In the first of a series of articles about how to start and fund a fledgling business, James McKenzie examines the art of securing money from venture capitalists
I read somewhere that about a third of all workers in the UK don’t enjoy their jobs – and that more than half would rather work for themselves. So if you feel the urge to start your own business, you’re not alone. In fact, one new company is set up every minute in Britain. They’re generally founded by people who have spotted a gap in the market or have the technology to solve an existing or future problem.
These days, setting up a company is easy. You only need to spend a few hundred quid filing the firm, opening a bank account, picking a website domain name and sorting out an e-mail address. The real challenge is securing enough money to fund the business until it can sustain itself from sales. Records show that 89% of start-ups in the UK survive their first year, but fewer than half make it beyond five years.
According to the Institute of Directors, about half of all new businesses (across all sectors) start out with less than £5000 in their pocket. That’s probably enough if you’re a gardener, hairdresser or decorator. But most physics-based businesses need much more. In fact, it can take several years – and many rounds of investment – for them to succeed. That’s why many hi-tech firms look to venture capitalists (VCs) – people who will invest cash in potentially risky but promising businesses in return for a stake in the company.
Keys to success
But with fewer than 10% of all start-ups ever securing VC funding, what’s the secret to winning their support? For answers I turned to Hermann Hauser, the physicist who in 1997 co-founded Amadeus Capital Partners – a VC firm that specializes in the computer, semiconductor and telecoms sectors. Hauser rose to fame in the 1980s as the co-founder of Acorn Computers, which later spun-out Arm – today’s hugely successful chip-licensing business (May 2021).
Hauser, who is an honorary fellow of the Institute of Physics, told me that after 30 years in the VC business, he realized that deciding whether to invest in a company boils down to three key factors. “The first,” Hauser told me, “is the size and growth rate of the market. The second is the team. And the third is the defensibility of the technology”.
There is little sense in investing heavily if the market is too small
There is, indeed, little sense in investing heavily in a product or service if the market is too small. Hauser cites Cambridge Silicon Radio (CSR) – a company making single-chip Bluetooth that Amadeus invested in in 1998. Admittedly, the market size was zero, but the growth rate was potentially huge if single-chip radios like Bluetooth became part of mobile phones, which they did. CSR went public in 2004 and the company was bought by Qualcomm in 2015 for a staggering $2.5bn.
As for the team, Hauser says he wants people who stand out. “I am looking for a star – usually a technical star – as it’s easier to build a team around them as people want to work with them.” To Hauser, people are crucial and, when I quizzed him further, he was even blunter. “I have seen more situations where an A-grade team with C-grade technology has been successful than I have a C-grade team with A-grade technology win out”.
Hauser’s third point – about what he calls “defensible technology” – refers to the fact that if a product does well, everyone else will try to copy it. You therefore must protect your product, processes or materials through patents and other forms of intellectual property. That will give you a chance to grow and maintain high gross margins to build the business value. “Of the 100 investments I have made in the physical sciences, the technology doesn’t always work as well or as fast as predicted – but only once has one of my companies failed because the technology didn’t work at all.”
When talking to VCs, it’s worth remembering that they have to raise funds to invest in the companies based on their own reputation to pick winners and deliver returns. In the Wall Street Journal, Shikhar Ghosh – a lecturer at Harvard Business School – is quoted as saying that 75% of 2000 venture-backed companies he’d surveyed never returned any cash to investors. In fact, in 30–40% of cases, they lost their entire initial investment.
Fortunately, for physics-based start-ups there are some patient early-stage capital funds out there. In Britain, there’s the UK Innovation and Science Seed Fund (UKI2S), which supports hi-tech start-ups either in (or linked to) government labs. It recognizes that such firms can take a long time to mature – indeed about half the companies it backs are physics-based. Mark White, a UKI2S investment director, told me the fund is especially interested in great science that could answer unmet commercial needs.
“Of the investments the fund has made, fewer than 10% have not changed applications or markets for the technology as development has progressed,” he told me. “So we like to make sure the team has identified at least two or three applications for the technology.” This approach has paid off, with successes including Cobalt Light Systems – a Raman spectroscopy firm that first targeted medical markets before switching to airport security and pharmaceuticals. It was snapped up by US tech giant Agilent in 2017.
White’s advice for early-stage firms is not to fall into the trap of describing solutions in search of a problem. Instead, before even engaging with investors, you should first identify the problem you want to solve. If you want to secure VC funding, you’ll have to use your business plan to pitch the market opportunity and explain how you’re going to unlock it. If the VC agrees with you – and really believes in your team and your approach – then there’s a great chance you can get the investment to grow your business to the next stage.