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April 6, 2016updated 21 Oct 2016 5:01pm

PART TWO: Dr Mike Lynch: How to grow a successful tech startup

Exclusive interview: How to build a billion pound global software company in the UK. Beware: VCs overvaluing their assets, tech unicorn crashes.

By Sam

The UK tech start up scene has never been hotter. Fintech and cybersecurity firms are forming at a rate never seen before. Universities are partnering with investment incubators, major research centres such as Cambridge are attracting attention as never before.

People from research are seeking partnerships with institutional investors or private funders, be they VCs, banks or HNW individuals.

At a macro level attempts are being made to lay to rest the old saw is that the UK is excellent at producing technology that other economies then benefit from. The implication that pure research was valued over grubby commerce probably goes right to the heart of UK establishment institutionalism and academia. "It was ok to be Rutherford but not to be an engineer," says Dr Mike Lynch’s whose Invoke Capital has portfolio investments in technologies that he says are pushing the boundaries. ‘"We like things that are different."

His band of nerdy techies, as he calls them, are approached every day by firms with technology propositions. Many are hoping to be the next £1bn business. But in getting there having and developing great technology is only part of the battle.

So just what is the reality of today’s relationship between the tech inventors and investors.

In the earlier part of this piece we spoke about building a billion pound start and competing (or not competing) with Silicon Valley. "If you can take valley money, set up a sales operation in the Valley, that’s great," says Dr Lynch.

But he warns what you don’t want to do is set up an R&D centre in the Valley.

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"What we’re good at in the UK and where we have a big advantage in is doing R&D. You try doing R&D in the Valley, you’ll pay four or five times the cost and the people will leave every six months. You do it here and you’ll get amazingly good people. And they’ll work long term and make good products."

And that’s where we’re going next. Where are the products?

The technology start up space, and especially the software sector can be characterised as broken down into those taking products to market and those taking marketing to products (where they don’t exist).

Products for market

Says Lynch: "Look at the list of 100 coolest people in tech and there are wonderful companies that have raised £2m and not yet shipped a product. And on one hand that’s great."

But Dr Lynch makes the cautionary analogy with oil reserves, ‘standing around in a puddle of oil is not going to get you where you need to be.’

Asked about the UK’s ability in sales, the message is that great technology doesn’t sell itself.

"The lesson there is that the biggest thing we [Invoke] have to explain when we go and see a company is that it is about sales and revenues. We are unashamedly nerdy techies here, we love stuff that is different, but that’s irrelevant if they’re not doing a sales operation. The example of an Oracle or a Salesforce is the absolute of running a sales operation. And what has to happen with these UK start-ups is that we have to get away from the lifestyle business approach."

The image that technical geniuses come from UK labs with no idea of commercial reality is borne out by experience.

"They raise some money, produce a product and then they almost avoid the customer because they don’t want to see what the customer says about it. Or [worse] have to explain why no-one is buying the product. But the whole approach has to change around because you want to get it in front of a customer as soon as possible because they’ll tell you why it is not working."

"It is a psychological issue. And it is about ambition. In the early days of the UK tech start-ups scene, there were people who would raise some money. And they would raise some more money and say ‘I’m a tech entrepreneur’ but they’d never ship a product. We’re kind of moving onto the next level. People do want to build world class products but I’ve never seen a start-up work on a product that became the product the customer wanted to buy."

Marketing real and non existent products
"The most important thing is to get out there and get that feedback. But in a similar way you sometimes hear a start-up say, ‘we’ve got this great product and our competitors have a rival product but theirs is all marketing.’ It is the idea that marketing is cheating. And [as an investor] you have to say look to the Valley. Yes there are some firms who suffer from the curse of the $100m and they put is all in marketing and there’s no product. They will fail. And occasionally over here you will see amazing technology and no marketing and that will fail. The only ones that work are made of both. So the idea that marketing is cheating is a non-starter."

One the first business conversations Invoke has is about sales, the second covers marketing because ‘actually if they come from this part of the world they are probably quite good at technology.’

Running at a loss
Dr Lynch believes the whole idea of running at a loss is massively over acceptable. There can be cases but they are rare when you should run at a loss. The argument is normally one of land grab. Well whilst that may be true in consumer shared economy, in tech, if at the end of the day, the customer doesn’t want to buy the product and use it, that’s a problem. And secondly the product doesn’t have a high cost margin, this is software, the marginal costs, are close to zero, this and Louis Vuitton bags are about the only two businesses were the costs and revenue can be so far apart.

"So if you’re not making money then there is something a bit wrong, so I’m always deeply sceptical about companies that are comfortable running at a loss," he says.

Profit, loss, valuation, (private and public valuations)
So you have your technology, you have turned it into a product you have some backing, how much are you worth?

First check the weather. The technology funding world is just like farming. Everyone forgets that when you have Summer, you will also have Winter. And that’s a relevant conversation because what’s been happening in the US, says Dr Lynch.

He quotes a recent bank report on how to spot a tech bubble.

"You start by valuing a business on PE ratio of 10, then it gets to 30. Then you move to revenue multiple, and that goes from five to fifteen, then you go to monthly average users, and then the last box is "you just don’t get it." Some of my friends have another box which is "when property developers start investing in tech, at that point, run"," he says.

And we are just entering the ‘you don’t’ get it’ phase.

Crazy valuations of privately held companies
What has happened, believes Mr Lynch is there are a whole series of false valuations in the market. Normally a company would get valued with private money and then you would IPO. Right now public company valuations are at their usual frothy level but they are normal. But, he says, on the private side the company valuations have gone crazy.

"Now the reason this is important is there is no way out. Because to get out, to get public, you need to come down in valuation and we’ve seen this with a whole series of IPOs that have happened recently. What happened, in the US, venture capital funds do mark to market. They put the value of the company they are holding up and up and up. But they can’t sell any shares at that value because no-one wants them. And at some point this has to unwind. And there is no liquidity, so it has to come down. And when this happens, there will be a shake out because those VC firms have been telling their investors that they have a 80% return. And suddenly that’s doing to disappear and go negative."

In January the investment giant Fidelity Investments wrote down valuations of pre-IPO privately held start up technology companies by as much as 17%.

Dr Lynch says there will be some pain coming. "This is what’s going on in the Unicorn space. A VC owns ‘that much’, [let’s say X-amount, then they put in ‘that much’ [Y-amount] at a very high valuation for the money the put in – but they re-write the whole valuation of the book. There are 3 or 4 unicorns in Europe that are utterly fictitious because there is no way you could IPO and trade shares in these businesses."

The message is there will be debris falling from the sky. So his advice to companies running near a profit is we are in Autumn going into Winter so run your business carefully, because the mess in the US is much bigger than here and if you can’t IPO, then how do you give the investors back their money.

So to wrap up some of the key points on what is required to have any prospect of building a billion pound technology business in the UK.

Have a great technology. When ready don’t delay bringing it to market. Be aggressive on sales and marketing and cautious on valuation. Don’t think lifestyle business, think long haul.

Coming soon, Part 3: What is happening in cybersecurity

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