Where do start-ups go to die? The strange reality of Picassos in the cemetery

Paul Adams on businesses that failed.   Paul Adams talks about his latest column on NBR Radio and on demand via MyNBR Radio.

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Globally about 120,000 businesses fail each day. The failure rate by country and by industry/sector varies greatly, but a rule of thumb in the USA at least is that roughly 80% of all new businesses will fail within the first 18 months. Of those that survive, many more than half will not make it through the next three years.  

Of the 2 million new businesses created annually in the USA a few thousand receive venture capital (“VC”) funding, but the VC failure rate is no better than the average. Ironically VC funded companies don't fail fast when investors bail out. Unlike their less well-capitalized peers, VC-funded companies tend to die slowly, eking out their last capital round over an average of 20 months of terminal illness. Such VC funded failures have consumed a median of $1.3m of shareholder funds before they expire. But VC’s bury their dead quietly, as Shikhar Ghosh, of Harvard University has noted and this statistic goes unheralded.

Irrespective of the source of funding, the three primary reasons for the failure of new businesses are: 

  • Dysfunctional leadership or management team breakdown.
  • Weak business model 
  • Insufficiently differentiated market or product position 

To these three we would add a critical fourth reason: raising insufficient capital to fund initial growth.  This is a major problem and we come across it daily.  

The liquidity bubble has increased availability of early stage funding
One consequence of the global credit collapse in 2008 has been a bull run in equities, as low interest rates and monetary easing has pumped liquidity into the market.  This has supported a strong IPO market (for life sciences in particular) and generated significant gains for many Angel/VC investors. The trade sale market has also boomed over the last few years as larger companies raise cheap debt and use it to acquire others. 

The impact of Central Bank funding has led to falling yields on bonds and encouraged many high-net-worth (“HNW”) investors into diversifying into more risky investments such as venture capital, often with tax breaks.  The net effect of this is that it has never been easier to raise small ($1-3m) money for start-ups. It’s always challenging to explain to entrepreneurs that they need to think about their capital structure from the beginning, but this is one chicken that always comes home to roost.

One problem for start-ups in accepting small amounts of money from high net worth investors is that the initial due diligence tends to be cursory, given the limited amount at stake. It is in effect a lottery ticket.  Equally problematic are those investors who have made extraordinary gains in a bull market and ascribe those gains falsely to their own investment skill.  The non-discriminatory investment approach from both of these types of investor eliminates a valuable filter for non-viable businesses, sets unrealistic pre-money valuations for a second (“up”) round and provides the context for super-negative reactions when/if things do not go according to plan (which in a start-up they never do).

A further consequence of this style of investing is that it does not attract aligned or strategic investors with the intention or the capacity for follow-on money. For management teams there can also be another less evident consequence, which is that a culture develops where “respect for the money” is not engendered.  This can be catastrophic later on.

Intellectual Property due diligence is a bedrock for investing in early stage companies
One element of the funding decision that is almost never addressed properly by the due diligence common in first round money is the intellectual property of the start-up.  This may include freedom to operate (infringement risk analysis), the potential strengths and weaknesses of the intellectual property, chain of title (does someone else actually own the intellectual property – more common than you might think) and the potential/likely sale value of intellectual property to competitors, each of which provide valuable insight into the intrinsic value of the new business.  Since the company’s intellectual property often underpins its product differentiation and business model, doing this work early addresses two of the three most common causes of business failure. Perhaps understandably the primary reason for not doing this work is cost.  A good intellectual property due diligence study runs between $10,000 and $50,000.  For a start-up raising $1m this is not insignificant (1 - 5% of funds), but without this work the combination of indiscriminating capital and poor insight into intellectual property has failure as a likely outcome.

Intellectual Property is the orphan of business failures
When a business does fail the next stage at which value is destroyed is in liquidation. The intellectual property assets of early stage companies are often abandoned or sold for a fraction of their potential value by shareholders anxious to get something back quickly or write off taxes, administrators who lack the expertise and management teams who are anxious to move on.  This is particularly true in technology or life science businesses, where the failure rate is highest, but also applies in other industries such as financial services and education, where failure rates are also very high - 50% even after 3 years of operations.

In the last few years we have been asked to value, find buyers or finance IP for a number of failed businesses in multiple industry sectors. Typical cases have included telecommunications patents, domain names, biotechnology patents (particularly in genomics), medical device patents, designs and manufacturing, polymer manufacturing patents, customer lists and trade secrets and even entire management and R&D teams seeking a new home. What each of these different situations has had in common are that the intellectual property in question is poorly articulated and documented, the owner has no real idea of the market demand/value (often either wildly over or under estimating value) and is receiving no clear of useful advice from their current advisors.

Monetizing value from insolvency or collapse
The process of analysing the quality of the assets in these situations, identifying potential buyers or licensees and then conducting an appropriate sale process is often expensive and time consuming for start-up intellectual property, however it can yield gems. In the past five years we have seen patents from failed start-ups sold for millions of dollars, failed business assets being re-launched with new management and money (>$50m) and targeted private auctions resulting in investors recouping a significant percentage of their initial invested capital. We recently assisted in the sale of a patent owned by an otherwise “failed” start up that went for an eight figure sum, generating a 45 fold return for the investors – that’s a VC sized return from what was otherwise a salvage operation. 

To sum all of this up: start-ups are often overlooked in terms of the intellectual property value that they hold, in part because of the nature of the funding process for new ventures which is heavily influenced by investor sentiment and indirectly driven by macroeconomics. The failure rate of start-ups however makes looking for value in the wreckage of a start-up business a worthwhile endeavour for investors.  Often the failure has nothing to do with the intrinsic value of the proposition or its intellectual property. In this context, if large companies might be thought of as having “Rembrandts in the Attic” then failed start-ups can equally be described as having “Picasso’s in the Cemetery”

Co-authored with Chris Donegan. Dr Donegan is CEO of EverEdgeIP UK. He is a partner at Azure Wealth LLP, a specialist wealth manager based in London, Geneva and Zurich, He holds BSc and PhD degrees in Biochemistry & Microbiology and Molecular Neurobiology from Leeds University and Imperial College, respectively.

Paul Adams is CEO of EverEdge IP.

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