Why investors should take a stake in high-growth UK tech companies

 
Robin Klein
THE campaign to reawaken the London tech initial public offering (IPO) market has kicked off. Recent announcements from Downing Street and the London Stock Exchange should result in some small but important regulatory changes. They are important steps towards making London a major hub for tech IPOs.

But regulation is not the only barrier to a robust and vibrant IPO market. A number of other parts of the ecosystem need to simultaneously evolve, not least investor confidence. The common view is that Europe’s public markets are not ready for international tech companies. However, blow away the myths and institutional investors will see that early-stage tech is nothing to be wary of. Indeed, the space is a rare ray of light in an otherwise gloomy economy.

So what are the myths? One common concern is the issue of governance structures and procedures. But those tech companies that are backed by venture capital firms have strong governance built in from their first investment, which is typically a Series-A funding round. Formal board meetings are held, usually monthly. Compensation and audit committees are commonly set up and meet at least annually. Key decisions will normally need investor director or shareholder approval. The governance rules are set out in the company’s articles and shareholders agreement. By the time the typical fast growth technology company is ready to come to the market, governance will have been refined and tightened. Good governance is in their DNA.

Then there is the worry that early-stage tech companies will have dominant shareholders, directors or founders running the company. In fact, tech companies seeking IPO will typically not have any controlling shareholder. All preference shares would be converted to common stock. The founders will generally own less than 50 per cent and there will be at least two venture capitalists, often four or more. The company will typically have little or no debt. Venture-backed companies are, by nature, equity funded. The distinction between this and the typical private equity backed company could not be clearer.

With the founders, perhaps a bigger challenge is their ability to adapt to life running a public company. But even though this will be an entirely new experience for many of them, being accountable to a board or shareholders will not. To get to this stage founders, chief executives and chief financial officers will have had to have raised multiple rounds of finance, involving many detailed presentations to investment committees. They will have been required to take investors through detailed accounts, budgets and three to five year plans.

Some are worried that flotation is designed to allow founders and other shareholders a quick exit. But the main reason we have pushed for the minimum float rule to be reduced from 25 per cent to 10 per cent is to align founders’ longer-term interests with incoming investors in terms of flotation price. A 25 per cent dilution is a large one for a founder to take, especially for one whose business is growing at more than 50 per cent per annum. But a 10 per cent float feels less like selling out and more like another funding round on the road to building a large successful company.

Over the past few years, some of the most successful exits by European companies – including MySQL, Skype, Playfish, Lovefilm, Net-a-Porter, Last.fm and PanGenetics – have been trade sales, while only a few such as Genmab, Betfair, Asos and Addex have gone public. This begs the question: are there enough suitable tech IPO candidates in Europe?

In short, yes. Last year the 100 fastest growing private tech companies had an average growth of 81 per cent with total revenues of £2.8bn. These companies already employ 11,000 people (adding 7,500 annually) and 75 per cent of them had operating profits as well as rapid growth. Of these, 40 are backed by venture capitalists or private equity firms, and 51 per cent are still majority owned by their founders. Following the Facebook debacle, the US tech IPO market is now heating up once again. Isn’t it time Europe took its first steps and followed suit?

Robin Klein is partner at Index Ventures.