. This is not the book in which to consider winding up and liquidations. However, investors should realise entrepreneurs tend to be optimistic until the removal of the telephones. Thus the investors must provide the realism. The earlier realism sets in the more likely investors will be able to recover some of their investment. Also, the investors should ensure they participate in any sale discussions. Often entrepreneurs wishing to save their own skins and gain credibility with new buyers will forget their fiduciary duties to present shareholders. They will team up with the new buyers and try to persuade the current investors to accept a fire-sale valuation. It is galling to decline what turns out to be a good investment opportunity. But it does not compare with what investors on the wrong side of a fire sale feel when they suddenly see their disposal become a successful business. There are various tactics that venture capitalists adopt to prevent a writedown. One technique is to convert the equity to debt, which will be paid with a balloon payment and accrues interest cumulatively. Such an arrangement removes any upside but delays a writedown for the term of debt.

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Other techniques are to license unused intellectual property, or buy another company if there is any residual cash left. Generally, however, these two alternatives are not available. The venture capitalist may choose to sell out to management and get releases from any liability. Otherwise, the best alternative may be to consider the business as a start-up, decide on what is the best capital structure with management and participating investors, and then wash out from the capital structure all non-­participating investors.

Australian exit history The annual AVCAL/Thomson Financial survey tabulates the various exits achieved by investor members. The results of those members who elected to report are set out in Table 21.1. The substantial writeoffs and liquidations in 2003 and 2004 show the risks of venture capital investing. While IPOs are fewer in number, the IPO remains the primary objective of the venture capitalist and the entrepreneur because public markets tend to pay higher prices than nearly any other buyer group, particularly in bull markets. According to the Thomson/National Venture Capital Association’s US venture capital survey, the United States has a similar experience where the calendar year 2007 saw 86 IPOs with an average offer amount of US$465 million and 347 sales to trade buyers at an average of US$177 million. As with Australia and most of the world, US IPO activity in 2008 has been very subdued due to the end of the bull run. Table 21.1 Australian venture capital exits (year ending 30 June) Writeoffs/liquidations Floats Sale to trade buyers Other exit Total

2003

2004

2005

2006

2007

10

23

8

1

3

4

5

7

2

0

27

25

36

28

8

4

17

3

6

10

45

70

54

37

21

Part V

Australian success stories

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22

Hitwise

In 1997, two Melbourne-based entrepreneurs, Adrian Giles and Andrew Barlow, formed a consulting business called Sinewave Interactive, specialising in search engine marketing. They were friends from the days when Adrian’s family owned a pub in Andrew’s suburb. Andrew had an existing business called Creative Access, which he had formed in 1995 to help companies establish websites and web marketing strategies in the early stages of the World Wide Web. Its customers ranged from small businesses to large corporations like the now-defunct Ansett Airways. As part of its service, Creative Access developed its own internet service provider (ISP) and analysed log files for customers to work out what users were doing. Armed with this data, customers had begun to ask for assistance in driving users to their sites. One of the key drivers for creating Sinewave Interactive was to help such customers do this through search engine optimisation. As Sinewave Interactive began to grow, its customers also began to shift their focus to how they were tracking relative to their competitors. While the traffic for most was typically growing at the time, so was the web channel in general, and it was possible that they were actually losing share of mind and market to customers without being aware of it. There were also significant limitations in web market usage and competitive data provided by companies like ACNielsen. Such data were typically

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based on sampling methods or consumer panels using set-top boxes in the home. While they could yield accurate results on large websites like Yahoo!, MSN and Amazon, data on websites with more limited reach like Colgate, Nissan and L’Oreal, were either not available or only accessible on a post hoc weekly or monthly basis. The value of such data to consumer product and service companies in a realtime environment like the web was extremely limited. With the web growing rapidly as a marketing and customer relationship channel, a detailed knowledge of how customers and competitors actually behaved in that environment was needed, as distinct from how customers said they behaved in surveys. Giles and Barlow saw a timely opportunity to automate the collection and analysis of web traffic, and to provide more granular, immediate market data by focusing on traffic through ISPs. They decided to invest in developing a ‘popularity’-based search engine and a complementary competitive intelligence service leveraging this data. As young entrepreneurs in their early twenties they were only able to kick in about $5000 each. An additional $250 000 was provided by family members, on a valuation of the business at $1 million. This was sufficient to fund both the research and the preparation of a business plan and investor documentation. The research led to a new measurement method being developed, which would enable ISPs to anonymously monitor more traffic and to report on a much wider range of websites. In 1999, a search engine based on this technology was launched in the Australian market as ‘Top100. com.au’ and in 2000 the ‘Hitwise’ competitive intelligence service was also launched, which featured site rankings, profiles and charting features. The target customer was the Marketing Director of major consumer brands. Key partners in delivery were the ISPs, which needed to provide the data to make it work. These were signed up initially on a revenue share basis (later, as the company grew, it became possible to pay some for provision of the data). As a web-based business, with marketers experiencing the same problem in overseas markets, it was likely that the company was internationally scaleable. An A series fundraising round of $6.3 million (on a post-money valuation of $16 million) was commenced in 2000 to support international expansion. A series of presentations to HNW individuals led to the introduction of Allen & Buckeridge, an Australian venture capital firm specialising in the ICT sector.

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In April 2000, during the middle of the fundraising round, the dot.com bubble burst and the stock market plunged. This led to a ‘do or die’ ­meeting between Giles, Barlow, A&B and several of the HNWs. After a detailed two- to three-hour presentation and responding to questions, Giles and Barlow were left outside to sweat on the outcome. Fifteen ­minutes later, the word came that all the players were in. ‘Most Aussie VCs didn’t understand the technology, but A&B did and could see where it could go. Later on they were able to contribute people with operational experience like Roger Allen, who became an active contributor on the Hitwise Board,’ according to Tessa Court, who would later join Hitwise as Sales Director. What made Hitwise attractive to Allen & Buckeridge and the HNWs? According to Roger Allen: ‘We liked the business model from the start. The online marketing area was growing rapidly and effective measurement was clearly a critical issue, so there was a need. It was a very scaleable model (“software as a service” via the internet) and data collection was automated in stark contrast to the methods its competitors were using. It had the potential for high gross margins from the beginning and it was also easy to view how customers were using it. ‘We also liked the recurring (subscription) revenue model, which generated early and predictable cash flow. The team seemed to be very focused and competent, but we judge that over time. It was the model that really sold it for us initially.’ The founders and new investors were keen to bring in hands-on experience in rapidly growing internet businesses and Andrew Walsh, formerly COO of Sausage Software, was brought in as the CEO after a period consulting to the business. The team was expanded further with Tessa Court and Gary Salter as CFO. The company at that stage comprised about 20 people. A review of six available product options was conducted and led to an agreement between the executive and the Board that the company should choose the one that looked most scaleable and focus on that. It turned out to be the ‘Hitwise’ service. The principals felt at the time that $6.3 million was a lot and it would be a challenge to spend it. As it turned out, the aggressive growth strategy that was pursued led to the company returning to the capital market within eighteen months. A ‘Go to Market’ strategy for Hitwise was developed, which included signing up the ISPs for three- to five-year contracts, direct selling to the

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Chief Marketing Officers (CMOs) of major consumer brands and initiatives to build customer retention and revenue per customer (Hitwise ISP ­customers proved to be very loyal, with fewer than a handful opting out once signed up). Internally, there was emphasis on building an attractive work environment and strong culture, which included social activities like a Hitwise golf club. Hitwise’s prior domain knowledge as consultants in internet marketing and active use of user groups and Board input also helped with the further refinement of the product. Four key measures were introduced and monitored carefully: • new installations; • usage per installation (an early warning of issues or potential customer loss); • renewal rates; • dollar value per customer (this successfully increased from around $1000 per customer at the start to over $40 000 on average).

Hitwise was introduced into New Zealand as a test market, followed by Hong Kong, Singapore and the United Kingdom in quick succession. An attempt was made to enter the Japanese and Korean markets, but the expenditure required to do this successfully was found to be too great for that stage of the business. In 2001, the 9/11 disaster had a big impact on ISP traffic worldwide and Hitwise revenues. Already stretched from its aggressive growth strategy and living off cash flow from monthly sales, Hitwise was forced to reduce its head count from 90 to 55. While this was very difficult for management at the time, this action helped put a floor under the business and some of the staff involved returned to the business when it again began to expand. The research-intensive US market became the next focus. By then the company had an international track record and a significant base of customers. However, it was short of capital due to the experience in 2001. A second financing round of $2 million started in 2002 to support the US expansion. A series of pitches was made to Australian and international venture capitalists, but it was the previous investors who provided the additional capital. This was a ‘down round’ (at a company valuation lower than for the previous round), which meant that with anti-dilution clauses in place for some investors, the principals had to give away more of the equity than they had envisaged. 

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The company launched in the United States in 2003 with Chris Maher as US General Manager. After some debate, Hitwise headquarters was moved to New York to be closer to ‘high-use’ customers and the UK market, then the company’s largest. The company then set about building a strong customer base of ISPs. R&D activity, however, remained in Melbourne. In 2003, Adrian Giles was named an Ernst & Young Entrepreneur of the Year finalist. In August that year, the company received a call from Insight Venture Partners, a New York-based venture capital fund, offering to invest in the business. Because Hitwise was already cash positive, management felt at first that this was unnecessary. After some discussion, the company decided that additional capital was worth considering and made contact with a range of venture capitalists on the West and East coasts to see what options were available. After this period of due diligence, it was decided to work with Insight which, according to Adrian Giles, ‘appeared well connected in the United States, had good domain knowledge of the internet and a track record in growing and exiting businesses. Most importantly, they were positive people with a good approach—the chemistry was positive.’ Insight’s minimum investment by its charter had to be US$10 million, which was more than the company needed. The opportunity was thus taken to put $5 million in as new capital and to use the other $5 million for a share buyback from existing shareholders: ‘This gave something back to our early backers and took a bit of pressure off both them and us. It meant that our capital could be more patient and we could focus on what was needed to really grow the business.’ From 2004, the company’s focus was on expanding its share of the US market. It also received some industry recognition, as a finalist in the Telstra Small Business of the Year, American Business Awards and Victorian Export Awards. It made the Deloitte Touche Tohmatsu ‘Technology Top Ten’ from 2002 to 2005. New products were launched to broaden the revenue base per customer, including the Keyword Intelligence service and Hitwise Conversions Technology. Hitwise also purchased the HitDynamics marketing management platform and began to build relationships with potential acquirers and investment banks with a view to exit. In 2006, several companies in the industry began to show a more active interest in acquiring Hitwise, and Deutschebank was engaged to

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identify the best options. A listing on the ASX was discussed, but rejected as ‘too thin a market, with not enough knowledge of the sector for a good valuation’. Various trade sale scenarios were explored. The company was eventually acquired by Experian, the world’s biggest data aggregator (providing credit services, decision analytics and marketing services in 36 countries), for US$240 million. Experian had been a Hitwise partner for about five years, which helped set a realistic valuation expectation on both sides and ‘pretest’ what genuine synergies existed. Two key factors in Hitwise’s decision to go with Experian were a price that met investor expectations and Experian’s likely approach to the Hitwise brand and its staff. The Hitwise principals and Board had a strong sense of wanting Hitwise ‘to go to a good home’.

Hitwise’s relationship with investors This seems to have been unusually close for an early-stage tech company. The Hitwise Board, after the 2002 round, comprised five people (two investors, one founder, the CEO and a non-executive director). Until the entry of Insight, Board meetings were monthly and very hands on. As the company grew, they became quarterly, but were typically linked to strategy workshops over a couple of days, where Board members were given an opportunity to gain exposure to the broader executive team and to contribute their experience. Communication with Board members was described as very open and ‘typically weekly’. The Board’s personal contacts were also actively used. This proved particularly useful in the US market for securing key staff and gaining access to potential acquirers and the investment banks. While Hitwise delivered 100 per cent growth every year for five years, it also adopted a conservative approach to forecasting, and met or exceeded budget almost every quarter. This ‘helped take the pressure off us from the venture capitalists a bit’.

Things Hitwise might have done differently Not surprisingly, Hitwise executives are generally happy with these outcomes. Their comments about lessons and things to do differently included: We would have liked not to scale quite so fast in the early days. That led to living from cash flow and having to lay off staff. We should have been more sequential in how we addressed overseas markets.

hitwise  263

In all of our funding rounds, we should have involved international venture capitalists with their connections or high net worths with the right domain knowledge. It’s very important to choose investors that have operational experience in companies and know the sector.

Factors that probably contributed to success Clearly there was an innovative idea and a market need—a significant gap between what marketers needed to manage and assess their online marketing and the information available to do just that. Hitwise’s market entry timing was also good, and its specialist domain knowledge as a consultancy in online marketing wouldn’t have hurt its credibility. The founders had a global focus from the beginning: ‘We often get asked if we ever thought that the business would ever become a global enterprise. The truth is we always did.’ This contrasts with a lot of Australian technology ventures that start with a focus on the local market and consider themselves lucky if they win some offshore business. A global focus is also a key factor in being able to attract HNW and professional investors. Hitwise had an executive team and an international Board that appeared to get on well, and it leveraged their overseas experience and industry contacts better than most early-stage tech companies: Our executive team stuck it out through challenging times. We think we had the right incentives in place to support this. It’s also important to avoid Founder Syndrome—it’s better to appoint good people to run the business which allows you to work on the business rather than in the business. And listen to them—good execution is key. If experienced key executives can be attracted to the business to complement the founders’ skills, there’s a much greater likelihood of success.

Hitwise management and investors also considered its subscription model to be an important factor. Hitwise was able to achieve very high customer retention rates in excess of 95 per cent and to increase revenue per customer from around $1000 to $40  000 per annum. Being a web-based service, its gross margins were high right from the beginning, allowing it to ride through bumps in the market without having to return to the market too often for additional funding. The sequence it adopted for market entry was also considered important: ‘To be honest, New Zealand was a pilot, to see how we went without

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doing ourselves too much damage. Not going straight to the US market was also key. By the time we got there we had a track record, which made it a lot easier.’ (Hitwise by then was up to version 6 of the product and had 500 customers.) Finding a venture capitalist with good knowledge of the US market also seems to have been a factor at that time. And Hitwise appears to have been honest with itself and its investors. Board papers and KPIs appear to have been very visible and forecasts realistic. It resisted the temptation to get too excited and ‘believe its own PR’—a common failing of early-stage ventures after a big contract, a partnership announcement with a big market player or a successful fundraising.

23

ResMed

ResMed is one of Australia’s leading technology commercialisation ­success stories. Founded in 1989, it is now a global leader in medical products for the treatment and management of respiratory disorders, and is best known for its pioneering work in sleep-disordered breathing. It operates in over 80 countries. In 1980, Dr Colin Sullivan, a specialist in sleep-disordered breathing at Sydney University, was approached by a Sydney worker with a serious problem. The worker’s sleep disorder was causing him to fall asleep regularly on the job, which was something of a problem because he worked on high-rise scaffolding. Sullivan found that he suffered from a condition called Obstructive Sleep Apnoea (OSA), a condition where the soft tissues at the back of the throat collapse during sleep, blocking the airway. OSA sufferers, who represent about 20 per cent of the population, are usually not aware that their sleep may be interrupted as many as several hundred times each night. OSA has been associated with noisy snoring, daytime sleepiness, intellectual and personality change (including depression), hypertension, stroke and heart failure. OSA sufferers also have five times more likelihood of being involved in a car accident than the general population. Sullivan took the opportunity with the worker to test a device he had developed called a Continuous Positive Air Pressure (CPAP) device. It

266  australian success stories

comprised a nasal tube attached to an airblower that gently pushed air down the airway. The worker had his first good night’s sleep in many years and the results of this treatment and four others were published in The Lancet a year later. Sullivan filed a patent application, and by 1985 was treating more than 100 patients with the device. Attempts to raise capital in Australia to commercialise the device were initially unsuccessful, and the first serious sign of interest came from Respironics, a US-based respiratory devices manufacturer. Respironics had been tracking Sullivan’s publishings and had started building their own CPAP device. Sullivan terminated the discussions, saying that he preferred to see the technology commercialised in Australia. In 1986, Sullivan was approached by Dr Peter Farrell, then Asia-Pacific Vice President of Research for Baxter International and director of a new centre at Sydney University, the Baxter Centre for Medical Research. ­Sullivan showed Farrell a video of a lookalike Sumo wrestler sleeping. Monitors showed the man’s heart rate and blood pressure varying wildly and almost stopping at frequent intervals. In Farrell’s words: They then put what looked like a toilet seat on the guy’s face and turned the device on. You could see from the monitors what a huge difference it made to stabilising his sleep patterns and clearly he woke feeling hugely refreshed. I decided that if more than 100 people were prepared to wear such a Rube Goldberg apparatus for long-term treatment there had to be something in this.

Sullivan expressed a desire to have the device further developed in Australia. Ideally, he wanted an Australian company to be involved, but the next best thing was to have the system developed and further pioneered in Australia. Baxter gave him that commitment and, after further discussions, Farrell and his colleagues within the Baxter Centre for Medical Research became convinced that the opportunity was commercially viable. Farrell recommended to Baxter that it purchase Sullivan’s patents and invest in developing the technology in Australia. After some negotiation with Sydney University, Baxter purchased the patent and agreed to pay five years’ royalties. Between 1987 and 1989 they invested $1 million in the research, with a focus on improving effectiveness, patient comfort and aesthetics, and reducing noise levels. At the time, the commercial potential of the business was hard to assess, as there were no reliable estimates of the incidence of OSA in the population.

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In 1989, Baxter sold its respiratory care business and Farrell saw an opportunity for a management buyout. He and five others, including ­Sullivan, put in some personal cash. A series of pitches was made to venture capital firms and HNW individuals. Eventually David Greatorex (former chairman of the State Bank of New South Wales and board member of various companies, universities and charitable bodies) committed $50 000 to the venture. David also introduced the team to John Plummer, a former athletic champion (who had the distinction of running second in the Australian mile championships at the time when John Landy and Herb Elliott were dominating the event globally). Plummer was also a successful entrepreneur, whose success stories have included Centacom and Chandler & McLeod, a recruitment company taken from $3.5 million turnover in 1993 to $600 million in 2005. When Farrell met Plummer, the first part of the conversation focused on a sports training book Peter had co-authored with Gary Pace, one of the other founders. The discussion then moved on to the sleep apnoea devices opportunity. By the end of the meeting, Plummer had committed $500 000 in equity and a $500 000 loan. Plummer secured a discount on the original share premium but still paid above the price to the owners and their advisors; the share prices at that time were $1.75, $0.50 and $0.75 respectively. The founders had raised $1.2 million and ResCare Holdings Ltd could now be registered. The patents and assets were then acquired from Baxter for $558 000. Nine former Baxter staff were recruited into the new company, which commenced operations in Sydney in August 1989. From day one, there was a strong emphasis on maintaining a high level of commercially focused research, averaging over 10 per cent of revenue, and on meeting commercial milestones. Many of the early recruits were former graduate students of Farrell’s. Michael Berthon-Jones was a former student of Sullivan’s. The company started with an advanced prototype that needed a lot of development, unknown market size, limited working capital and negligible manufacturing facilities. Marketing and sales activity mainly comprised a renal nurse contacting respiratory physicians while on her rounds in Sydney and New Zealand. Manuals were printed on A4 paper and stapled together. It was clear that the major markets would be in the United States and Europe, but these had strict regulatory frameworks and standards in place. One of the founders, Chris Lynch, travelled the world to gather this

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information and identify potential distributors. During the first year of operation, a grant of $150 000 was received from the Industrial Research and Development Board. Sales of $1 million were achieved (along with an operating loss of $230 000). The following year the company received a Business Development Grant of $110 000 from Austrade to support its export marketing activities. This government funding made a big impact as this early stage of the company’s development. Further developments in mask design resulted in the registering of another patent in Sydney University’s name, with ResCare securing an exclusive licence. The company then received a National Procurement Development Grant of $489 000 on a dollar-for-dollar basis. Growth enabled ResCare to retire $500 000 in HNW loans at the same time as it achieved sales of $2.1 million and reduced its operating loss to $146 600. It was time to seriously consider the US market, not only because of its size but also because of favourable market factors like the establishment of a Congressional Sleep Disorders Commission, which elevated the visibility of sleep-related conditions and their consequences. The US market for OSA-related conditions in fact grew from $US100 million in 1993 to over US$400 million in 2002. The home-based health-care market also grew from US$2.4 billion in 1980 to US$28.8 billion in 1995. Farrell recognised, however, that ResCare would need additional ­capital to establish itself as a lead player in this market, and as a first step negotiated a five-year exclusive distribution with Medtronic, a major US medical devices distributor. The deal included US$1 million to fund research into the next CPAP device and transfer of 16.7 per cent of ResCare’s equity. Medtronic was also given a three-year option, expiring in 2003, to acquire all of ResCare’s assets for US$30 million. ResCare then set about building its market visibility. A range of articles was published on sleep disorder consequences and treatment, and Farrell became a regular speaker at conferences on the subject. A medical advisory board was also established, comprising known international experts, to advise on treatment and product trends. During the next financial year, ResCare received an International Business Achievement Award from Austrade and achieved its first profit of $552 000 on sales of $4.4 million, of which 50 per cent comprised exports. Despite this, the company decided that the Medtronic channel, which focused on sales to the end user, was not giving it the market penetration

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that it wanted. Medtronic’s stake and exclusive rights were repurchased for US$2 million and ResCare established its own sales operations in San Diego, recruiting four ex-Medtronic staff in the process. Medtronic became a passive shareholder, through the exercise of 200 000 options for $8. The channel strategy could now focus on home health-care device resellers. In 1992, ResCare’s previous investment in patents became significant. Its main competitor, Respironics, started to sell in the Australian market through a distributor, Anaesthetic Supplies. ResCare was convinced the company was breaching the original Sullivan patents and took it to court, winning a favourable finding. Respironics, however, lodged an appeal. The next financial year saw revenue more than double again to $11.8 million. ResCare was also a finalist in the Australian Exporter of the Year Award and received a $1.1 million Austrade loan at favourable rates for US market development. Significant investment in product refinement and development continued, including the introduction of automatic airflow adjustment. ResCare began to expand its focus to the European and Asian markets, initially via distributors but subsequently through its own sales offices. The market was competitive, the key players being MAP, a significant competitor based in Germany, and Respironics. ResCare and Respironics engaged in product leapfrog as new features were introduced like variable pressure and improved face masks. The first reliable study of OSA incidence by the University of Wisconsin then found that it was higher than expected, at 4 per cent of females and 9 per cent of males. This finding put OSA on a similar playing field to smoking as a source of health-care costs. By June 1994, sales had increased a further 80 per cent to US$13.8 million. Additional funds were secured through sale of 100 000 shares to Nomura/Jafco and the company registered in Delaware as a joint US/ Australian company. A further product enhancement came with the development of automatic starting and stopping of airflow when a mask was worn or removed. Three more patents (covering delay timing, mask design and autofeedback) were due to issue, and negotiations commenced with several companies to exploit these. Respironics was one of these, proposing a merger. For the next nine months, a Respironics team conducted detailed due diligence into ResCare under a secrecy agreement. In late 1993 ResCare received a shock when the Australia Federal Court upheld Respironics’ appeal against the

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original CPAP patent infringement finding. The patent was revoked and ResCare lost its legal protection in Australia against a competitor introducing nasal PAP treatment. A few hours before the time for signature of the proposed merger, Respironics withdrew its offer. ResCare then felt obliged to initiate action to protect its three surviving patents, and legal action between the two companies was to take up resources for several more years. By 1995, ResCare was the number two player in the US market behind Respironics. New products were coming on stream with the capacity to diagnose and treat disordered breathing. Projected revenues of US$23.5 million included 92 per cent growth in the United States and 62 per cent growth in Europe. However, there was expensive litigation in the pipeline and the increased visibility and projected size of the market was attracting new competitors. It was resolved that the company needed to scale up quickly to protect its market position. To do this it would need more capital—this time via a public listing. After finding that Australian valuations were about two-thirds those achievable in the United States, ResCare moved its headquarters to the US and changed its name to ResMed (its Australian name had been used in that market). It listed on NASDAQ, raising US$25 million on a P/E ratio of nearly 17 with the company then valued at $85 million. Farrell then moved to San Diego to drive US operations, while Dr Chris Roberts, one of his previous students, took responsibility for the rest of the world. In 1999, the ‘Autoset’ was brought to market, three years behind the competition but with some superior features. ResMed spent time evaluating other opportunities, including the stroke and congestive heart failure markets, where a correlation had been found with sleep disorders. However, it found significant differences in medical procedures and that practitioners in these areas needed widespread and very expensive clinical trials to be conducted before they would consider the ResMed approach. In 2001, MAP, ResMed’s main competitor in Germany, was considering an IPO. Farrell made direct contact with the owners and a deal was concluded for a private acquisition at US$69 million. In 2003, ResMed and Respironics also agreed to cease further litigation. ResMed sales grew from US$3.4 million in 1992 to US$716.3 million in 2007. In the first five years, this represented an annual compound growth rate of 92 per cent. Market capitalisation at the end of 2007 exceeded US$3 billion. Now operating in more than 80 countries, ResMed’s reach

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continues to expand. It has diversified its base away from the US, with Europe and the Asia–Pacific region now constituting nearly half of its global revenue. The ResMed product range now includes airflow generators, diagnostic products, mask systems, headgear and accessories like humidifiers, carry bags, and breathing circuits. ResMed also manufactures related data communications and control products, such as the ResLink, ResControl and ResControl II that facilitate transfer of data to and from the flow generators. It still manufactures in Australia, with 97 per cent of its output exported (53 per cent to the Americas, 41 per cent Europe and 6 per cent to the Asia–Pacific). ResMed has received an impressive number of awards. They include being identified as one of the Forbes Best Small Companies in the US for ten years in a row (a record), the Engineering Excellence Award, Australian Exporter of the Year (twice), Australian Design Award, Business Week’s 100 Hot Growth Companies, Investor’s Business Daily’s top 100 and Australian Technology Award. ResMed chairman and CEO Dr Peter Farrell has been the Ernst & Young Australian Entrepreneur of the Year® 2005 and US Entrepreneur of the Year for Health Sciences, Member of the Order of Australia, Australian Export Hero and National Engineer of the Year, and has received the Clunies Ross Award from the Australian Academy of Technological Sciences and Engineering.

ResMed’s relationship with investors According to the principals, this was always transparent and brutally frank. Reporting was quarterly to all shareholders and forecasts carefully developed and conservative: ‘Results were within 5 per cent of forecast every quarter for five years. This while we were growing at 90 per cent compound.’ The original ‘angel’ investors did not play an active role on the board, which gave the management team freedom but also meant that they had to access other resources via advisory groups to gain market and technology understanding and personal contacts: ‘Don’t hoodwink your shareholders. To paraphrase George Bernard Shaw, “I freak people out—I tell them the truth”.’

Things ResMed might have done differently In looking back, one mistake we made was to put too much emphasis on the expectation that sleep lab physicians would be so impressed

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with our Autoset diagnostic system that they would beat a path to our door to buy Autoset CPAP devices, which were more expensive, but gave the treatment a patient needed, when they needed it and at much lower overall pressures. We convinced ourselves, if not others, that the autosetting algorithms were the only real way to go. Sadly, this is only now beginning to happen—years after we expected. And there were two major reasons: first, physicians were not convinced that the extra money patients were asked to pay was worth it (we still don’t have government reimbursement in Australia for devices, while all other developed countries do), since they reasoned that good enough was good enough; and second, physicians made money from setting the fixed-pressure devices in their labs, while the Autoset was fully automatic. In short, they lost money if they recommended the Autoset, and this was probably the biggest influence on market penetration of autosetting devices.

Why did ResMed succeed? The sleep apnoea device was solving a significant (in some cases lifethreatening) problem for a significant number of people: ‘In my opinion, the only possible rival for a single product that would produce such an upturn in life expectation and quality of life for humanity was the introduction of penicillin.’ (Dr William Dement, Stanford University) The business was scaleable: ‘It was a big market and was definitely going to happen in our lifetime. It still stacked up, even after we applied the 4–2 rule—that is, that all research projects take either four times as long to produce the result and twice the money or the other way round.’ (Peter Farrell) Competition was weak in the early stages and the market timing was clearly good. ResMed was an early player in a large, growing market, with its growth fuelled by increased awareness of the issue, legislative change and supportive parallel market change, like the growth of home-based diagnosis: [home-based diagnosis was] … greatly resisted by the sleep establishment, since most sleep physicians felt it would dent their income by reducing the role of their labs. We feel that this is nonsense since there are 90 different sleep disorders and the use of home-based sleep testing will uncover loads more of these other 89 disorders which were never really being found. In short, the analogy is that the market will

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move from fishing in an island pool to the ocean, and so many more of the other sleep disorders will be uncovered and far more interesting sleep medicine will be the consequence.

The company was realistic with its forecasts and apparently parsimonious with its capital: ‘We weren’t too greedy with our early valuations and we made sure we had enough money for the end game.’ It was technically and managerially strong, with a high degree of team familiarity/unity. One factor contributing to this was the prevalence of prior students and colleagues in the executive team. ‘We made sure we really understood the technology and what the IP actually was—the know-how and the business model as well as the patents. We had to ask ourselves honestly and repeatedly—is this an area we can be good at?’ There was a strong focus on building visibility and leveraging other people’s knowledge and contacts: ‘We made sure we always had access to world class people, either in our team or on our advisory board. They needed to be people who would tell you if you were heading in the right direction. We regularly workshopped with such people.’ ResMed also appears to have kept its focus on what it is good at, even after evaluating a number of opportunities to diversify its product set. The temptation for many early-stage technology companies is to be sales driven and go for any business that is available: ‘We went for the lowhanging fruit—the US market and people who would actually buy. You have to discover the 4–10 per cent of early adopters who are really interested in moving forward, as early as you can.’ Clearly there was a strong culture of urgency and effective execution: ‘Execution is 1–2–3. B grade technology with A grade people will work, but A grade technology with B grade people won’t.’ And a bit of resilience doesn’t hurt: ‘You have to be able to say “I’m really glad I got into this game” every morning, despite all of the setbacks that will happen.’ And the nature of the product was unusual for a medical device, creating a base of repeatable revenue for masks and other disposables: ‘The fact that it was a treatment, not a cure, created an annuity, provided patients remained compliant, which is a continuing challenge where we need to make the treatment more and more user-friendly.’

24

LookSmart

LookSmart is an online search, advertising and content management company founded in Melbourne by husband and wife Evan Thornley and Tracey Ellery in 1995. Its products and brands have included at various times the ‘Wisenut’ search engine, ‘Furl’ social bookmarking website, ‘Find Articles’ premium content search service and ‘Net Nanny’ content management software. The company was originally called Homebase and was backed and majority owned by Reader’s Digest (RD), which invested $5 million for an 80 per cent share. The original business concept was to build a femaleand family-friendly portal to supplement the Reader’s Digest magazine business. After leadership and strategy changes at Reader’s Digest, which reduced its focus on online business, RD wanted to close Homebase down. This would have cost about $4 million in payouts and other termination costs. The founders, together with a friend and former McKinseys’ colleague Martin Hosking, presented the less costly alternative of a leveraged buyout. This would involve RD loaning $1.5 million to the business and taking a reduced equity position (about 10 per cent). A further $500 000 in short-term debt finance was secured from Macquarie Bank, some angel investors and Sandhill Capital. The business model was then changed for the first time. It was decided to move from developing a retail online brand to becoming a ‘white label’

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provider of search services to other companies. The initial focus was ISPs that wanted to compete with America Online (a customer base which grew to over 70 ISPs). Directory services were also offered under licence to companies that didn’t have them and had a pressing need to maintain a strong online presence (AltaVista, Excite and Microsoft all took this up). The strategy to exploit this opportunity included choosing the right partnerships, ‘doing deals well’, adapting to the different requirements of customers and basing operations in the United States, close to major cust­ omers and sources of mezzanine finance. Cash flow was a constant challenge: ‘We went through the Valley of Death many times, in fact were two days from not being able to do payrolls on nine occasions.’ (Thornley) In May 1998, the company raised a further $8.3 million in concurrent A and B rounds, with the ‘A’ round comprising $2.3 million from AMWIN (CHAMP) and the ‘B’ round $6.0 million from Cox Media and Macquarie Bank. The post-money valuation was $23.3 million. Bill Ferris, together with Paul Riley, one of the CHAMP principals involved, described the experience: Evan sat in our office and said … he had a burn rate of $500 000 a month, and I asked him how much cash he had and he said oh we’re fine, we’ve got $400 000! So we knew we had a few weeks only to do a deal, and we did do I think a sensible analysis of what was needed. His proposition … was we’re going to be a category-driven engine, not a word-driven one. Remember at the time most of the emphasis from Yahoo! and Lycos and others was that you’d key in a word and you’d get a mountain of stuff that you didn’t really want to get. Evan was leading this category-driven search process and he would develop intellectual property on the way through by customising the databases. He would hire hundreds, literally hundreds—which he did—of students in Melbourne and San Francisco to edit other people’s websites, to edit databases in museums and other such receptacles around the world, and build this proprietary database which he would over time license to Microsoft and others. So we thought well okay, if this works, we get everything right and the wind is behind us, we could make ten times our money in this venture. And so we initially put up $2.2 million to get the business plan to a second level, and what happened was the $2.2 million turned into $245 million cash, which was 111 times the original investment in less than two years. On the way there and pre-IPO, we did a second round and we put up another $3.2 million from our second fund, which also did well, turning in $29 million.

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With this funding secured, LookSmart was able to focus on expanding its presence in the US market. A number of key hires took place, including a COO, CFO, SVP Marketing and CTO. A keynote licensing deal was signed with Microsoft to provide directory and listing services, with an upfront payment of $30 million and a commitment of $5 million per annum over five years. Microsoft was willing to do this because of the urgency for them of catching up with Yahoo! and because LookSmart’s directory was superior to the one to which Yahoo! had access. AltaVista, Hot Bot, Netscape, Inktomi and British Telecom were also signed. The employee base grew to 500 by 1999.  A Series C round in April 1999 brought in a further $59.6 million from a combination of Australian investors (including Macquarie, CHAMP and the Packer family) and US mezzanine finance firms on a post-money valuation of $430 million. It was at the time the third largest private round of finance in internet media history (Star Media raised US$80 million and Yahoo! US$63 million prior to going public). The additional funding was used to complete acquisitions, expand in non-US markets (Australia, the United Kingdom and Canada), start consumer branding campaigns and work on new product initiatives. It also allowed LookSmart to begin executing a second change in its business model. This was to move away from supporting the traditional ‘banner ad’ format which was not attractive to users or effective from a marketing perspective, to providing search listings. The payment model was also changed so that customers only paid when people visited their website (per click), akin to the principle with telemarketing companies of paying per lead generated. In 1999, the company began to position for a listing. Pre IPO, there was considerable communication to staff on the company’s plans and how to respond to questions from outsiders about the company’s intentions and its likely value. A ‘bake off’ was conducted of bankers to manage the process, resulting in Goldman Sachs being selected as the lead. Filings were made and a roadshow followed, covering seventeen cities to get the message out to the market. There was a story to tell—LookSmart was by then the number twelve website on the planet with 10 million users, one place behind AltaVista and three ahead of Snap). Quarterly revenue had grown from $804 000 in the first quarter of 2008 to a more than respectable US$13.3 million in the third quarter of 1999. Profitability was forecast by mid-2001. LookSmart eventually listed on the NASDAQ in August 1999 and raised a further $92.4 million at a valuation of $1.0 billion. The stock,

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which debuted at US$12 per share, reached a high in excess of US$70 in early 2000. The return to shareholders, on a March 2000 valuation at $30 per share, was impressive. It is shown in Table 22.1. Table 22.1 LookSmart’s share return as valued at March 2000 Timing

Round

Amount $A000

Value March 2000

Gain X

1996–97

RDA

6 500

270 000

41.5

May 1998

Series A

2 283

190 578

83.5

May 1998

Cox

6 005

429 832

71.6

Apr 1999

Series C

60 418

362 506

6.0

Aug 1999

IPO

92 400

231 600

2.5

Source: Data courtesy of Martin Hosking.

In the first quarter of 2000, the search listings offering and new pricing strategy were launched. The share of LookSmart’s revenue that this represented grew rapidly (reaching over 50 per cent of revenues by late 2001). But dark clouds were gathering and the ‘tech wreck’ broke in 2000. Over 40 per cent of LookSmart’s customers went out of business in the fourth quarter of that year, including several major advertising customers. LookSmart was forced to reduce expenditure and lay off a large number of staff in early 2001 to survive. Thornley and Ellery, who had sold stock after the IPO, suspended their stock sale program once the stock price went below the IPO price of US$12. They did not resume selling the stock until 2004. After the cost reductions in early 2001, the company worked hard to broaden its revenue base. LookSmart’s listings and licensing business, dominated by the contract with Microsoft, quickly became its major source of revenue, and in 2002 the company became profitable. In July 2002, Thornley announced his intention to return to Australia and resigned as chief executive, moving into the role of chairman. Jason Kellerman, the previous Australian head and COO, took on the CEO role. Three venture capitalist directors resigned and were replaced by Teresa Dial, former CEO of Wells Fargo, Mark Sanders of Pinnacle Systems and Gary Wetsel of Aspect Communications.

278  australian success stories

In 2002, the new ‘submit a site’ model (where businesses paid to have their site listed in the LookSmart directory and again per click) attracted a class action lawsuit from businesses whose websites had been listed under the previous system. A number of internet companies, including Look­ Smart, were also involved in an inquiry by the US Attorney-General into internet gambling and agreed to cease accepting text advertisements from internet gambling companies. Then the big news came. In late 2003, Microsoft announced that it would not renew its contract, which at the time accounted for over 70 per cent of LookSmart revenue. Large-scale redundancies occurred, including the closure of all non-US operations. At the time, Macquarie Equities analyst Alex Milton said: ‘LookSmart’s ability to get new business while needing to cut an estimated US$60–70 million from marketing, administration and product development was unclear. The worst-case scenario … has occurred.’ The decision came as quite a shock. Relations with Microsoft had been perceived to have been amicable, and no reason had been given for its decision. However, it became clear that Microsoft/MSN had been under pressure to catch up with Google and Yahoo!, and had been experimenting in Britain with its own search algorithms. Kellerman resigned and was replaced by Damian Smith, CEO of LookSmart Australia. Thornley subsequently stood down as chairman in May 2004 and a new United States-based CEO, David Hills, was appointed in October 2004. LookSmart acquired the Furl social bookmarking site, closed the ­volunteer-built directory Zeal and sold the ‘Grub’ search crawler to Wikia. It now appears to have achieved a turnaround, with revenues for the first quarter of 2008 reported at US$17.5 million, up from US$11.9 million in the same quarter of 2007. The company’s net loss was reduced to $0.5 million and total paid clicks per quarter have increased from 94 million to approximately 152 million.

LookSmart’s relationship with investors Through each stage of the capital-raising process, LookSmart appears to have maintained good relations with its professional investors and with Cox Media. Relations with Reader’s Digest and Microsoft varied from very positive to more strained as the strategic direction of those companies parted with that of LookSmart.

looksmart  279 

Things LookSmart might have done differently Strategic relationships can be a double-edged sword. As a small company, we had limited capacity to evaluate the long-term implications of the relationships with strategic investors and partners. As noted, Reader’s Digest and Microsoft both at times took decisions which significantly impacted LookSmart. ‘Small companies in this situation need to filter the deals they get involved in. The headline value always looks good, but you have to be honest about your motives and get beyond the press release. The right question is, can you work with them in the long run? (Hosking) With the benefit of hindsight, we would have gone to the US venture capitalists much earlier in the process. But then they may not have been interested at that stage of our development. Now I’d pick up the phone to Sequioa or one of the major players at an early stage. (Thornley)

Why LookSmart succeeded Understanding strong trends in the market (emergence of the World Wide Web and the importance of advertising through this channel) and development of a differentiated service offering were clearly key. So too was good capital market timing. There was general excitement about the internet and the scaleability of businesses taking advantage of it: ‘A NASDAQ IPO or trade sale on US markets proved to be the value maximising exit for investors in this sector. The market was liquid and the process was rapid.’ As Bill Ferris subsequently said: Analysis just went nowhere and people were hopping into this stream of belief about backing these things. We took it to the IPO market in America on NASDAQ and it listed at A$2.5 billion capitalisation. It was the highest technology float then and since, or ever in the history of Australia I think, and we exited the day after escrow expired and I think it was 21 days after that when the market collapsed … therein lies the story about timing dwarfing analysis.

A US base close to major corporations spending big on advertising, the major search engines, LookSmart’s other strategic partners and the mature US market for exiting ICT ventures was also a contributing factor. Staying close to strategic partners was also a success factor in the early days: ‘Work it actively, don’t stop with the press release.’ Cox Media and

280  australian success stories

Microsoft both made a big difference to LookSmart’s business. However, too many eggs in a small number of investor/customer baskets eventually proved to be a big risk for the business.

25

Lessons and common threads

There is a lot that can be learned from reading some of the more detailed case studies and publications on these and other successful NTGFs. Some of the common threads from these three and others to which the authors have had exposure are set out below. • Successful companies are led by smart entrepreneurs. The more one deals with successful entrepreneurs, the more one is struck by a combination of factors. They are smart, have a good eye for detail (in particular the numbers and ratios that drive business success), and are commercially focused. They also learn very quickly to speak the language of investors. They use agents to teach them about finance and do not use agents to be their substitutes. • Global focus but sequential entry. All three started with a global business in mind, but got there by focusing first on the major markets that could give them impetus. Hitwise conceded that it was too thinly spread in the early stages and burned time and resources attempting to enter the Japanese market too early in its development. The Hitwise experience suggests that the US market doesn’t always need to be the first focus, which flies in the face of conventional wisdom at some funds. • Strong need and scaleable business. Each was addressing an emerging need not satisfied by existing solutions. The more serious the need, the better— the case of sleep apnoea-related death being a good spur! • Their market entry timing was very good. They were early entrants at an

282  australian success stories early stage of their market category’s development. As Bill Ferris said about LookSmart, ‘timing dwarfs analysis’. • Their teams were close-knit and held together for long periods. In the case of ResMed, prior students of the founders played a key role. In the cases of both LookSmart and Hitwise, strong team dynamics were also established early. As Steve Killelea (founder of Software Products and Integrated Research and a significant angel investor and philanthropist) puts it: ‘The CEO needs to make sure that the future employee can see the vision. The good ones join because of the vision, the CEO’s drive and the opportunity to work with exciting new products. Free-riders join when success is already apparent. You also have to work with people you can trust. That means having a common view of the universe, like whether you have a cooperative or “take no prisoners” culture in the business.’ • There was a competitive culture and sense of urgency. As David Greatorex, ex-chairman of the State Bank of New South Wales and investor in over 20 start-ups, puts it, ‘we always assume that there’s someone on the other side of the hill who’s two years ahead of us’. • They had (apparently) good communication with their boards. This involved regular reporting, ‘bad news early’, weekly contact with individual board members, newsletters and updates, leveraging members’ industry contacts, involving members and advisory board members in strategy workshops. • Forecast results were delivered. Conservative forecasting, a focus on execution and tight monitoring of KPIs were features. Being within 5–10 per cent of forecast for sustained periods builds trust among stakeholders. As Rick McElhinny of the Founders Forum puts it, ‘many early stage companies kill their credibility and miss their numbers, because they really don’t understand their sales cycles’. This is particularly common among ‘B2B’ businesses like the enterprise software industry, where sales cycles may be nine to fifteen months but are frequently assumed to be half that in business plans and presentations to investors. • They used different funding sources at different stages in their business. Government agencies and ‘angels’ played an important role in the very early stages, while venture capitalists, customers (e.g. Microsoft for LookSmart) and channel partners (e.g. Medtronic for ResMed) played important roles in entry into overseas markets. Mezzanine funds and strategic partners played a role in further scaling the businesses, while the trade sale option was exercised for Hitwise into Experian and the IPO option for LookSmart and ResMed. In the ResMed case, the founders are still very active in running the business. Killelea also advises entrepreneurs to ‘bootstrap as much as you can and have a strategy for achieving self sufficiency as soon as possible, so you can manage your own destiny. Your investors’ expectations and timeframes may not match yours.’

lessons and common threads  283  Peter Kazacos (founder of IT services firm Kaz Software and at one stage Chairman of the Australian Information Industry Association) was also a creative ‘bootstrapper’. Favourable credit terms from IBM, his first corporate customer, provided a key source of finance in the early days of that business. Later, during a Sydney property downturn, Kazacos was able to get his landlord to fund a new $1 million data centre in exchange for future business. He also advises companies to use debt finance as much as possible, rather than equity, if the business can support it. • There was high market visibility at an early stage. Both Farrell and Kazacos placed significant emphasis on making their companies visible, particularly in lead-ups to funding events. In the case of ResMed, it was done through conferences and papers, while at Kaz Software the management employed a public relations company, Taurus Marketing, to achieve regular press and radio stories.

Glossary

Add-ons  Marketing term used to describe the extra charges and fees added to the basic price of a product. Affirmative covenants  Terms contained in a shareholders’ agreement where the company or management agree to carry out certain actions. Examples would be to prepare annual budgets and supply monthly accounts. Aftermarket support  Term used to describe the activities of a broker or underwriter after a listing to ensure the share price remains steady or rises. This can vary from acting as a principal buying shares to demanding immediate payment of the underwriting fees. Agency capture  What happens when politicians full of good intent create a bureaucratic agency to protect consumers instead of using the threat of competition. The major suppliers then capture the agency and change it into a lobbying agent for themselves among the politicians. Angel  A private individual who subscribes early-stage capital. Annuity  Stream of fixed payments over a specified period of time. Aquaculture  Growing crops in water rather than on land. Agriculture has been in existence for about 10 000 years and aquaculture for around 100 years, which provides a reasonable insight into the risks involved. Asset intensity  The value of assets required by a business to support $1.00

glossary  285 

in sales. The figure is the reciprocal of asset turn and varies from, say, $2.00 for a capital-intensive manufacturer to $0.15 for a retailer. Asset redeployment  Term used by new owners of a company to explain how they intend to improve the return on assets. For example, actions might include selling businesses which are not an intrinsic part of the business, rationalising product lines, and so on. Asset turn  The ratio obtained when the annual sales are divided by the assets of the company. The ratio can vary from 1 for a miner to, say, 8 for a retailer. Blue chips  In Australia, the top 100 companies ranked by market capitalisation, which would be able to borrow unsecured from banks and whose shares would be an automatic choice in most institutional portfolios. Bootstrapping  Funding working capital needed to support growth from the company’s retained earnings. Many successful entrepreneurs have been creative in minimising their external capital requirement through ‘bootstrapping’ techniques. Refer to Chapter 25. Break-even analysis  Financial tool which is used to establish whether the gross profit of a business will exceed the fixed costs. Buy-in price  Price at which an investor purchases new shares for transactions where the cash remains with the company. Buyout price  Price at which an investor purchases old shares for transactions where the cash goes with the seller. Call option  A contract whereby the holder of an option has the right to buy from the grantor shares at a specific price (strike price) at some time in the future. Carried interest  The share of venture capital fund’s investment profits that goes to the venture capital fund manager—typically 20 per cent after the investors have recovered all their invested capital. Capital employed  The sum of equity and long-term debt used by a company to purchase long-term assets and for working capital. Capital gain  The amount realised on exit less the amount invested. Capital intensity  The amount of capital needed by a business to support $1.00 of sales. The reciprocal of capital turn. Capital turn  The ratio obtained by dividing the annual sales of a company by the capital employed. Captive funds  Venture capital funds that are usually part of a bank, using a bank’s retained earnings to invest in equity of private companies.

286 Enterprise and venture capital

Capital structure  The composition of a company’s source of funds, especially long-term funds. Closed-ended funds  Funds with a limited lifespan—for example, ten years to be invested and realised. Cold call presentation  Selling term used to describe the first meeting between a buyer and seller where the initial contact has been at most a telephone call arranging a meeting. Contributing shares  Shares on which only part of the capital amount and any premium has been paid. Often useful in tranching structures. Contribution rate  Accounting term expressed as a percentage calculated by subtracting the variable costs from sales. The contribution rate then describes what percentage of each sales dollar is available to cover fixed costs. Convertible notes  Hybrid fixed interest security whereby the holder has the option of converting the debt to equity at some prearranged date and conversion price. Convertible preference shares  Preference shares that may be converted to ordinary shares at the option of the holder. Corporate fund  A venture capital fund wholly owned by a corporation and typically managed by in-house staff. Cost of goods sold  Accounting term defined by the equation opening stock plus purchases plus expenses related to purchases less closing stock. Deal flow  Venture capital term used to describe the number of proposals being received by a venture capital fund on some calendar basis, such as three deals a week. Debt  Capital supplied for which there is a fixed income, fixed repayment period and fixed repayment schedule. Development capital  Capital required by an established company to fund the expansion of the business. Dilution of equity  Stock market term used to describe the situation whereby the issue of new shares results in the original shareholders owning a smaller share of the company. Dividend yield  Stock market term that expresses as a percentage return the annual dividend per share divided by the latest market price. Due diligence  The process of researching a business and its management prior to proceeding with a venture capital deal, or not. Entitlement issue  See Non-renounceable rights issue.

glossary  287 

Earnouts  Venture capital term used to describe the technique whereby the management or owners increase their ownership or sell-out price according to the profits they produce over some period. Early-stage capital  Finance for companies to initiate commercial manufacturing and sales. Economies of scale  Economic term used to describe the cost benefits that accrue from increasing size such as volume discounts on purchases or spreading fixed costs over an increasingly larger production base. Equity  The proportion of a company that shareholders own. Sometimes described as shareholders’ funds. Owners typically receive income in the form of dividends, have no security with regard to repayment of their investment, and there is no defined time period for holding their investment. Equity hybrid  A security that combines the characteristics of debt and equity such as a convertible note. Equity kicker  Shares or call options offered to lenders, underwriters, promoters or management as additional consideration for services rendered. Equity sweetener  Effectively the same as equity kicker, but generally used when referring to free options granted to subscribers to a new issue of shares. Escrow provisions  Legal term used to describe undertaking given by present shareholders not to sell shares unless certain conditions are met. Exit mechanism  Venture capital term used to describe the method by which a venture capitalist will eventually sell out of an investment. Expansion capital  See Development capital. Financing gap  Venture capital term used in leveraged buyouts to describe difference between the purchase price of a company and the debt raised on the assets and cash flow of the company. Fire sale  Finance term used to describe the situation when a company is forced to sell off assets cheaply because of a lack of cash. Fixed costs  Those costs such as rent that do not vary according to changes in sales levels. Flip  A short-term investment made by a venture capital fund manager with the intention to list and exit within eighteen months. Floor  Stock market term used to describe the situation where a buyer has a permanent order in to buy shares at a certain price.

288 Enterprise and venture capital

Franked dividend  Dividend paid out of after-tax profits on which tax at the full corporate rate (presently 39 per cent) has been paid. Recipients of franked dividends are not subject to further taxation on the dividend. Gearing  The ratio of debt to equity as stated in a company’s balance sheet. Golden share  A share whose vote must be included in any motion passed by the shareholders. Gross profit  Sales less cost of goods sold. Hands on  A relationship involving close regular contact and significant influence and participation in management decisions. Hands off  A relationship involving less frequent contact and only participation and influence in major strategic decisions. Hurt money  Cash invested or exposure made by an entrepreneur to the business. The greater the proportion of the entrepreneur’s personal wealth represented by hurt money, the more convincing the argument to the investor. Identifiable intangibles  Intangible assets for which it is possible to set a valuation such as future income tax benefit. Illiquid  Term used to describe an investment for which there are few buyers. Implementation plan  Plan defining the steps and activities required to achieve goals. Independent funds  Venture capital funds raised from more than one source and run independently. Information memorandum  Legal document stating the objectives, risks and terms of investment involved with a private placement. Initial public offering  The first fundraising done from the general public, which generally results in a listing on a stock exchange. Intangible assets  Assets owned or generated by a company that are not easily sold except with the company as a whole, and usually are not easily measurable. Intellectual property  Legal term used to describe the patents, licences, copyrights, trademarks and designs owned by a company. Interest cover Pre-interest cash flow divided by interest payments. Internal rate of return  The basis by which returns to the investor are forecast or measured. Effectively, it is the compound rate of return over the life of the investment and combines capital gain with income

glossary  289 

earned either in the form of dividends or interest. It is greatly affected by the timing of the exit. Learning curve  An imaginary curve describing the reduction in cost that occurs as a factory makes more and more of a particular product. Also used to describe the increase in skill of an employee over time. Letter of intent  Document that is not legally binding, but is given by one party to another to show good faith and that describes the main agreed points of a transaction. Leveraged buyout  Purchase of a company where the purchaser uses a larger than normal amount of debt to finance the transaction. Living dead  Term used by venture capitalists to describe investments which, while not decreasing in value, are showing no growth. Management buy-in  Usually a leveraged buyout organised by new managers or management team. Management buyout  Usually a leveraged buyout organised by the existing management of the company. Market capitalisation  Value of a company calculated by multiplying the number of shares on issue by the last sale price. Management fee  The fee paid to a venture capital manager for running a venture capital fund. Typically for the first five years it is 1.5–2.5 per cent annually, and is paid quarterly. Mexican standoff  Term in a shareholders’ agreement which states that a shareholder who offers to buy shares from another is obliged to sell to the other party at the same price. The clause is used to ensure any offer is fair and reasonable. Mezzanine financing  Financing obtained using instruments that fall between the bottom floor of equity and the top floor of secured debt. Monopolistic competition  Industry structure where there are many small suppliers, each of which has a monopoly position in the area it serves. Negative covenants  Terms in a shareholders’ agreement that state the actions the management of a company may not carry out without the permission of the investors or their representatives. Examples include changes in executives’ salary levels and sales of major fixed assets. Negative pledge  Sales less all expenses, which may or may not include corporate tax. Net tangible assets  The difference between tangible assets (e.g. stock, debtors, land, etc.) and liabilities in the balance sheet.

290 Enterprise and venture capital

Net worth  The difference between the assets and liabilities of a company on its balance sheet. Net worth is equal to shareholder funds. Non-price competition  Competition among suppliers using such items as warranty periods, credit terms and after-sales service. Non-renounceable rights issue  Rights issue where the shareholders may either take up rights or let them lapse. The shareholders are not allowed to sell the rights to another party. Also known as an entitlement issue. Oligopolistic structure  Industry structure where a few suppliers dominate the market. Open-ended funds  Funds with no set time span imposed. Ordinary shares  The equity in a company constituting ownership; ordinary shareholders are entitled to dividends and to vote. Owner’s equity  The residual of assets less external liabilities. Paradigm  Accepted philosophical or theoretical framework. Paradigm shift being a change in the view of how things work—for example, Newton’s theory on gravity resulting from his observations on the fall of an apple was a paradigm shift from the commonly held view of Physics and how gravity worked. Partly paid shares  See Contributing shares. Per-capita basis  Per each individual in the population. Per capita income of $20 000 is an average of $20 000 per individual in the identified population. P/E ratio  Price/earnings ratio. The ratio of share price to earning per share. Petty patent  Special patent that allows the inventor to only protect one aspect of an invention for only a short period of time (five years); it is less expensive than a standard patent and obtained within six months. Portfolio diversification  Investment strategy where the portfolio manager spreads investments across many industries, thus trying to diminish the risk of a single industry depression reducing the portfolio return. Positioning strategy  Marketing term used to define a strategy where a company tries to distinguish itself from its competitors by focusing on some market segment. Post-funding valuation  Valuation of company after an equity injection that is obtained by multiplying the total shares on issue by the share purchase price.

glossary  291 

Preference shares  Shares that rank ahead of ordinary shares for dividends or payment upon the winding-up of the company. Preferred return  Distribution of a venture capital fund’s profits made first to institutional investors until they have recovered their initial capital investment and in some cases an indexed addition amount. Pre-funding valuation  The valuation of the company prior to funding, calculated by subtracting the cash that remains within the company from the post-funding valuation. Price taker  Marketing term used to describe a supplier of goods whose price is set independently by the market. Price-to-book value ratio  The ratio of the share price to the net worth per share. Price-to-revenue ratio  The ratio of the share price to the company revenues per share. Pro forma accounts  Balance sheets and profit and loss statements for future years, prepared in the same format as the current accounts. Product differentiation  Marketing term used to describe strategy of defining new or current product features or benefits that distinguish it from the competition. Prospectus  Legal document used to describe securities being offered to prospective investors. It typically provides a description of the business, financial statements, biographies, staff compensation, litigation, material properties, and other relevant information. Put option  A contract whereby the holder of the option has the right to sell to the grantor shares at specific price (strike price) at some time in the future. Ride  Venture capital term used to describe the potential percentage of profits or equity ownership available if a deal works out as planned. Redeemable preference shares  Preference shares which at a stated maturity date will be redeemed by the issuing company. Revalued asset  Asset assigned some value other than the book value (cost price less any depreciation). Revaluations may be either downwards (investments devalued to market price) or upwards (e.g. real estate or directors’ revaluation of licence agreements). Rights issue  An issue of new shares on a proportional basis to existing shareholders, usually at a discount to market price, to raise additional shareholders’ funds. The shareholder may allow the offer to lapse or, if the issue is renounceable, sell or transfer the rights to another party.

292 Enterprise and venture capital

Roadshow presentation  Series of presentations made to institutional and large private investors to sell a new issue. Running yield  The return on an investment expressed as cash earned over cash invested. No account is taken of potential capital gain or redemption. Scaledown  Management fee structure whereby, after the investment period, the management fee declines as the venture capital fund moves to divestment. Scale-up  Management fee structure where, for the first one or two years, the management fee rises as the fund builds investment momentum. Second-line stock  Shares of listed companies that do not rank as bluechip or first-line companies. Secured debt  Loan where the lender, in the event of a failure to meet either an interest or principal payment, gains title to an asset. Secured lending  Making loans only to parties who can provide an asset as security in the event of non-payment of interest or principal. Seed capital  Financing allowing the development of a business concept. Seller’s note  Sometimes known as vendor finance, where the seller of the asset accepts some part of the payment on deferred terms. Sensitivity analysis  Financial analysis where variables such as selling price are adjusted upwards and downwards by some factor (say, 20 per cent) to establish the effect on profits. Shelf company  A company which has been created but never traded. Shortfall  The difference in a fundraising between the expected amount and amount actually raised which in turn must be provided by the underwriters. Stag profits  Profits made by someone who subscribes to a new issue and sells on the first day of trading. Start-up capital  Financing allowing product development and initial marketing. Strike price  The price of the underlying share at which a call or put option is exercisable. Subordinated debt  A loan which ranks behind other debts if a company is wound up. Subordinated loans, if provided by a venture capitalist, would either command a higher interest rate or have call options attached. Substitute product  In the broadest sense, any purchase that would take the dollar that might have been spent on your product. More typically

glossary  293 

interpreted as any product or service providing similar benefits to yours, that would reasonably be considered as an alternative by the customer. Suppliers’ credit  An often-overlooked form of financing provided by creditors when they offer extended payment terms. Takeout mechanism  See Exit mechanism. Taking a bath  Slang term used by an investor who has seen a significant reduction in the value of an investment or an underwriter with a significant shortfall. Technology parks  Industrial estates located next to universities or other research establishments, and designed to attract advanced technology companies. Term sheet  A short two- or three-page document that outlines the investment agreement between an entrepreneur and investors. Tranching  Investment made in stages, each stage being dependent on achievement of targets. Trial close  Selling term used to describe when a salesperson asks for the order, not expecting success but hoping to unearth further objections from the prospect. Turnaround  Company converted from making losses to profits. A turn­ around situation is a company that is still making losses but that an investor believes has sufficient turnover to make potential profits. Under-capitalisation  Situation for a company where insufficient equity has been supplied by the shareholders or retained in the company to support the activities of the business. Unsecured lending  Lending where the borrower has not provided any assets in the event of non-payment of interest or principal. Uprates  Marketing term used to describe upward revisions in pricing schedules. Vapourware  Computer industry term used to describe non-existent products compared with actual hardware and software. Variable cost  Costs such as materials and manufacturing labour that vary with the level of sales. Warranties  Terms in shareholders’ agreement whereby the promoter or vendor guarantees the past and present operating condition of a company. Examples include operating in a legal fashion, no bad debts or stock, and so on. Breach of warranty gives the investor the right to claim damages but does not destroy the contract.

294 Enterprise and venture capital

Working capital  Capital employed by the company to fund the excess of current assets (stock, debtors, etc.) over current liabilities (creditors, leave provisions, bank overdraft, etc.). Yield  Income payable by an investee to an investor.

Bibliography

Andersen, A., AVCAL Survey of Venture Capital, AVCAL, Sydney, 1993–98. Australian Academy of Technological Sciences & Espie, Frank, Developing High Technology Enterprises for Australia, The Academy, Parkville VIC, 1983. Australian Venture Capital Journal (various), Private Equity Media, Sydney. Bell, C.G. and McNamara, J.E., High-Tech Ventures: The Guide for Entrepreneurial Success, Addison-Wesley, New York, 1991. Bygrave, W.D. and Timmons, J.A., Venture Capital at the Crossroads, Harvard Business School Press, Boston, 1992. Churchill, N.C. and Lewis, V.L., ‘The Five Stages of Small Business Growth’, Harvard Business Review, May–June 1983. Coopers & Lybrand, The Economic Impact of Venture Capital, Sydney, 1997. Drucker, P.F., Innovation and Entrepreneurship, William Heinemann, London, 1985. Ferris, W., Nothing Ventured, Nothing Gained, Allen & Unwin, Sydney, 2000. Golis, C.C., ‘Where angels should not fear to tread’, JASSA, June 1994. —— ‘Criteria for choosing a development capital fund manager’, Australian Venture Capital Journal, September 1994.

296 Enterprise and venture capital

—— ‘Why are PDFs a better investment vehicle than tax transparent trusts?’, Australian Venture Capital Journal, September 1994. —— ‘A Pro-active Development Capital Investment Strategy for Australian Institutional Investors’, Australian Venture Capital Journal, September 1995. —— ‘Nothing ventured: Why our institutions have no appetite for Alternative Assets’, JASSA, December 1995. —— Empathy Selling: New sales techniques for the 21st century, McGrawHill, Sydney, 1996. —— The Humm Handbook: Lifting your level of emotional intelligence, Wilkinson, Melbourne, 2007. Gompers, P. and Lerner, J., The Venture Capital Cycle, MIT Press, Boston, 1999. Kaplan, J., Startup: A Silicon Valley Adventure Story, Houghton Mifflin, Boston, 1995. Kim, W.C. and Mauborgne, R., Blue Ocean Strategy, Harvard Business School Press, Boston, 2005. Kuhn, T., The Structure of Scientific Revolutions, University of Chicago Press, Chicago, 1962. Legge, J.M., The Competitive Edge, Allen & Unwin, Sydney, 1992. Lewis, M., The New New Thing: A Silicon Valley Story, Penguin, London, 2001. Lipper, A. III, Investing in Private Companies, Dow Jones-Irwin, Homewood, IL, 1984. Moore, G.A., Crossing the Chasm, 2nd ed., Harper Collins, New York, 1999. Nesheim, J.L., High Tech Start Up, The Free Press, New York, 2000. Porter, M.E., Competitive Strategy: Techniques for Analyzing Industries and Competitors, The Free Press, New York, 1984. Silver, A.D., Venture Capital: The Complete Guide for Investors, John Wiley & Sons, New York, 1983. Thomson, D.G., Blueprint to a Billion, John Wiley & Sons, New York, 2006. Timmons, J.A., ‘Venture Capital: More than Money’, Pratt’s Guide to Venture Capital Sources, 8th ed., Venture Economics, Inc., New York, 1983. Wallace, J. and Erickson, J., Hard Drive: Bill Gates and the Making of the Microsoft Empire, John Wiley & Sons, New York, 1992.

Index

ABC Flying Start Award 41 ABC Learning Centres 53 acquisitions 249–53 add-ons 142 Adelaide University Research Park 91 Advent 102 advisors, use of 183–4 affirmative covenants 179 after-market support 247 alignment of interests 108–9 Allco Finance 53 Allen & Buckeridge 192, 258–9 Allen, Roger 192, 259 American Research and Development xx, 284 American Transfer and Trust Company 102 AMWIN 275 Andersen, Harlan xx angels 71

annuity revenue stream 143 anti-dilution provisions 232–3 ANZ Capital 90, 102 Apple 26, 62 Archer Capital 112 Asia Pacific Growth Partnerships 72 asset intensity 28, 205 ASX see Australian Securities Exchange ASX admission criteria 74, 243–4 Ausdoc 112 Ausindustry 76, 82 Austrade 89 Australia Post 18 Australian Association of Angel Investors (AAAI) 72 Australian Bureau of Statistics (ABS) 14, 17, 63, 86, 199 Australian Pacific Technology Exchange 93, 97–8

298 Enterprise and venture capital

Australian Securities and Investments Commission (ASIC) 240–3 Australian Small Stock Offerings Board (ASSOB) 93–97 Australian Securities Exchange (ASX) 51–3, 73–5, 243–5 Australian Technology Park 91 Australian Venture Capital Association (AVCAL) 72, 85, 173 Australian Venture Capital Guide 72, 85, 173 backdoor listing 248–9 Bakers Delight 61, 147 balance sheet 27, 29, 160 Ballarat Technology Park 90 Barlow, Andrew 257–64 barriers to entry 25–6 Baxter International 266 Bechtolsheim, Andy 115 Bell, Gordon 67, 172 BioAngels 72 Bishop, Arthur E. 120 Blue Ocean Strategy 17, 137 Blueprint to a Billion 147, 179, 200 Bluetongue Brewery 18 boards of directors 165, 179 Bond, Alan 38–9 bootstrapping 56, 283 Borland International 4 Brambles 201 break-even analysis 152–5, 162 Brin, Sergey 115 Brisbane Technology Park 90 BSI 72 Burger King 19

Business Enterprise Centres (BEC) 91 Business Innovation and Incubation Australia 91 business parks 90–1 business plans 115–20 Business Review Weekly Rich 200 List xxiv business risk 31, 37 Byte 4 Cadburys 146 call option 184, 230 Caltex 145 Canberra Technology Park 91 capital employed 28–30 capital gains tax 45, 47 Capital Health 73 capital intensity 29 Carlton United Breweries 18 Carlyle Group 39 Caroma dual-flush toilet 48 cash flow forecasting 157–60 Castlemaine Tooheys 18, 39 Centacom 267 Centro Properties 53 Chandler & McLeod 267 Chep Pallets 201 cheque shock xxiii Chrysler 36 Churchill and Lewis small business growth model 60–2 Cirque du Soleil 137 Cisco Systems 12, 51–2 Clean Business Australia 82 Cleanaway 102 Coates Hire 38 Cochlear xxxii, 24, 76

INDEX  299 

Colorado Group 112 Columbus, Christopher xx COMET 76–7 common law 121 company constitution 126 company secretary 127–8 competitive analysis 136–8 competitive rivalry 20–1 Computershare xxiii confirmation bias 134 conflicts of interest 111 Consolidated Press 38–9, 103 consumer demand 10 Continuous Positive Air Pressure (CPAP) device 265 contributing shares 231 contribution rate 153, 162 control premium 215 convertible notes 175, 227–8 convertible preference shares 230 copyright 169 cost of goods sold 32 Costarella 73 Cox Media 147, 275 Crossing the Chasm 132 CSIRO 48 CSL xxxii CSR Limited 198 cum dividend 227 Curves 137 customer decision analysis 133–4 CVC Asia Pacific 39 CVC Capital Partners 39 Dbase 144 debtor finance 98 Dell 223 Deloitte xxiii

demand types 10–12 desired income point 205 development risk 196–7 Digital Equipment Corporation (DEC) xxi, 34, 62, 67, 92 dilution of equity 54–60, 219–23 directors 165, 179 disclosures 179 discounting 143 distributor demand 11 dividend imputation 125 dividend yield 242 DKS Pty Ltd 41 Doriot, General xx double-entry book keeping 6 double whammy 60 down-round 222, 233 Drucker, Peter 239 due diligence 196–207 Dun & Bradstreet 202 early adopters 132 early majority 132 Early Stage Venture Capital Limited Partnerships (ESVCLP) 80–1 Earnings Before Interest and Taxation (EBIT) 32 earnouts 231 EBITDA 104–5 Ellery, Tracey 274 employee buyouts 39 employee contracts 170, 232 Employee Stock Ownership Plans 170 enterprise value (EV) 102–3 Enterprise Workshops 83 entrepreneurs characteristics of 3–5

300 Enterprise and venture capital

entrepreneurs (cont.) definition 52 needed skills 5–7 negotiating with investors 176–85 objectives 225–6 producers of business plan 115 entrepreneur-venture capital game 54–60 envy ratio 108 Espie Report 76 E-Trade 52 Eurostat 13 ex-dividend date 227 executive summary 117–8 exit history 254 exit mechanism 242–254 exit risk 206 exit routes 46–7 expansion finance 64, 78–100 Experian 262 Export Market Development Grants Scheme 89–90 export strategies 145–6 Farley Lewis 139 Farrell, Peter 4, 192, 194, 266–73 Federal Express 222 Ferris, Bill 275, 279 financial analysis 151–63 financial projections 158–60 financial ratios 161–2 financing gap 107 financing risk 30, 204–6 fixed costs 153 follow-on financing 56–9 Ford 140 Ford, Edsel 4

Ford, Henry 4, 8 Fosters Brewing 18, 36 Founders Forum 72, 178, 282 franchising 147 franked dividend 125 free float 248 Freedom Furniture 112 funding mix 30 Funtastic 112 future maintainable earnings 216 Gates, Bill 4, 68, 203 Gauss, Johann Carl Friedrich 6 gearing 53, 161 General Motors 6 Giles, Andrew 257–64 Global Entrepreneurship Monitor 49 Goldwyn, Samuel 163 Google 14, 62, 68, 115 Greatorex, David 192, 267, 282 gross margin 153 gross profit 32 GroundProbe 89 guarantees 232 Hawkesbridge Private Equity 40, 102 HC Sleigh 145 Hershey 146 Hewlett Packard 92 high net worth individuals (HNW) 173–5 Hills Hoist clothesline 48 Hitwise xxiii, 239, 257–64, 281–2 Hosking, Martin 274 hourglass effect 87 Hungry Jack’s 19

INDEX  301 

hurt money 193 hybrid securities 178 Iacocca, Lee 36 IBM 147 identifiable intangibles 212–13 i-Lab 90 impact of dilution 219–23 implementation plan 166 Incitive 73 incubators 90 industrial demand 11 industry stages 16–17 information memorandum 117 initial public offering (IPO) 46, 51, 243–8 initial screening 189–95 Innovation Investment Funds (IIF) 79–80, 85 innovators 132 InnoVic 84 Insight Venture Partners 261 intangible assets 182, 212–13 Integrated Research xxiii, 72, 76 Intel 94 intellectual property 167–70 interest cover 161 Investing in Private Companies 231 iPhone 26 iPod 142 James Hardie 41 Just Jeans 112,139 Kahn, Philippe 4 Kaz Software xxiii, 147, 282 Kazacos, Peter 283 Kiam, Victor 36

Killelea, Steve 72, 282 King, Stephen 3 Kipling, Rudyard 133 KKR 39 Knitwit 139 KordaMentha 36 Kuhn, Thomas 9 La Trobe University Research & Development Park 90 laddered fees 251 laggards 133 late majority 133 learning curve 138–9 legal fees 180 leveraged buy-out (LBO) 30, 36–40, 64, 101–2, 211–12 Levitt, Theodore 119 limited company 124–30 Link Market Services 102 Lion Nathan 18 Lipper, Arthur 231 living dead 207, 242 LookSmart xxiii, 76, 147, 274–80 McDonald’s 19, 25, 139, 147 McElhinney, Rick 178, 282 McKinsey & Co. 232 MacMillan, Professor Ian 204 Macquarie Bank 214, 274 Macquarie Investment Trust 249 Macquarie University Research Park 91 MAMECH mnemonic 190–4 Management and Investment Company Program xxi management buy-in 103

302 Enterprise and venture capital

management (cont.) buy-out 101–12 risk 202–4 team 164–5, 191–3 manufacturing risk 197–8 market analysis 9–16, 131–8 capitalisation 52 risk 199–201 segment analysis 131–3 marketing concept 10 strategy 137–40 Marks and Spencer 165 Mars 146 Mercedes 25 Mexican standoff 233 mezzanine financing 107, 226–7 MFS 53 Microsoft 147, 223, 275–80 Mincom 76 mission statement 118 MIT xx, 92 Monier roof tile 139 monopolistic competition 18 multi-stage financing model 54–60, 219–23 Murray, Professor Gordon 87 Myer 37, 39, 102 My Net Fone 73 MYOB xxiii, 76 NASDAQ 51, 270, 276 National Australia Bank Microenterprise Loans 91 National Stock Exchange (NSX) 93–4 negative covenants 179

net margin 30, 161 net worth 182, 212 Neverfail Spring Water 62–3, 249 New Enterprise Incentive Scheme (NEIS) 91 New Technology Growth Firms (NTGF) 67–70 Nolan, Lisa 191 Nomura/Jafco 269 Nucleus 139 NuKorc 11 objectives 225–6 Obstructive Sleep Apnoea 265 Olsen, Kenneth xx, 34 operating cash cycle 156 operating margin 203 operations strategy 166 Ownership Quotient (OQ) 193 Oz Brewing Limited 73 Page, Larry 115 partnering 147–8 PBL Media 39 Plummer, John 267 Polaroid 16 Pooled Development Fund 81–2 Porter Model 19–21 Porter, Michael 16, 19 post-funding valuation 208–9 post-investment activities 231–41 Power Breweries 9 preference shares 229–30 pre-funding valuation 177, 208–9 Pre-Seed Fund 78, 85 price-to-book value ratio 212–3 price-to-sales ratio 215–6 PricewaterhouseCoopers 46, 51

INDEX  303 

pricing 141–4 private equity, definition xxii product life cycle 148–50 production engineering 34 profit and loss account 32, 160 promotion and advertising strategy 146–7 proprietary company 125–6 prospectus 85 Provident Cashflow 99 public company 126–7 public-to-private 112 Puls, Tony 94 put option 207, 230 Quadrant Private Equity 102 R&D tax concession 77, 125 receiverships 253 redeemable preference shares 178 redemptive mechanism 207 rejection, reasons for 195 re-leveraging 249 Remington 36 Repco 39 representations (in shareholders’ agreements) 178 research and development 34 Reserve Bank of Australia (RBA) 49 ResMed xxiii, 4, 24, 76, 165, 192, 194, 265–71, 282 Respironics 269–70 return on capital employed 28–30 return on equity 161 Rich List 200 see Business Review Weekly Rich 200 List

Riley, Paul 275 Route 128 92 Rowntree Hoadley 146 Ryanair 17 Ryan, Mark 36 Sabre Group 112 Safe-n-Sound baby capsule 48 sales/employee ratio 161, 205 Schmidt, Eric 62 Scientific American 130 screening criteria 189–95 Section 39 Public Interest Program 197 seed finance 65–87 Seek.com xxxii, 76, 192 self-financing growth rate (SFG) 155–7 seller’s note 252 Series A round 196 Seven Media Group 39 share buy-backs 249 Siebel 147 Silicon Valley 67, 71, 92 Sloane, Arthur 140 Sock Shop 165 sole trader 122 Southcorp–Rosemount merger 140 Southwest Airlines 17 spread of shareholders 59, 221 St George Bank 215 staged financing valuation 54–60, 219–23 start-up finance 34, 65–87 Strategon 72, 191 statute law 121 step-up 209–11

304 Enterprise and venture capital

Structure of Scientific Revolutions 8 structuring 105–11, 224–35 subordinated debt 178, 229 Sullivan, Dr Colin 265–6 Sunshine Coast Innovation Centre 90 suppliers’ credit 30, 100 sustainable competitive advantage 22, 26 T3 Capital 72 Tasmania Technology Park 91 Tassal 36 technology parks 90–91 Tempo 112 term sheet 178 Texas Pacific 39 Thompson, David 147, 179, 200 Thornley, Evan 274 Three Fs 71 Tie Rack 165 Tooheys 18, 35 tortious interference 235 trade secrets 169 trademarks 169 trading trusts 122–4 turnarounds 36, 101 undercapitalisation 33 underwriter 245–8 underwriting agreement 246 Underwriting Laboratory 201 unique selling proposition (USP) 22–5, 139 US Census 12–13 US Venture Capital Association xxiii

valuation risk 206 valuation techniques 208–23 value innovation marketing strategy 139–40 VeCommerce 247 Veda Advantage 202 venture capital, definition xxii venture capitalists description 50 choosing 172–5 lawsuits against 234–5 motives 225–6 negotiating with 176–85 post-investment activities 236–41 Victorian Economic Development Corporation 90 Vision Systems 76 Vita Life Sciences 73 Volvo 140 Wang 92 warranties 178–9 Warren black box recorder 49 West Australian Development Corporation 90 Westfield 139 Westpac 215 Wilde, Oscar 117 Windy Knob Resources 73 working capital ratios 161 wotif.com xxiii, 76 Xerox 18 Yahoo! 147, 276 [yellowtail] 17, 137, 140