Starting up: show me the money!

Starting a software business is far from easy. In this first extract from his forthcoming book, Making it Big in Software, Peter McHugh shows where you should go to fund serious business growth.

The financial options available for young UK software companies are fairly straightforward, and pretty limited.

Bootstrapping is the first order of the day. For example, Coda's founder Rodney Potts took a consulting contract to bring in some money during the company's first 10 months as Coda had no product to sell.

For the first year and a half, Coda's initial three-man team paid themselves an annual salary of £1,500, which coincidentally was the national insurance limit. All three worked from home and borrowed computer time from a customer contact to minimise outlay on kit. Coda is now a global software business and part of enterprise resource planning giant Baan. (To find out what happened to most of the companies mentioned here, see the box on page 45).

Similarly, Rolfe & Nolan, founded back in 1974, initially spent money very cautiously. The company was two years old before it bought a computer, for which the founding team borrowed £40,000. The founders developed their software by hiring machine time on a bureau basis. They minimised their costs by sharing offices with customer, and 51% founder shareholder, Jeremy Oates, who also paid their salaries for the first six months.

Friends, family and contacts are still a common source of early-stage finance, although the process is rarely as unconventional as for Mike Lynch, who has set up two companies based on chance meetings with unusual individuals.

Cambridge Neurodynamics was started in 1991 after Lynch met an English eccentric (who had discovered some major rock groups, including Genesis) in a Soho bar, and convinced him to invest £2,000.

Within six months, Neurodynamics was profitable, and Lynch was able to pay the money back. Second time round, he raised venture capital money from Apax Partners to fund web searching tools manufacturer Autonomy.

He also raised funds from currency trader and football club owner Joe Lewis, via his investment vehicle English National Investment Company.

Consulting and contract programming work is an obvious potential source of funds to keep the wolf from the door while product is being developed.

The big challenge with this type of funding source is keeping your focus on the priority - completing the first version of the product and getting it out the door, without getting diverted by the demands of this secondary work.

To fund the early development of SunSystems, the founding team at Systems Union continued working as IT consultants. Office costs were minimised by working out of founder John Pemberton's house, and the business grew over the first five years to the extent that it took over the whole house.

Pemberton says he realised he was no longer playing at running a business came when the local authority issued an enforcement notice, giving him 60 days to stop using the house as a business.

Bank finance is another common source of funds, normally through overdrafts or loans, although other financing options such as invoice discounting have proved popular. However, small exporting companies often get crippled by the trading covenants imposed by banks who can be reluctant to finance trade debt, in particular foreign debts. This poses many difficulties for software companies, as exports often soon become an important part of the revenue mix.

Government and state funding is not very common in the UK. Kewill's first product development was part-assisted by a Department of Trade and Industry loan of £150,000. Irish vendor Iona initially received funds from the European Union as part of the Esprit research and development programme.

It was one of about 500 different Esprit projects, most of which never saw the light of day, although French software vendors Ilog and Business Objects are two companies which also had a helping hand from Esprit. Iona was also helped by the Irish State Agency (now called Enterprise Ireland) via employment grants and some preference share investment. Another other Irish software vendor, CBT Systems, was similarly well supported at an early stage by the Irish agency.

Customers can in some cases fund the early-stage development activity, particularly for vertical market applications where they may have a motivation to assist, as an alternative to developing the software themselves. London Bridge's first product grew out of a bespoke project at TSB Bank. In the early days, Smallworld was funded in part by a £l million investment from customer Southern Electric which was interested in its geographical information system (GIS) software.

While these sources are feasible for funding early-stage growth, for any company with ambitions to enter the high-growth zone - which will require international expansion and possibly acquisitions - the only real alternative is equity finance. Very occasionally, fast-growth software vendors which produce the required funds from their own operations do emerge. But relying solely on this source is difficult, and only one example from our set of case studies was developed in this way.

That company is privately-owned Systems Union, now a £51-million revenue business with 24 sales offices worldwide and an installed base of 17,000 licenses for the Sunsystems package. Systems Union has achieved its compound annual revenue growth rate of 46% over the last 10 years primarily by bank overdraft and re-investing retained profits. The company could possibly have grown even faster, in particular by acquisition, if it had access to external funding.

Pemberton says the major difficulty that Systems Union has encountered with bank financing is that while banks will lend against up to 65% of the company's debtors, they will not lend against overseas debtors. This has been very limiting, considering the company's dramatic overseas expansion.

On the world scale, the picture is much the same, with few privately-owned companies making it to the top. Notable exceptions are SAS Institute, Attachmate, Quark, Candle and Cincom. The rest have followed the much-travelled path of raising equity funding.

Equity finance

The nub of the matter in equity finance is that in return for receiving money, you must give up some ordinary shares and yield at least some control over the operation. A lot of entrepreneurs can have a problem with that.

As Autonomyn's Lynch put it in an interview last year: 'This sort of secret-huddling-around-the-table over an idea is a very English thing, and it's holding the whole industry back. To get funding, you are going to have to give up something.'

The entrepreneur's other great fear is that he or she only has so much equity to trade, and when it comes to pay day - for example, trade sale or initial public offering - he or she wants to have a reasonable amount left to cash in. The real issue is whether or not you are comfortable having a small slice of what can become a very big pie, or whether maintaining control - in the form of voting rights attached to ordinary shares - is paramount. Even small pieces of pie can be very tasty. In the case of Tetra, founders Sean Dowling and Roderick Cooke owned only 14% of the shares each after initial public offering, but this was equivalent to £5.6 million each! Henry Beker was down to just eight per cent - equivalent to £6.5 million - when Zergo, the company he founded, moved onto the London Stock Exchange in 1998.

One of the greatest truisms of equity fund raising is that the best time to start looking for investment is well before you actually need it, because this is an exercise which can prove tortuous and drawn-out. Having the money lined up well in advance is particularly important if funds are required for acquisitions, which once identified usually need to be completed quickly.

Types of equity funding

So with those markers laid down, let's look at the four options for raising equity finance: business angels, venture capitalists, trade investors, and the stock market listing or float. (The table on the facing page summarises their suitability for the three key stages when a software vendor needs funding.)

1. Business angels

This term describes an individual who invests his or her own funds in a company, and who also gets involved in some aspect of the business in a non-executive, part-time role. This source is usually appropriate for an investment of anything from £50,000 up to £250,000 (as part of a syndicate).

It is most suitable for companies seeking seed capital, or which are at an early-growth stage.

Often, business angels are people who have themselves started and run a successful business before cashing in. Staffware is one example of a company that successfully went down this route. Founder John O'Connell highlights in particular the non-financial benefits which their angel brought to the company.

O'Connell has capably filled the role of chairman, and led the effort to float Staffware on London's junior stock exchange, the Alternative Investment Market (AIM). He has been able to get on with the day-to-day running of the business.

Business angels look for two prime things in any investment: a reasonable return on their money (although generally they have a lower return expectation than say a venture capitalist), and most importantly, opportunities where they can get actively involved, usually on a part-time basis.

Business angels will therefore be more attracted to products and markets about which they already know something or have some of which they have experience. For example, Coda founder Rodney Potts is actively involved in a number of small software businesses. Ideally, business angels can contribute some functional expertise that the business is lacking. Hot buttons which stimulate this interest can be very effective in garnering their interest.

What most distinguishes business angels from other investors is that they do not have to invest in any company. They can take it or leave it, unlike an institution which having raised a fund of money on the promise of securing good returns, needs to put it away somewhere if it is to generate those high returns. Of course, this is not to say that the institution needs to put its money into your particular business. This can mean that business angels' attitude towards investment can be suspicious and a little cynical, and they may often be looking for reasons to say no.

The biggest problem is identifying a business angel, which is commonly done through the company's accountant. There are also a number of business angel networks which are designed to act as an intermediary between the company and potential investors.

For these reasons, you will need to prepare a different proposal for business angels than for other investor types. A proposal must emphasise opportunities for direct involvement. As business angels reject many proposals based on personal investment requirements and their own preconceptions, you often need to target large numbers to find one willing to invest.

Venture capitalists

Some venture capitalists get bad a press in the UK for their reluctance to invest in software companies at the early stage, particularly in start-ups.

Venture capitalists are generally interested in companies at the development or expansion stage, with a funding requirement of at least £250,000. Some venture capitalists will have higher thresholds. Many invest as part of a syndicate of venture capitalists to spread the risk, particularly when the total investment requirement is greater than they would normally be comfortable with.

Quite a number of the UK venture capital companies have been involved with our cast of companies from an early stage, if not necessarily at the moment of start-up itself.

For example, once it had proved a viable concept and launched its product, Select Software was financed through a combination of loans and equity from the UK's largest venture capitalist house 3i.

One year after start-up, founder Stuart Frost wrote his own business plan and began the process of looking for venture capital.

It took about nine months to raise the initial £160,000 from 3i. The company put in up to £300,000 for 33% of the ordinary equity over a number of years, and a further £3.5 million in the form of loans and preference shares. Indeed, Frost even says that Select broke the record for the most rounds of funding from 3i.

3i's patience was well rewarded, when Select's initial public offering (six years after 3i's first involvement) valued the company at $45 million (£28m).

So what do venture capitalists look for when assessing investment opportunities?

First, they are only interested in businesses with very high growth potential.

This presents the entrepreneur with a significant challenge of balancing the need for hockey stick projections (some dip in profits initially, followed by exponential growth) with the need to come across as a company firmly rooted in reality.

Venture capital is all about trying to achieve a reward commensurate with the perceived risk involved. Of course, venture capitalists realise that all investments are risky, and that risk cannot be eliminated. But it can be minimised, or at least factored in, if they know about it in advance.

There are about four types of risks which concern venture capitalists and which promoters must address effectively if they are to raise funds from them:

• Product risk - the product will not function properly; there are problems in the technology; the application will get blown away by some new cool thing coming down the track; or the product lacks sufficient uniqueness
• Market risk - customers do not have a strong enough need for the product; they will not be able to afford it; the competition will be too strong; or it will cost too much to sell the product to customers
• Financial risk - the product proposition will not be profitable; the business will not have sufficient funding to last the course; the business model will not work (sales, marketing and product spend will not generate the revenues predicted); future funding requirements have not been adequately considered
• Management risk - the team lacks experience; it does not have skilled managers for each key function, such as finance, sales, marketing or technical; its members lack charisma; the team is not committed enough to growth. Venture capitalists are wary of what they consider to be a so-called lifestyle business.

By far and away the most important is the management. An average product with a good management team will always get backing ahead of team of novices in charge of a great product - unless bringing in external management is up for discussion.

This makes sense: having capable management in control of a fast expanding business is critical to its success.

Topics that generate the most discussion among venture capitalists will be the company valuation, and thus the percentage of the ordinary share capital that the venture capitalist will want. Company valuation is more of a black art than a science, although most venture capitalists use a figure based on historic profits or discounted future profits to help estimate value. It is really all down to negotiation.

Another key issue will be venture capitalists' ongoing involvement, and how much control they will want to have over the direction of the company.

They will normally want to appoint a non-executive board member to represent their interests and ideally contribute to the strategic management of the business. But they would be less directly involved than a business angel.

A further important discussion point will be the 'exit'.

The venture capitalist makes no money until he or she can sell the shares on to someone else. Recognising this end-point from the start will help discussions.

There are two realistic exit options, unless the management can generate the wherewithal to buy out the venture capitalist: a trade sale to another IT company or, less usual, an initial public offering - which is a stock market listing.

Timescales for the venture capitalist exit will vary, but a five-year horizon is generally acceptable to both sides.

The point that tends to generate the most ill feeling regarding venture capitalists is the high return they seek on their investment.

To understand the thinking behind a venture capitalists who are typically seeking a 40%-plus compound annual return, you need to consider their complete portfolio of investments.

A common portfolio might be made up of 15% of companies, which can yield a total loss; 25% partial loss (venture capitalist may get the original investment back); 30% or 'the walking dead' (still going, but with no hope of an exit); and 30% winners (where you generate a positive return).

To ensure a good overall return from all its investments, venture capitalists need the winners to generate a significant return to compensate for the expected losses in the rest of the portfolio.

One of the less obvious benefits of venture capital involvement is the discipline that they can ensure a company adopts in the areas of management reporting, preparing accounts, and justifying actions to external investors.

These are valuable lessons for any company with thoughts of seeking a stock-market listing in the future.

Successfully raising funds from a venture capitalist requires that you focus only on those companies known to be potentially interested in your particular market or product category. A scatter-gun approach is almost bound to fail. Next you must spell out the significant growth potential which exists in your business while addressing the four key risk factors.

You will need to take a realistic view on company valuation and the need to plan for the venture capitalist's exit. If have a choice, choose the venture capitalist which brings more than just money to the table - perhaps specialist expertise or a good network of contacts.

Trade investor and sales

An alternative form of equity investor may be a company also involved in the IT business - a so-called trade investor.

Sometimes the investment may be at the start-up stage. More commonly, trade investors get interested when a vendor has developed a product and is seeking funds to bring it to market.

Many of the large software, hardware and IT services players operating on a world scale regularly make investments in small companies, usually motivated by a desire to gain access to, if not control over, some new piece of technology. This is often called corporate venturing. Trade investors are more appropriate for technology products as opposed to business applications.

For example, SunSoft took an early position in Iona (a 25% stake for $600,000) because of its interest in using Iona's Orbix product to make its Solaris operating system work with Windows. Intel has recently taken an equity position in Zergo as part of the latter's acquisition of Baltimore Technologies.

Such investments can often deliver great credibility for an early-stage company's technology. The money can also be important, with trade investors often paying a premium to access strategically important technology, or just because they are in a better position than neutrals to understand the potential of the technology.

If a minority stake is at one end of the spectrum, the other end is a trade sale, whereby the company is sold in its entirety to another software vendor.

While initial public offerings are often termed end-games (rather erroneously, considering the view that a listing is just a means to the end) trade sales really are an end-game. Indeed, many companies considered trade sales before ultimately deciding to float.

Coda has faced the possibility of trade sale a number of times in its history. Coda was approached by McCormack & Dodge at the end 1989, but the proposed deal fell apart through corporate changes outside of Coda's control. Four years later, Coda founders began thinking seriously about what they were going to do with the company. They favoured a trade sale, but by this stage the company was really too big for this to be an attractive alternative.

Chief executive Rodney Potts engaged merger and acquisitions specialist Broadview Associates to look for a suitable candidate. After discussions with Misys and American Software, the team decided Coda was better off going for an initial public offering. However, soon after listing on the London Stock Exchange, Coda ran into trouble as its core virtual address extension (Vax) business turned down dramatically, and the newer open systems version of its financials application took longer than expected to come to market.

Coda struggled for a couple of years, and the upshot was that in March 1998, Dutch enterprise resource planning (ERP) vendor Baan bought Coda for £53 million.

The Baan deal appeared an attractive option, with the promise of greater marketing muscle and broad geographic reach. Rather ironically, Baan itself has since run into difficulties recently, with rumours now circulating that it is an acquisition target.

From the national viewpoint, the downside of trade sales is highlighted by the current debate in Israel. Although it is now a world leader in high-tech development - boasting 1,500 start-ups from a population of only 4,000,000 people - there are no truly big Israeli technology companies. This is mainly because many Israeli companies prefer the softer option of selling out to larger corporates (typically US companies) rather than trying to build global computing businesses themselves.

Israel is now a very popular place for foreign companies looking to access innovative technology, and this has engendered a short-term time horizon in many Israeli start-ups.

As a local venture capitalist comments: 'Instead of developing their businesses for the long term, which would create an advanced Israeli industry that could contribute to the gross national product, the strong companies are selling out to foreign giants.'

Securing the backing of a trade investor is only likely if there is a clear strategic motivation for another IT company to get involved with your product.

This means finding someone who wants access to your particular technology or application. The number of candidates will therefore be small, and readily identifiable. Trade sales are a commonly used end-game, although the company will probably change radically under new parentage.

Part two follows next week. Making it Big in Software - a guide to success for software vendors with growth ambitions by Peter McHugh costs £20 and is published in the UK in July by Rubic Publishing (ISBN 0-9535487-0-8) For more details, visit the Rubic web site at www.rubic.co.uk.

WHERE ARE THEY NOW?

CBT Systems (1983) is one of two Irish software vendors included in this study. CBT is a leading provider of interactive education software for IT professionals worldwide. The bulk of its revenues are generated in the US where its corporate headquarters are now based.

Coda (1979) developed what became acknowledged as one of the leading high-end financials packages worldwide, growing into a global business with local operations in nearly 25 countries. It ran into trouble delivering the open systems version of its product and ended up being acquired in 1998 by Dutch enterprise resource planning (ERP) vendor Baan.

Iona Technologies (1991) is the second Irish software vendor profiled in this study. In just seven years, Iona has built a $83 million business and a market leading position in middleware software. Its flagship product is called Orbix, the first implementation of the common object request broker architecture (Corba) standard - an industry standard for object communications defined by the Object Management Group. Iona has headquarters in Dublin and Boston. The US is where it made its first sale and now accounts for over 70% of its revenue.

Kewill Systems (1972) is a diverse business operating in four different markets: ERP, ecommerce, logistics and computer-aided design. It has grown via an aggressive acquisitions strategy, and now generates nearly half its revenue outside the UK.

London Bridge Software (1992) sells high-end debt management software to banks, utility companies and mobile phone companies. The company has recently built a strong position in the US via numerous acquisitions, and in the Far East via a start-up operation. Its shares were one of the best performers on the London Stock Exchange during last year.

Rolfe & Nolan (1974) sells software and services to commodity brokers and financial traders, and has operations in all the key markets worldwide. The founder stepped aside in 1986 (although he maintained a non-executive role for the following 10 years) to bring in new management which could drive the export business forward.

Select Software Tools (1988) is notable for having the youngest founder (aged 26) in our cast, and being one of the first UK software companies to list on Nasdaq - the US stock exchange. Select started by selling low-end modeling tools, but has expanded to encompass a full software development environment. It has struggled in the recent past to maintain management stability, with the founder recently stepping down.

Smallworld (1988) is a world leader in high-end geographic information systems. It has a very geographically-dispersed operation, with its major markets in Germany and the US. Most of the original founding team of nine are still with the company.

Staffware (1980) competes in the workflow market, where it has built a world leading position. It decided to focus on this market in the mid-1980s, when its original financial consolidation software business began to face serious competition. Run by the original founder, Staffware has built a truly global business with operations in 30 countries and an extensive partner network.

Systems Union (1981) has customers for its mid-range accounting package in nearly every country in the world, where it sells primarily through a reseller network. Uniquely among our cast of case studies, Systems Union has grown to a substantial business without ever taking in equity finance. It is still run by the original founding team.

Tetra (1979) has a long history of selling accounting and distribution software via a channel network, and now operates in the broader ERP market space. The original founders made way in 1996 for management experienced in building international business, and since then, Tetra's export revenues have grown to account for 40% of total revenues.

Zergo (1988) sells Information security, encryption and public key infrastructure software on the global market. Following acquisitions of several competitors, Zergo (now called Baltimore after its most recent acquisition) is a $30 million business, with footholds in most of the key export markets. An early raiser of venture capital, Zergo moved from the Alternative Investment Market on to the London Stock Exchange in 1998.

(The date is when the original company was formed).