By Matthew Cushen For early stage investing under the Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS) in the UK, the timing of the onset of the pandemic added to the turmoil. March arrived – normally the busiest month for tax advantaged investing – and we were struck with something where none of us could anticipate the short or long-term impacts. Hence a reticence from investors to commit. Anecdotally we hear most funds were at 50% of the prior year levels. The Start-Up Series Fund invested just a little more than in 2019 – but well behind our growth trend. It’s only as we turn from June to July that investor activity seems to be picking up. With a common question – what can we expect to happen to valuations? And by implication, are investors better off waiting before committing to seed investments? SCENE SETTER 1: VALUING A START-UP We have a simple way of looking at start-up valuations. It is only vaguely related to the science of valuing an established business – there is not enough data to make objective calculations. It’s more a way of having an objective conversation. We talk about Evidence x Momentum x Potential = Valuation. It is a qualitative framework not a quantitative equation, but one maths principle is deliberate. It has multiplication signs, not plus signs. If any of these elements are missing the result should be zero. Evidence: the proof points the start-up has already gathered – early revenue, or even some insight or research. Momentum: an entrepreneur capable of executing, a clear plan for the next steps and delivering on previous promises. Potential: the scope and scale of market, the competitive dynamics, the strength of innovation and the probability, speed & multiples available for exits. Entrepreneur column by Matthew Cushen: The Valuation equation SCENE SETTER 2: THE PRE-CORONA CONTEXT Many seed investors have seen valuations getting ‘frothy’, or in some cases egregious, for a while. Overweighting the value of potential, based purely on a great idea with very little in the way of evidence or momentum. This seems to be particularly true of crowdfunding, probably as there is not a proper objective conversation between entrepreneur and investor. We have always been conscious of not getting sucked into sectors where valuations have got out of step with potential and ensuring that the entrepreneur is clear on the value we add and therefore is motivated to keep the valuation fair for both parties. So, to the question: what can we expect to happen to valuations? In our view, there are three forces in play: impact on individual sectors & propositions – from lockdown and then the more sustained changes in behaviours that are starting to emerge macro-economic spending & investment supply of & demand for funding. 1. IMPACT ON INDIVIDUAL SECTORS & PROPOSITIONS When the pandemic broke, we moved quickly to help our portfolio businesses understand the impact and how they had to change their priorities. And frankly, for the first few weeks we struggled to comprehend the full impact. Over the last couple of months this has become clearer and we use this simple matrix to contrast the short-term impact of lockdown from the long-term impact of systemic changes to behaviours. I’ve included 5 examples from our portfolio: Weekly10: subscription software for companies to measure and improve employee engagement and business culture, and performance on business objectives and goals. The immediate impact of the lockdown was to suspend all the conversations they were having. But they were fortunate to have launched their Microsoft Teams add-in a fortnight prior to European/North American lockdowns (to add to desktop, iOS, Android & Slack versions). Then fundamentally, they are perfectly positioned to take advantage of a long-term shift to remote working. Therefore, the job here was to shift the sales & marketing effort from a sector-based strategy to maximise short term customer acquisition driven by remote working. Since then they have been adding customers quickly and now their more strategic conversations are starting back up again. Bedfolk: direct to consumer retailer of their own ethically produced, high quality bedding. They had already been growing very quickly – delivering 25% more sales than promised between our first investment in April 2019 and April 2020. Concurrently with further improving their brand, marketing and introducing new product, they have benefitted from a huge increase in eCommerce whilst shops have been closed and a particularly marked increase in spending on homewares as consumers spend more time at home. Their proposition, centred around nesting & wellness, is well positioned for current, and we expect continued, consumer sentiment. At some point, they will lose the homewares tailwind but the long-term shift to eCommerce is here to stay, so we are confident they will maintain a strong growth trajectory, just a little less spectacular. Both Weekly10 and Bedfolk have added to their evidence and accelerated their momentum. Then systemic deepening of remote working (for Weekly10) and the even faster growth of eCommerce (for Bedfolk) have increased their long-term potential. Vitrue Health: smart motion detection and depth sensing hardware and software for physiotherapists & orthopaedic surgeons assessing & treating musculoskeletal (MSK) conditions. The lockdown has been difficult as it curtailed some very successful event based selling activities. But the team changed their approach quickly to both selling (going to virtual demos) and to product development, including a smart and timely method of assessing posture through a webcam, so posture assessments can be conducted at scale for home offices. Their solution – that has patients in an out more quickly than current assessment – should prove a little more attractive as physiotherapists return to their practices with a reduced capacity. And the increase in home working is not reducing the incidence of poor posture! So, whilst they lost and then regained momentum through lockdown, the proposition is a net a little positive for the long term. Zobi: has a first product, the Hedgehog, a patent pending cybersecurity device using artificial intelligence to discern between routine and non-routine communication between Internet of Things (IoT) devices on a network. Zobi are pre-revenue, busy getting their first production run started and finalising their software. For which there has been no impact of lockdown. There is maybe a slightly positive impact in the long term, as more people are working from home, so more corporate IT boffins are getting exercised by home network security – exactly Zobi’s target market. Nightly: a new way to book hotels – giving travellers the option to switch hotels once during their trip to get the best value, a different experience and save as much as 70%. Unfortunately, a devastating impact of lockdown – zero revenue. Then we expect the increased hassle of travelling over the next 18 months (at least) and a sensitivity to turnaround times (for both traveller & hotel) makes their core proposition much less attractive long-term. This is the one business in our portfolio that we will lose as a result of the coronavirus. 2. MACRO-ECONOMIC SPENDING & INVESTMENT Our view (lightly held – this is evolving) is that consumer and small business spending will, of course, be heavily impacted but that it will be polarised. There are plenty of individuals and small businesses that have not had their income impacted by lockdown and have some pent-up disposable income to splash. But sadly, there will be swathes of unemployment. Looking at sectors, the pain to a large extent looks likely to be felt by those that were suffering before, in a further widening of the wealth gap. So we expect premium products & services (like Bedfolk or Zobi) to be less impacted by consumer spending slowdown than those targeted at a more mainstream audience (likely Nightly). Business investment appetite is very sector specific, but we expect enlightened businesses, that have the cashflow, to continue to invest. For a business like Weekly10 that appeals to progressive leaders looking after high value employees this could bode well. For those like Vitrue Health selling to large & small healthcare providers, that are likely to have been heavily cash impacted, this might prove to a headwind. 3. SUPPLY OF & DEMAND FOR FUNDING Anecdotally funding has slowed up over the last three months. And most deals seem to be follow-on from existing investors, with the occasional business that has a short-term opportunity and needs cash to fund it fast. We see pent-up demand for funding that is likely to lead to a downward pressure on valuations. It’s difficult to predict how supply will pan out over the medium term. Clearly investor sentiment is impacted by losses in public equity markets, but equally many investors see that early stage businesses are less impacted by global turmoil. Young businesses are generally quicker to adapt. They have relatively little revenue to lose, cash flow is more driven by spend – when resources become cheaper. Although inherently high risk/high return, the relative risk between seed investing and public equities narrows when risk with public equities increases. We anticipate that the remainder of 2020 will be a behind 2019 but volume will pick up in the first quarter of 2021. There is an argument that investors able to act early could pick up extra-keen valuations this year. So, I’ve laid out some forces at work and some examples. Whilst studiously avoiding a broad-brush prediction of decreasing or increasing valuations. The pandemic, and more importantly the longer-term changes to behaviours that result, will have an impact. But, as ever, valuations deserve to be looked at opportunity by opportunity and it will have a positive impact if more investors and the entrepreneurs they are talking to, take more objective and considered views to get to a fair valuation.



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