Can a sector as diverse as venture funding be judged on an average performance basis? If you are considering investing in this area what can you learn from successful venture capital investment?
Last week I was sent a study on the performance of early stage companies.
The study followed on from a 2016 report, Rise of the Growth Hunters, focussing on the performance of 519 UK companies that raised seed or venture funding in 2011. All performance data was provided by Beauhurst, the independent research agency.
The highlights of the report are:
- The 519 companies demonstrated an impressive average increase in valuation between 2011 and 2017 of 30% per year, measured by Compound Annual Growth Rate (CAGR).
- 73 (14%) of the companies have exited with a total value of £3.78 billion.
- In 2017 there were 12 exits, down on the 21 exits achieved in 2016.
- The average value of the exits in 2017 increased by over 58%.
- The same number of companies failed between 2011 and 2017, 73 companies (14%).
- 31 companies failed in 2017.
- IPOs on NASDAQ achieved both quicker and larger exits at 98% CAGR compared to 33% for AIM IPOs.
The report concludes that if an investor has invested £10,000 evenly across the 519 companies the holding would now be worth £63,848 assuming EIS claimed on all investments.
This figures is made up of a return of £23,745 on exits and EIS income tax relief; an estimated value of £38,394 on the remaining companies and loss relief on the companies that have failed.
Looking at these highlights it is hard not to be impressed especially against studies form Harvard Business School discovering that 75% of venture-backed businesses in the US fail.
So where do I sign?
Hang on one second. Is the above a fair reflection on the performance of the class of 2011 and what can private investors take from these results?
The first point I would like to make was that there were actually 578 companies that raised seed or venture funding in 2011, Beauhurst tracked 519 of these. It is fair to assume that with the mass of data available, the 59 missing companies have failed in the interim. This would increase the number of failed companies to 132 or 22.8%.
As such, all the performance percentages in the report are incorrect as they are based upon 519 companies rather than the full cohort of companies funded.
Secondly, not all of the investments would have been open to private investors. Venture backed companies tend to be funded by either VC funds or private investors, rarely both.
VC funds will often invest through a mix of debt and preference shares or more complicated structured investments with the aim of mitigating the high risks involved.
Private investors generally prefer to utilise the considerable tax benefits available through the Enterprise Investment Scheme (EIS Scheme) where available.
Even if it was possible for private investors to take a stake in each of the 578 companies, this is the opposite approach to the VC funds who will use their expertise to identify the companies that best match their investment objectives. Only a small percentage of the companies are likely to make the grade.
What are the typical trends of VC investing?
The number of exits and failures in 2017 demonstrate a typical pattern in the performance of venture backed businesses. With any wide ranging investment area, you will have short term successes that exceed expectations and achieve an exit. These should be viewed as exceptions and are not the norm.
Once the businesses have burned through the seed or initial funding, they will be judged upon their achievements. Those in line or exceeding original business plans can expect an up round of investment. The new investors will have higher expectations based upon the businesses maintaining their upward growth trajectory. This partly explains why there were 43% fewer exits in 2017 compared to 2016 and also why the average value of exit increased by 58%.
After the initial backing, those businesses that have fallen well short of expectations can expect a heavily discounted follow-on at best. At this stage, the number of failures will start to increase.
The pattern of fewer successes and more failures will typically widen going forward for the cohort of businesses.
As a number of the fundings would not have been open to private investors and not all of the companies would have been EIS approved, the use of averages do not provide a true reflection of performance and should not be used for comparative purposes by private investors.
Just looking at the top three exits in 2017 as detailed in the report:
| Valuation 2011 | Exit Valuation 2017 | Increase | |
| Nucana | £7.14m | £504m | + 6,964% |
| Cobalt Light Systems | £2.5m | £40m | + 1,496% |
| Fusion Antibodies | £4.35m | £27m | + 520% |
All three are life science companies.
From this we know 75% of the exits in 2017 showed less than 5.2 times money. Additionally, it’s reasonable to assume a number of the exits were at a loss.
So the range of exits for 2017 is huge, with investment returns differing greatly if you invested in Nucana or not.
Obviously, it would be much better if we only invest in the successful companies. Whilst this is not possible, we can follow the lead of the VC funds by being highly selective with the aim of identifying the successful companies.
Judging each opportunity on its own merits
There are a number of key considerations when evaluating a potential investment:
- Management – this is vital to the success of the business. Strong founders will recognise their own strengths and weakness. They will bring in skilled personnel as required. For more information on the importance of management teams click HERE
- Size of market – VCs would expect business plans to include a detailed market analysis. VCs are trying to identify companies that can generate revenues of £100m +. Also the larger the market size, the deeper the pockets of the major players and the more likely a trade sale.
- A competitive edge – ideally the company will present a solution to a real problem not solved by others in the market place. The larger the problem, the greater the value of the competitive edge.
- Detailed risk assessment – whilst all early stage investments are high risk, VCs will dig deeper to identify any possible future regulatory or legal issues; whether the market is ready for the product; whether the level of funding can achieve significant milestones; what is the most likely exit and who are the potential suitors. VC welcomes risk but wants to a full assessment to decide whether it is justified.
If you are satisfied that a company meets all of the above criteria, it does not guarantee success but does mean that it has the right upside potential. Building a smaller, selective portfolio of venture backed companies has proven to be effective for VC funds.
Before putting money into an opportunity, venture capitalists spend a lot of time vetting them and looking for the key ingredients to success. They want to know whether management is up to the task, the size of the market opportunity and whether the product has what it takes to make money.
For more information on how to identify early stage companies with the highest upside potential click HERE.
Conclusion
The 30% average valuation increase, whilst eye-catching, is hugely dependent upon a small number of stellar returns. A blanket approach to investing in early stage companies is neither feasible nor the best investment strategy. In the same way you would not invest in every company in the FTSE100 to build a blue chip portfolio.
Private investors seeking the higher returns possible from venture investments should follow the lead of professional VC funds by:
- Analysing each opportunity on its own merits
- Building a select portfolio of companies capable of the highest returns
- Accepting successes will probably be in the minority
- Embracing the high risk nature makes the high returns possible
- Utilising EIS benefits to mitigate losses.
Since 2001, CSS has been identifying early stage companies with high growth potential. Each company identified will be presented through a full disclosure placing document. The private client service provided by CSS Partners is designed to provide investors with sufficient information on the companies and a point of contact in order to ask questions. Our aim is to enable investors to make an informed decision on whether any opportunity meets their investment requirements.
CSS Partners has raised over £165m for entrepreneurial companies since 2001. To learn more about how we enable private investors seeking higher capital growth to invest with confidence in smaller companies click HERE.
Important Note
The information in this website is provided by CSS Partners LLP. This website has been approved for the purposes of section 21 of the Financial Services and Markets Act by Charles Street Securities Europe LLP (CSSE), which is authorised and regulated by the Financial Conduct Authority. CSS Partners is an appointed representative of CSSE.
Any views or opinions expressed in this blog are those of the author alone, except where specifically stated that they are the views of CSS Partners LLP.