Investment (Part 10) – The Great Escape?

Founders may be having fun running a company, but investors want their money back.  This has a number of important implications for a business that takes external investment.

The first of these is that the business cannot become a lifestyle business.  Especially in software, it isn’t uncommon for companies to start out doing consultancy based around their emerging software product with the intention of selling primarily product later on.  Sometimes it will seem that this consultancy business has the opportunity to be a nice lifestyle business for founders and staff, avoiding the risk and effort of moving to product.  However, consultancies are seldom scalable or acquirable – so investors are unlikely to support this sort of business model.  Instead they are likely to push for a “scalable product or bust” approach.

NOTE: Many of the following comments come from perspective of the Scottish market and UK tax rules – some of the driving forces may be different elsewhere.

In fact, investors may be better off letting a company go bust than letting it tick along as a lifestyle business or consultancy.  In neither case are they likely to see a return on investment, but under some circumstances UK tax rules entitle them to “loss relief” on investments in companies that are wound up.  This means that they effectively get some of the money they invested back from the HMRC.

UK Angel Investors usually receive ordinary shares (see this post on Preferences and Angels) which means that ambitious expansion plans requiring significant further investment from VCs are likely to be unpopular.  While these may ultimately yield more return for the founders, the angels would have to wait longer and will probably receive less return than the VCs.  They tend not to like this idea.  Elsewhere in the world (and in other times) VCs would buy out angels to avoid this problem.  That is not currently a common occurrence in Scotland.

The reality is that Angels in Scotland are looking for businesses they can support from their own resources (no more than a few additional funding rounds) to the point where they can be sold to a trade buyer.  These exits tend to be in the £10m-£50m range and this can lead to a conflict between founders who would rather hold on (perhaps doing a further round of investment) and build more value in the business for a bigger exit while investors are quite happy to get their money back more quickly.

The only area where things happen significantly differently is in pharmaceuticals and medical devices where the huge cost of trials means large scale investment will be needed, and VCs and Angels are much more likely to work together.

Of course, exit seems a long way away when starting to look for the first investment in a business, but it is still important to be aware how taking on external investors may limit choices in the future.  After all, the exit is why the investor is involved in the first place!