“SUCCESS IS NOT FINAL; FAILURE IS NOT FATAL:

IT IS THE COURAGE TO CONTINUE THAT COUNTS.” WINSTON CHURCHILL

At a recent GBI Magazine EIS Round Table, kindly hosted by Calculus Capital, the spotlight fell on the success/failure rate among early stage companies and how it is perceived by fund managers and investors alike.

Chairman for the day Richard Angus of Hardman & Co reported a recent conversation with an investor who said that of “...the next 10 investments he would make, 3 would survive (with 1-2 being successful) and 7 would fail. “And that’s a good risk reward profile. But do you as advisers think you can take the investment proposition to the next stage with your client with that information?

John Glencross of Calculus agreed: “Anyone who says they’ve never had a failure in business is not being totally straightforward as this is about growth investment. As growth investors, we know it works, we know there’s plenty of intellectual capital in this country, and the communication of that risk and reward to the outside world can be tricky.

I went last night to my old university where they brought together people from the fund management industry and students, and someone said if they get it right 60% of the time, they’re ahead of the market, which is true.

“The important thing is the investor. If you were as rich as Steve Jobs, I’d say if you like that company, invest in it, but for people for whom this isn’t their day job, you have to have a portfolio to spread the risk. After Andy Davidson of We Are Nova reminded the participants that 90% of early stage companies fail to make it past year 3, John emphasised “I think you have to tell clients there will be failures and say that’s okay because that’s part of growth investing, but the loss relief on failures is very attractive.

“The bottom line is if you want a big income fund, fine, you don’t expect companies to fail, but they seem to quite regularly. In growth investing, though, you will get failures. You have to tell the client it’s okay, the important thing is to have a portfolio and have a growth manager with a track record.

Andy Davidson suggested it all comes back to the data: “You need to go back to your client and say what the market has done. What appears to be happening is that all this growth in the market is coming from a small number of companies so you need a really big portfolio. Fund managers have different specialities, but I’d say if you’re going to invest £100,000, I’d put £10,000 with 10 different managers. Different managers have different specialities. It is important to talk about failure in the context of the wider market growth, and the way to mitigate risk is to put your money with as many as possible.”

Andy Davidson reckoned that in early stage, you need a portfolio of 50-80 companies to offset failures and as you can’t influence the outcomes you need them to fail quicker and thereby consume less capital.

Over the previous year, Calculus explained that they had explored investing in around 600 companies, while We Are Nova had looked at 1,600 founders and completed 27 deals.

Davidson noted that he and Calculus are at opposite ends of the lifecycle.

“For us, we’re big practitioners of the lean movement, we fund a number of things we do, we don’t try and fund high counting businesses, we try and build in a variable cost base and we try and achieve the next proof point. We might work with a medical professional, we’ll buy at £400,000 and take 25% of the equity, we will provide them with a team to get to a minimum viable product to get tested in a hospital. You might fund them for six months with an outcome they need to achieve. If you don’t fund them, the business doesn’t fail, but you don’t put in any more money until they hit their next traction point. If they need to get hospitals to trial their product, it can take three days, three months or three years, it doesn’t matter to us.

“We don’t fail things, we just ‘not yet’ them. If they want to take the next steps and need capital, we won’t fund that until something happens and then we might fund it for another six months. That’s the strategy we use to make sure we spend as little investor capital as possible.

“We do that with 45 companies at once and we want to expose investors to all those. We buy at £400,000, so a successful EIS funding round for us would value the business at maybe £5m, as you get more than 10 times the uplift in value. It’s important that we have a broad spread of risk.”

John Glencross told how one of Calculus’ portfolio companies, Essentia Analytics, had been founded by an ex-fund manager who had identified that investment manager bias influences outcomes.

“The investment decision is very scientifically driven in active fund managers, it’s very controlled. However, sale decisions can be more emotional, especially if the company is not performing as expected. One of the hardest parts about what we do is to say we will not finance a business anymore as we don’t believe it will achieve its objectives. We don’t just pull the plug on a business when it’s not working, you can’t do that as an investor, we work with the management teams to help enact positive change, and if they can’t look to further capital from us we may help them raise other sources of funding, or if appropriate, we’ll look to sell in the market. Making investment is the easy bit, the tough bits are the decisions afterwards. This is real, these are real companies and we have to be prepared to take tough decisions. By and large, we get it right.”“The three important things in property are location, location, location. What’s important in growth investing? People, people, people, because it doesn’t matter if you have the best business plan, if you don’t have someone capable, it’s not going anywhere. We spend a lot of time working with pre-investment to ascertain how they will function, and we do our own due diligence. Our people assess the strength of a management team including the senior people.

“What do we look for? Experienced management that has a reasonable track record that will give us a good indication and a service that is ready for market. We want a discernible market lead and a reasonably competitive situation. People, people, people; then ‘ is the product ready for market and is there a need?’ You do an awful lot of due diligence in making an investment, but you have to be ready to pull the plug. If you have 35%, you control the situation, or you say they’re not having any more money. There’s the famous adage that the best way to lose money is to double up.”

The best thing about having a portfolio of EIS investments is that when an investment does fail, not only do you have the downside protection of loss relief, but you have other potentially successful investments to fall back on and provide you with a strong return.

The discussion then moved on to cover communication, EIS admin and exit strategies, which are covered in our next article. GBI