Calculating an investment decision

While visiting California in January 2001, I decided to call in on a company that I'd learned had a neat little product that supplied an excellent messaging and bulletin board system. Expecting the company to consist of a handful of dedicated technologists, I was amazed when I walked into sumptuous offices with hordes of employees.

What I'd discovered was one of the fabled dotcoms, a company that had acquired $10 million dollars of venture capital funding within a year of startup. From the original two founding partners, the company had expanded to a staff of around 50 people that now included some very high profile sales and marketing executives together with many illustrious technical experts. The company looked very busy and were justifiably proud of their growing customer base. To all the world it looked like a successful company that seemed likely to be satisfying the requirements of the venture capital company that had organised their funding.

However, if we go back in time to when a decision was made to fund this company, we can go though some of the calculations that might have been made. Firstly, we'd look at what the £10 million dollars might have returned as a less speculative investment. Let's say it could have been invested fairly safely by spreading the capital around many different established companies to provide an average return of 7.2 %. That is $720,000 per annum.

The investors would be looking to significantly better this return to be able to justify the risk in investing in an unproven venture. However, it would be accepted that such profitability would take some time to materialise. Lets say this time would have been estimated to be three years: not an unreasonable projection.

With the investment not expected to reach this level of profitability for three years, the value of the investment at that future time would have to be discounted back to be able to compare it with the present day value of the $10 million. From figure 3.2, we can see that every $100 has its value reduced 81% when discounted back at 7.2% over three years. This would mean that the value of the investment must rise to $3.346 in three years time just to retain its value.

In terms of an earnings target for the company, it would mean that the break even profitability of the company would have to be increased from $720,000 per annum to $890,000 per annum – just to equal the returns from a safe investment.

As the investor would be looking to see a reasonable gain by choosing to invest in risky ventures, it is most likely that the aim would be more like a minimum of $1.2 million per annum earnings – increasing the value of the investment by about a third. However, this extra return would only be an acceptable target if the profitability actually materialised. In reality, the company might fail, so, the risk of the company failing to make this profit has to be taken into consideration.

At the time the $10 million dollars was invested in this dotcom company in California, investors were investing in hundreds of other similarly promising e-business startups – each of whom the investors might have been confident in expecting to succeed in reaching a suitable level of profitability.

As was subsequently revealed, the failure rate of the dotcom startups was of the order of eighty percent. Only one in five was reaching profitability before their capital ran out. If this risk element had been factored in when the decision was made to invest $10 million dollars in this Californian start up, the investors would have been looking to see a profitability of five times that $1.2 million: about $6 million per annum to sensibly justify their investment decision.

To make sense of this $6 million figure, imagine the investors spreading their risk by investing not in a single company but dividing up the $10 million to take shares in many dotcoms. With four out of five dotcoms failing, eight million of the ten million dollars will have been lost, so, the remaining two million of surviving investments would have to earn five times as much to make up for the lost earnings of the losers.

In theory, it may seem possible for a company to earn $6 million per annum in profits. However, the reality is that any business that is making substantial profits will attract competitors. This competition will compete aggressively for clients, not only winning clients over to them but also raising the cost of attracting new clients. This competitive activity effectively puts a cap on the profitability any company can realistically expect to achieve.

It is like any market situation. If a store starts to earn huge profits by selling a particular item, it won't be long before other stores will be selling it. As they compete with each other for customers, the price would be driven down so that the level of profitability gradually gets in line with all other items that are on sale.

After visiting the dotcom startup in California, I used various search engines on the Web to trace the company's activities as it had been reported in various news media. I found a brief history that explained how the core product had grown out of a university bulletin board system that one of the founders had created. Another of the founders was an experienced deal maker, who had wide connections with venture capital companies in the USA.

The company had acquired an impressive list of executives that included: Vice-president of Marketing/Operations Vice President of Engineering Vice President of Sales, Director of Business Development, Director of Product Management, Director of Quality Assurance. The board of Directors included an impressive list of CEO's from the many different companies that had syndicated in the funding. At a guess I'd say this company was running with an overhead of something like $4 million per annum, in which case, they would have to be trying to obtain an income of at least 5$ million a year – which runs out at about four hundred and twenty thousand dollars a month.

When I read through the impressive looking list of executives and directors, the thought that ran through my mind was "too many fingers in the pie". It certainly didn't look like the lean and adaptive kind of organisation that was needed in a rapidly evolving, massively connected information environment. Sure they had a great product, but, it wasn't so great that it couldn't be copied by hundreds of other competent companies that had far less overheads and without the ball and chain of ten million dollars worth of investment that needed servicing.

They may have a great sales team, they may have hundreds of current clients, but, they were highly vulnerable to other companies being able to offer a similar product – at far less cost – to a market that their ten million dollars of funding had created. What hadn't seemed to have been realised was that the Internet isn't like the world of bricks and mortar where a product is established only by a strong sales force. The competition is just one click away and the ease with which the knowledge of less costly solutions can so easily diffuse through the Internet community means that everyone will soon know where that click is.

This is not to predict that the company I visited would fail, but, its not one that I'd be queuing up to invest in.