I: Executive Summary
The nature of innovative technology start-up assets exposes the firms that create them and their investors to risk. For new technology products there is uncertainty about the real future demand - uncertainty in the ouput market. And since many technology products rely on other technology suppliers, be they product, service, labour, the input market is also uncertain.  It is therefore natural that investors will want a very high return for their leap of faith. Matching the players with the ideas to the players with the money in a form that suits them both is a delicate balance. Thorough business analysis will help them both better understand the assets under development, the potential risk and make for a better partnership.  

II: The nature of innovative technology assets in start ups  
At the start of a new venture many of the assets created out of innovation in technology tend to fall into the intangible category, as they result from exploitation of intellectual property. These assets can be difficult to quantify and codify because of their inherent complexity. For the most part the complexity of theseassets implies that they will be inimitable i.e. they will be initially difficult for competitors to copy e.g. SAP's ERP system. This means an investment into painstaking research and development without guaranteed return.  

However, though complex, the nature of intellectual property driven assets is that once they have been created once it can be easy for the owner of the rights to replicate the asset. For example Oracle's database software, while selling for tens of thousands of dollars can be replicated onto a CD-ROM costing only a few pounds. This will require careful attention to and expenditure on legal fees and patenting. It also significantly increases the risk surrounding the venture for investors.  

Further down the line firms start to invest heavily into supporting IT systems – as the intangible becomes increasingly linked with the tangible.Given the “clustering” characteristic of technology, the new assets are often dependant on complementary assets – since new ideas are formed at the forefront of old.  

III: Case Study: “Pushme-pullyou”’s cash flow  
The company “Pushme-Pullyou” has been working on a piece of software to pull infotainment content to consumer mobile phones and push statistics on the consumer usage back to a global management system in order to promote similar types of recommended infotainment to the consumer; with an increasingly complex array of products, pushing content to an apathetic consumer seems to be key to leveraging content revenues.  

First feedback from prospective B2B clients including operators and device manufacturers are promising and Pushme-pullyou now seeks funding. The technology is in a very embryonic stage however there is little uncertainty as to whether it will work; the bigger problem is that the industry is pre-consolidation and and even if their product works and is sold, it is doubtful that it will turn a profit for many years since more and more investment into iterative development will be needed to keep it ahead of a desperate competition. The cash flow that results from the creation of pushme-pullyou’s software follows a J-shaped curve.  

As a sector technology empirically exhibits high unsystematic risk. The massive weeding out of new technology firms when the Internet bubble burst is familiar to many people. The fact that rivals kill off technologies quickly and that shakeouts can occur in relatively short periods leads to an accelerated resolution of uncertainty for technology firms. Like the the development of the iPhone, Pushme-pullyou will have to continue to cannibalise its own market until the products and technologies start to converge.  

The pushme-pullyou managers can be seen to possess “real options”[1] in terms of their development decisions. Often firms like them will create a platform from which to launch further successful products in response to changes in the market. The cumulative cashflow is therefore drawn out into multiple shorter negative cashflows which prolong the time needed to obtain a positive return. Constant reinvestment may create a technology cluster which results in high barriers to entry and a practical monopoly; but investors will wait years to recoup the initial investment. 

 IV: Innovation Funding  
Funding for innovation will therefore reflect the characteristics of the assets created and of the product market in which the firm operates. High risk, uncertainty and time variables lend the investments themselves to real options valuations and staggered investment.   Fortunately initial investments in Research & Development can be relatively small in comparison with future the investments required for full commercialisation of a successful product. Since the product market gives quick feedback in prototype and commercialisation stages, many lenders can be persuaded to invest in the early stages as long as the potential loss is managed robustly. Some investors may consider that convertible debt is an appropriate vehicle for example since it means constant return of high interest which can also be converted into equity of the venture takes off. Companies will therefore typically require multiple-stage financing to work through the product lifecycle.  

As the cycle moves from innovators through early adopters into the early majority, culminating in a mature market, each stage typically requires different levels of resources and financing. Beware of the “chasm” which lies between the early adopters and early majority – the delay between these two stages will often cause firms who do not watch their cash flow to go under. The nature of the assets and product market ensure that technology firms will always pay a high cost of capital. 

 V: Characteristics of Sources of Finance
With public funding in general there exists high information assymmetry between managers and investors. Because investors will typically encounter the management team on a roadshow and use a prospectus to gain an insight into the firm, their knowledge is restricted to what the management team discloses. Trust has to be built in a very short period of time and even if funding is secured in the form of equity, the voice of the market as demonstrated by the share price will drive development in to a short termist reward pattern as opposed to slow steady growth. Administration and regulatory compliance may well weigh heavily upon a company which does not yet have the structure in place to support it.   If public debt is the preferred route, the same asymmetry exists and the firm is required to guarantee fixed repayment, even though it will likely have variable cash flow.The available security, which technology firms have to offer, is often of uncertain value. If the security is based on ‘work in progress' on the development of some intellectual property it may not be possible to realise value from that assets until a threshold in development has been reached. Whereas accounting regulation may allow capitalization of R&D once market feasibility is achieved under some circumstances that is no guarantee that the asset is in fact liquid.  

Private bank debt is equally characterised by significant information asymmetry and fixed replayment obligation. The provider is risk averse, usually more so than management or shareholders and this can limit management’s flexibility in fund raising.  

Private equity on the other hand is usually characterised by low information asymmetry. Providers (venture capitalist, VC, or high net worth individuals) meet the management privately and exchange company confidential materials with a due diligence process performed in many cases. The VCs are sophisticated informed investors, who will see many firms in a given sector and typically retain on their staff technologist and entrepreneurs. VCs can provide much flexibility, multiple rounds are common. One VC may syndicate a deal with others for a later round. The company retains control over competitively sensitive information by limiting the conditions and number of people to whom it is exposed. 

VI: Matching funding with growth  
In selecting the source of funding management seek to match the nature of the assets held and created with the characteristics of the financing available.From the discussions above we can match technology asset characteristics as follows:

Although not inevitable in all cases the table argues strongly in favour of equity over debt and private over public. The J-curve cash flow requires a leap of faith which public providers of finance are too risk averse to make. The firm’s management may not be able to explain with any clarity the true value of the assets to the public equity or debt providers. There is a lack of commonality of background between the parties that hinders effective communication and management may wish to deliberately restrict the publication of sensitive information for competitive reasons.  

VII: How business cases can persuade investors that your venture is not a lemon…A, B & C  
How can you persuade finance providers that they are not buying a lemon? The answer lies in entering into a meaningful and deep exchange of information with them. This exchange should not only occur at the time of the initial funding transaction. Continual monitoring is recommended to reduce information asymmetry over time. Following the process of pre-launch appraisal to post investment review is therefore very important.  

Planning for multiple stage funding can be assisted by using investment appraisal tools like decision trees, tornado charts and goal seek sensitivity analyses. Even more sophisticated analyses can be performed using real options or models showing several different scenarios.This kind of analysis and its supporting documentation, providing that it does not undermine the main objective of time to market, is a very clear indication to VCs that the business understands the nature of risk surrounding its products and has the appropriate expertise regarding the principles of finance. These analyses translate non verbal communication in the form of time, commitment and passion and are the true market signal to a savvy investor that the new product or service is not a lemon.  

Business cases (used in this sense as a definition of quantitiatve and qualitative evaluation) for the development of intangible assets requiring staggered investment should consider the following:  

A) Always include…a No-Go scenario!
In most cases a business case represents at the very least a binary decision – go vs. no go (in fact many decisions are more complex than this, but let’s keep it simple for now). This means that there will always be two scenarios.Even for a new product which has not yet secured funding, there will be financial and strategic consequences of discontinuation. Whilst one financial consequence of discontinuation may not be an incremental cash cost for decision making, but a write off on the P&L of a sunk cost, this should be at least a criterion of consideration. If people have already spent time and money developing a product, there may also be get out costs – redundancies? Continuing patent fees? All of these would exist in the no-go decision.  

At the later stage of development where the product starts to cannibalise itself, the no-go decision scenario becomes even more important. Given that a the business case is the delta between the go/new and the no-go/business as usual decision, the actual uptake of the product should be quantified in customer numbers, an assumption made of how many customers will migrate from the existing product to the new product and whether the price and corresponding usage will be different. Only by defining both, can you accurately assess the difference between the two on a comparable basis and can revenue and usage analysis be performed. Investors will be impressed.  

B) Always include…a cost and breakeven analysis!
In technology it is far easier to predict the costs than to predict the revenue. However often the cost comes as an afterthought!   All costs should be separated not only into their appropriate accounting category but also their behaviour category. Software, hardware and networks usually have a predefined variable or stepped capacity and can be tied via formulae to customer numbers.  

They can also come in the form of fixed costs which are components which tend to be unaffected by fluctuations in the levels of activity or unaffected at least in the time period considered;   If done correctly, a correlated cost breakdown can accurately model the breakeven point which is of even more importance in the start up world. It will also permit you to negotiate possible fixed costs either to a lower cost or to a variable cost and thus reduce the risk of your project and encourage more investment.

Remember, high business risk should be supported by low financial risk.

C) Always include…a sensitivity analysis
As a general best practice, sensitivity analyses should be included for all investment appraisal. However it is even more important to have modelled and tested the “what-if”scenarios and to have them in your pocket for those cross examinations to which cautious investors are prone.   It will

Sensitivity analysis can prompt you to reconsider the nature of the problem by identifying the route cause of the problem.   If you business case is thorough enough you will be able to answer “what-if” questions thrown at you by investors. Being able to answer “The Five Whys” will convince the most sceptical of protagonists of your expertise and thus make them far more likely to believe and invest in your future success.  


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