Accelerated M&A can serve as a solution to the value paradox inherent in knowledge intensive start-ups, writes BDO partner Stuart Deacon.
The ever increasing interconnectedness of the global economy presents myriad opportunities for entrepreneurs, start-ups and disruptive technology. Lord Young’s 2015 report into the changing face of British business concluded that small businesses in the UK, many of them in the tech space, were entering a new ‘golden age’ of growth and development. Backed up by encouraging data – 5.2 million small firms in the UK, an increase of 760,000 over five years, and high employment levels – such statements were perhaps defendable. However, the competition for global talent in the context of the Brexit vote increases uncertainty and places a sharper focus on the need for either a sustainable return or a value-based exit route.
Growing pressures in the knowledge intensive start-up space are now causing significant financial stress – in some cases distress – for the current wave of emerging tech businesses looking to become the next Airbnb, Uber or JustEat. Official Office of National Statistics (ONS) research released in 2015 cast light on a fundamental problem many start-ups continue to grapple with: the challenge of growing and establishing a business beyond the early stage development cycle. As the ONS data reveals, the average 5-year survival rate for UK start-ups, many of which are in the TMT sector, is well under 50%.
There are of course countless possible causes for business failure, not least the wider macroeconomic uncertainties, poor management strategy, product viability, availability of talent and more. However, of equal or even greater importance for start-ups as they move through the development process is the ongoing availability of funding. Start-ups that have successfully secured early rounds of funding typically require sustained support in order to realise their potential, such as providing fuller proof of concept, scaling up operations or eventually taking the business through to full profitability. However, despite developing innovative and viable product and service offerings, many start-ups find it difficult to access the funding they need to drive their business to the next level of development.
The tax framework encouraging early stage funding is in some ways part of the problem. Initial funding is formed generally through a mix of seed capital (often via family or friends), founder equity (perhaps benefitting from Seed Enterprise Investment Scheme (SEIS) or Enterprise Investment Scheme (EIS) tax incentives) and venture equity. Venture equity is often delivered via a venture capital trust (VCT), a structure through which UK investors can secure considerable tax breaks, such as favourable treatment of dividends, by channelling their investment into early stage and specialist companies.
However, the rules and structures of EIS and VCT-style funders come with drawbacks for those start-ups which aren’t able to establish solid financial and market foundations in a relatively short space of time. VCT schemes, initially set up in 1995, are designed to encourage individuals to invest in high-risk and potentially high growth unlisted companies, thereby providing a financial leg up to start-ups and entrepreneurs. Some VCTs are generalist, ostensibly evergreen in their investment strategy and with a closer interest (via due diligence processes and presence on company boards) in the start-ups themselves. In contrast, other VCTs operate shorter-term strategies with clear exit plans and timeframes in place.
Unfortunately for many, VCT funders can quickly reach the limit of the additional funding they are willing or able to make, whether due to investment limits imposed to preserve the beneficial tax status or closure of the investment window – particularly pertinent to those VCTs with a defined exit strategy. While individual investors may have access to capital previously unavailable, such as the 25% lump sum accessible via withdrawal from pension funds coupled with the lower lifetime limit designed to encourage more diverse portfolios, the ‘safer’ option of limited life VCTs means that these funds are not necessarily there to facilitate partnership investment models with start-ups. This, coupled with the fact that use of alternative or additional VCT funds within an existing umbrella is often conflicted or disallowed, means that tech start-ups can be left in an uncertain position, facing the prospect of looking for alternative investment sources or, potentially, failure.
There are also recent tax changes driving this trend. The Finance Act 2015, brought with it changes to both VCT vehicles and EIS. These changes relate primarily to the criteria used to determine companies’ eligibility for funding and the levels of investment they can receive and therefore set the limits and parameters for investors themselves. For example:
- Companies must raise their first investment from EIS or VCT within seven years of making their first commercial sale
- This is extended to ten years for ‘knowledge intensive’ businesses – meaning those who meet certain criteria such as total costs for research and development or innovation of at least 15% of the company’s operating costs in at least one of the previous three years
- These age limits don’t apply where a company has received SEIS/EIS or VCT investment it its first seven years or where the investment is more than 50% of the average turnover of the company over the previous five years – but only if the new funds are used to target completely new product markets or geographies
- Annual investment into companies capped at £5 million
- No single company can raise more than a total of £12 million in investment (£20 million for knowledge intensive businesses)
- Companies must have fewer than 250 employees (500 for knowledge intensive businesses)
These changes taken together have significantly affected the investment proposition that tech companies bring to the table. Essentially, the new rules are designed to ensure that capital is targeted at truly entrepreneurial businesses which will drive new growth across the UK economy, rather than being used to fund tax efficient structures for individuals. The key impact is that older, more established companies become less viable as potential investment prospects, ensuring those companies which have managed to grow through the first painful years of development can miss out on much needed additional funding.
There are still options for struggling tech companies, including seeking an IPO or launching crowdfunding initiatives – but EIS and VCT funding often continue to complement these strategies and both routes retain their own inherent difficulties, not least due to the typically high valuations these hitherto unproven companies often grant themselves despite their relative immaturity.
Given these overlapping difficulties, it’s little wonder that debate continues over whether the technology landscape is another bubble waiting to burst. The recent failure of Powa Technologies, one of the largest start-up failures of all time, only serves to emphasise the point. According to media reports, while Powa was initially relatively well funded, with over £50 million of private equity funding secured in 2013, it attracted only £14 million in PE during the next round of funding a year later. This decline, coupled with £42 million debt financing, subsequently drove the company into financial difficulty and eventually into administration.
Despite this gloomy picture, there remains an important and often overlooked solution for distressed start-ups facing funding difficulty via traditional investment routes: undertaking an accelerated M&A (AMA) process.
Central to any strategy is the duty for directors to maximise value for the company’s creditors, a considerable challenge when the company, ordinarily, has little in the way of tangible assets that can be attributed a market referable value (compare plant or stock). Whilst there are numbers of valuation models these could be subject to legal challenge as simply ‘opinion’. Unless a high level of IP protection has already been secured, such assets are difficult, to assign empirically based value to. It is the paradox of innovation that there are no comparables. Traditional business restructuring strategies, such as formal administration or conversely traditional and lengthy M&A negotiations, may therefore not be the best approach for creditors and customers to pursue.
In many circumstances, an accelerated M&A (“AMA”) can be launched in which an extensive and confidential marketing process is undertaken within the window in which the company has available cash – sometimes as little as a few weeks – to give the best possible sales outcome. The AMA process has a number of benefits to offer:
- it allows for greater protection of Directors / investors whilst complex and competing options can be properly assessed
- it drives out time-wasters and is accretive of value as it limits uncertainty
- it allows for a detailed assessment of contingency plans (which preserves the technology) preventing the very worst case, which is total abandonment of the tech
- the flexibility of AMA may preserve ‘old’ equity or equity-like debt in a new post deal structure
- it presents an opportunity for tech savvy, flexible investors to do very well and it is not a market with any dominant player.
If the offers that are elicited are for the trade and assets of the business only, then a ‘pre-pack’ sale may be agreed with a purchaser prior to the formal appointment of administrators resulting in a swift transfer of ownership and a near seamless continuation of trade under the auspices of new management.
One recent case of this type involved media and collaborative cloud-based ‘software as a service’ business A- frame. After a successful period of early stage funding, the company found the sustained working capital required to develop both product and service lines and expand the client base were swallowing up its cash rapidly. A lengthy, traditional M&A marketing process attempted to find a solution through a more traditional equity-based sale of the company but, due to many of the issues already discussed, not least contestably high valuations, a sale was not forthcoming. An AMA strategy was, therefore, pursued and within two months a purchaser had been secured, with the sale including the determination of a minority equity stake for the company’s founder.
The key insight here is that the accelerated M&A process quickly and efficiently elicited the real ‘market value’ of the business, which preserved the company’s jobs, saved it from failure and facilitated the influx of much needed capital to maintain its growth via the purchaser.
The UK has been at the forefront of the exponential growth of the global TMT sector, with Tech City companies at the cutting edge of development, attracting over £2.5 billion of venture capital investment in 2015 alone. Not all of these companies will become profitable instantly; most will need sustained support and investment, and some will inevitably fall by the wayside due to market forces. But there are solutions available that many tech start-ups run the risk of overlooking.
Accelerated M&A is, of course, not the answer for every tech company facing funding gaps and any such process should always be conducted with full transparency, particularly in cases where a potential sale involves a connected party such as existing shareholders or directors. But it and other similar restructuring facilities should not be seen as merely the last resort. The key for tech strategy in stress is pure Darwin: to survive and reproduce. AMA does that.
Stuart Deacon is a partner in BDO’s M&A practice in the UK. He focuses on turnaround, rescue finance, stressed and accelerated M&A processes.