Magazine article Financial Management (UK)

When Our Chip Comes in ... How Do Venture Capitalists Make Informed Decisions When Appraising Investments in High-Tech Firms Whose Inventions Are Still in the Early Stages of Development? Gavin Reid and Julia Smith Report on Their CIMA-Sponsored Project to Identify Emerging Practice in Risk Management

Magazine article Financial Management (UK)

When Our Chip Comes in ... How Do Venture Capitalists Make Informed Decisions When Appraising Investments in High-Tech Firms Whose Inventions Are Still in the Early Stages of Development? Gavin Reid and Julia Smith Report on Their CIMA-Sponsored Project to Identify Emerging Practice in Risk Management

Article excerpt

Venture capitalists are becoming distinctly jittery, about current proposals to force the consolidation of accounts of all firms within their portfolios. The new procedures will take effect in January, yet many experts believe that consolidation doesn't make much sense. The issue of how to evaluate and account for the risks inherent in early-stage high-tech firms is therefore of topical importance.

The government and the UK accounting bodies are interested in promoting high-tech investments. For example, the DTI issued a consultative document on equity gaps in small and medium-sized enterprises, proMoting the case for venture capital funding at regional level to support new high-tech businesses. The accounting bodies are pressing for reforms in the treatment of intellectual property such as that found in high-tech firms which leads to patented products. They favour simplifying intellectual property taxation with a view to encouraging innovation. For quoted high-tech companies, they favour an improvement in risk management by directors to secure a low cost of capital and increase shareholder value.

From a financial reporting point of view, venture capitalists are interested in how firms value the intangible assets tied up in their intellectual property as protected by patents, licences, trademarks etc. FRS10 recommends three ways to value an intangible: the amount it could be sold for; the difference between cost and fair value if it has been purchased; or by reference to any active market where frequent trading of such an asset occurs. In the US, intangibles are covered by FAS142, which has changed how goodwill is treated. In short, it means that investors now have to look much harder at a company's accounts to determine the long-term value of particular stocks.

In the case of high-tech firms that produce goods for untested markets, the valuation methods suggested by both these standards may prove unsuitable. So how are intangibles such as intellectual property valued when the inventions are new and untested? And what approach do investors use to evaluate potential investments in high-tech companies?

The dotcom meltdown of 2000 made UK venture capitalists wary. of high-tech investment to the detriment of the country's science base. For instance, 3i recently confirmed a dramatic cutback in venture capital and private equity investments, and the pattern is similar throughout Europe. Although risk is likely to have been a major reason for this, incomplete alignment of incentives, financial structure and human capital, among other things, have all played a role. As well as these internal factors, there have been external problems including spill-over effects--for example, a lack of supporting infrastructure and a failure to supply venture capital, entrepreneurship and innovative products.

From the investor's point of view, a high-tech venture can seem unstructured, risky and hard to control. In its development form, it can seem too much like a research project. The problem of cost overruns on such projects is endemic and investors often feel that they are being asked to bear all the risk without any clear sign of the prospective rewards.

Such an involvement undoubtedly embodies a considerable business risk. This is caused by the complex, competitive environment in which the high-tech companies operate. In a sense, competing firms are racing to be first to gain an entitlement to the intellectual property embodied in a new technology. So-called action-reaction effects come into play here: firms will redouble their efforts if they are close to their rivals, but will quickly give up if they feel outstripped in the race. Reading how other firms will behave in these situations and crafting your strategy appropriately are key aspects of this form of competition.

Another important category of risk is agency risk. This generally arises from an incomplete alignment of incentives between economic agents. …

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