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What are the 3 criteria measured by the investment community in evaluating investing behind technology IPOs?
A seasoned panel from Wall Street made the comment on what criteria they observe for an investor to be attracted to a technology company’s IPO. One panelist summed it up nicely – Growth (Potential), the Path to Profitability – and Risks (how are they addressed).
I keep jumping back to “growth” and how it must be demonstrated through traction. Institutional investors are not running non-profit programs. Retirement funds need to grow their portfolio’s values. Individual investors need a higher return than a common commercial bank’s savings rate. The company must achieve double digits.
Recently, an acquaintance related to me the frustrations in attracting $10 million investment. I asked what sales do you expect to achieve in 5 years (with current sales only hitting $500k). He related to me $20 million. So they are shopping around for investors to put in $10 million and expect to attract them. Now, if $20 million is returned in 5 years, the ROI would be 20%. But that is unrealistic—that a company would forgo all net revenues to pay back the investors and it is also unlikely. It is my understanding that the $20 million would be total revenues, not net income. If so, we are looking at a much longer time span than 5 years. The ROI drops to single digits. Since these investors are knowledgeable, they are not attracted by the story line.
The other factor – path to profitability – really relates to the strategy. How does the company intend to expand? Where will it achieve economy of scale? Where will it reduce its costs?
I have an example of a company in the health field that relates to live support to patients. The average phone lasts 15 minutes per patient. But as the model suggests, the more patients one brings in, the more trained phone responders the company must hire. That road to greater profitability is not possible with this model – unless one builds a software program that simulates a human voice and can interact with the patients.
Finally, every investor places a premium on return when risks are higher. What do they mean? I recently heard the business process description for a way to move personal items internationally. For example, if you need to purchase a purse in France, this person would bring the product back. The risks are several – whether the item would be purchased. Whether declaring the product purchased would bring about a duty being charged by the authorities. That some of the products would be illegally be brought in. Hence, higher risks mean higher return demanded by the investors.
Some of these risks are competitive in nature. For example, how do you intend to handle a direct but very large competitor? IP rights might help, but not always. Again every investor has been burnt in one form or another. If the company cannot directly analyze and counter each risk, the investor will go away.
For example, going back to the $10 million seeker, the company holds patents for a specific semiconductor gas sensor. During a meeting, the founder had not bothered to look at other patents in the same space. And that alone was costly, since it would reduce the risks if they had compared those patents in the same space.
Again – every company must respond to the following elements to attract any investor - growth, path to profitability and risks. And these ingredients make common sense.