Start up is a title which describes a very wide gamut of projects that may need external finance. They range from the commercial exploitation of an embryonic technology product, developed in a research establishment or university, to a management team setting up a business having been frustrated in buying out their own business or buying into another. Technology transfer out a research establishment is a particularly specialised process which is discussed further in Chapter X.
Potential investors are likely to look at start up proposals on the same basic criteria that they judge other types of proposals. These criteria are: what is the long term profit potential of the product or service......
There is likely to be particular emphasis placed by potential investors on the uniqueness of the product or service. Is it defensible, perhaps by patent or by a unique technology or process, through the inevitable early stage problems of a start up? In marked contrast to a management buy out or buy in, many start up proposals will be based on people, technology and resources that have not operated together before. Here, where there is considerable risk that the business will have internal operating, production or management problems, it is vital that the new company's product or service will have intrinsic competitive advantages to protect it from price or other market pressures from competitors.
Those start ups that are similar to a buy out or buy in; ie where the management team have worked together before, delivering a similar product into an known market place; will offer potential investors greater internal and operational predictability. This means that an investor might consider backing such a management team in an established product or service area where they would not enjoy any distinctive, defensible advantage.
Unsurprisingly, most start ups are a mixture of the innovative and proven. That is to say that the proposers will probably have had some appropriate management experience, that the technology will be proven to some extent and that there seems to be a market for the proposed product or service, even if it is hard to define and unquantifiable. In all cases, the management team will need to think about how they can reduce unnecessary risk from their plan by trying to optimise those elements of the business over which they have some control. Broadly, there is enough unavoidable, external risk in starting up without including avoidable risks in the plan. Areas of avoidable risk include finding the right key personnel, ensuring that the product or service has an opportunity to be assessed by the market at as early a stage as possible and ensuring that the project's projected financing needs are well thought through. While very large potential profits and defensible competitive advantage can give investors comfort about shortfalls in other areas of the project, such as the completeness of the management team, there will be minimum expectations on all the key assessment criteria.
First, it is inevitable that potential investors will expect the project to have considerable future profit potential to compensate for the risks of backing a start up. This is different to the criteria for backing a management buy out or buy in, where relatively marginal improvements in profitability can justify an investment in these projects. However, experiencet has shown that start ups have a higher than average risk of failure:
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In this context, investors must require a rate of return (see discussion of IRR/rate of return in CHAPTER X and in APPENDIX X) from start ups which compensates them for the additional risk that they carry: ie the successful investments must pay for those that fail. The calculation may well be....... However, as an illustration of a simple litmus test of profitability, the 3i Cambridge start up unit, making investments of £50,000 250,000 in 1986, used the rule of thumb that an investee must be capable of generating at least £100,000 profit before tax in its third trading year
