18 Feb
2015

Industry report -

Picassos in the cemetery

Fraserburgh

Co-published

Globally, around 120,000 businesses fail every day. The failure rate by country and by industry varies greatly, but a rule of thumb in the United States is that roughly 80% of all new businesses will fail within the first 18 months. Of the survivors, more than half will fail in the next three years. 

Of the 2 million new businesses created annually in the United States, several thousand receive venture capital (VC) funding, but the VC failure rate is no better than the average. This statistic is perhaps skewed by the VC investment bias towards technology start-ups, exacerbated by the Silicon Valley 'fail fast' culture. Ironically, VC funded companies do not fail fast when investors bail out. Unlike their less well-capitalised peers, VC-funded companies tend to die slowly and such VC-funded failures consume a median of $1.3 million of shareholder funds before they expire. But VCs bury their dead quietly, as Shikar Ghosh of Harvard University has noted, and this statistic goes unheralded.

Irrespective of the source of funding, the three primary reasons for the failure of new businesses are:

  • an insufficiently differentiated market position;
  • a weak business model; and 
  • dysfunctional leadership or management team breakdown.

To these three I would add a critical fourth reason: raising insufficient capital to fund initial growth. This is a major problem which I encounter daily. 

Liquidity bubble has increased availability of early stage funding
One consequence of the global credit collapse in 2008 has been a bull run in equities, as low interest rates and monetary easing have pumped liquidity into the market. This supported a strong initial public offering market (for life sciences in particular) and generated significant gains for many angel/VC investors. The trade sale market has also boomed over the last few years as larger companies raise cheap debt and use it to acquire others.

The impact of central bank funding has led to falling yields on bonds and encouraged many high-net-worth investors to diversify into more risky investments such as VC, often with tax breaks. The net effect of this is that it has never been easier to raise small amounts ($1 million to $3 million) for start-ups. 

It is always challenging to explain to entrepreneurs that they need to think about their capital structure from the beginning, but this is one chicken that always comes home to roost.

One problem for start-ups in accepting small amounts of money from high-net-worth investors is that the initial due diligence tends to be cursory, given the limited amount at stake. In effect, it is a lottery ticket. Equally problematic are those investors who have made extraordinary gains in a bull market and ascribe those gains falsely to their own investment skill. The non-discriminatory investment approach from both types of investor eliminates a valuable filter for non-viable businesses, sets unrealistic pre-money valuations for a second round and provides the context for negative reactions if or when things do not go according to plan (whichis always the case in a start-up).

A further consequence of the 'spray and pray' style of investing is that it does not attract aligned investors with the intention or the capacity for follow-on money. Nor does it attract strategic investors who will be helpful in securing follow-on money. For management teams, there can also be another, less evident consequence that a culture develops where 'respect for the money' is not engendered. This can be catastrophic later on.

IP due diligence is a bedrock for investing in early-stage companies
One element of the funding decision that is almost never addressed properly by the due diligence common in first-round money is the intellectual property of the start-up. This may include freedom to operate (FTO) or the potential/likely sale value of intellectual property to competitors, each of which provides valuable insight into the intrinsic value of the new business. Since the company’s intellectual property often underpins its product differentiation and business model, doing this work early addresses two of the three most common causes of business failure. Perhaps understandably, the primary reason for not doing this work is cost. A good FTO study costs between $50,000 and $100,000. For a start-up raising $2 million, this is not insignificant (2.5% to 5% of funds); but without this work the combination of indiscriminating capital and poor insight into FTO has failure as a likely outcome.

Intellectual property is the orphan of business failures
When a business does fail, the next stage at which value is destroyed is in liquidation. The IP assets of early-stage companies are often abandoned or sold for a fraction of their potential value by shareholders who are anxious to get something back quickly or write off taxes, administrators who lack the expertise and management teams who are anxious to move on. This is particularly true in technology or life science businesses, where the failure rate is highest; but it also applies in other industries such as financial services and education, where failure rates are also very high – 50% even after three years of operations.

In the last few years I have been asked to value, find buyers or finance intellectual property for a number of failed businesses in multiple sectors. Typical cases have involved telecommunications, domain names, biotechnology patents (particularly in genomics), medical device patents, designs and manufacturing, polymer manufacturing patents, customer lists and trade secrets, and even entire management and R&D teams seeking a new home. What each of these different situations had in common was that the intellectual property in question was poorly articulated and documented, and the owner had no real idea of the market demand/value (often either wildly over or underestimating value) and receive no clear or useful advice from its advisers.

Monetising value from insolvency or collapse
The process of analysing the quality of the assets in these situations, identifying potential buyers or licensees and then conducting an appropriate sale process is often prohibitively expensive and time consuming for start-up intellectual property; however, it can yield gems. In the past five years I have seen patents from failed start-ups sold for several million dollars, failed business assets relaunched with new management and money (more than $50 million) and targeted private auctions resulting in investors recouping a significant percentage of their initial invested capital (several hundred thousand dollars).

Comment
Start-ups are often overlooked in terms of the IP value that they hold – in part because of the nature of the funding process for new ventures, which is heavily influenced by investor sentiment and indirectly driven by macroeconomics. However, the failure rate of start-ups makes looking for value in the wreckage of a start-up business a worthwhile endeavour for investors. Often the failure has nothing to do with the intrinsic value of the proposition or its intellectual property. In this context, if large companies might be thought of as having 'Rembrandts in the Attic', then failed start-ups can equally be described as having 'Picassos in the cemetery'.

For further information please contact:

Chris Donegan
Fraserburgh

This is a co-published article whose content has not been commissioned or written by the IAM editorial team, but which has been proofed and edited to run in accordance with the IAM style guide.

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