Luke Johnson: The madness of investing in booming digital firms

Software firms offer tempting opportunities for VC investors - but often they are too risky, says Luke Johnson. He's taking a punt on a restaurant in Florida.

by Luke Johnson
Last Updated: 07 Jun 2016

My brother-in-law Lee is a software engineer who has helped create a couple of successful technology startups. I co-invest with him in a modest way in a few situations a year, relying on his ability as an IT wizard to identify value.

This is classic, small-scale venture capital - the deals tend to be early-stage opportunities that are inevitably high-risk but we hope potentially high-reward. It is a fairly long-term game, so we don't yet know the ratio of winners to losers.

These involvements have reminded me that there are very profound differences between VC investing of the sort Lee does and my mainstream activity at Risk Capital Partners, which is providing development equity.

One of the biggest contrasts is that almost all VC investing requires multiple rounds of funding. Hence each investment is not simply a case of making the first decision to participate - in all likelihood investors will face a series of occasions when they must choose whether to stick or twist, to borrow a metaphor from card gambling.

If you do not up the bet each time, you suffer dilution - even if the valuation of the business is higher. This means you cannot easily predict at the outset what your ultimate financial exposure is likely to be, or even the scale and timing of further cash injections.

A second, similar deep gulf exists between the pricing of companies I back at RCP and the expectations of high-tech investors. Typically, I like to value businesses at no more than seven times operating profits.

At the other extreme, advisers to booming digital firms suggest that they usually sell for a multiple of five to 10 times revenue - of a business that may well not even be in profit yet. That is apparently a common metric used by big corporate buyers when acquiring such sexy assets.

This is a market and an era when money will pay an extraordinary premium for growth. To me, it is close to madness and I can't begin to understand the reasoning.

Nevertheless, I hope my deep ignorance doesn't put off any possible bidders for my brother-in-law's dynamic projects.

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Later this year, I become chairman of a wonderful organisation called the Institute of Cancer Research. This London charity is the UK's leading academic research facility and the world's most successful drug discovery centre. I am very excited at being involved in such a great British success story.

The achievements of the ICR are a rebuke to all those who doubt our international prowess in science and medicine. The institute leads the world in isolating cancer-related genes and identifying new, targeted pharmaceuticals for personalised treatment of the disease.

Yet its budget is a fraction of that of its major competitors such the New York-based Memorial Sloan-Kettering Cancer Centre, which has vastly more financial resources at its disposal. For example, the ICR's scientists discovered and patented abiraterone, which is now branded as Zytiga and is being marketed by Johnson & Johnson in the US as a ground-breaking treatment for advanced prostate cancer.

I hope in my new role I can raise more money for the ICR's vital work and help it further exploit its intellectual property to beat cancer.

Like traditional venture capital investing, finding new cures for illness requires patience - I know I have much to learn about the subject. But that all adds to my keenness to contribute. In a way, my career has come full circle: I started off as an undergraduate studying physiology at Oxford and now I'm devoting my energies to supporting the battle against the world's deadliest disease.

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Last year I took a punt on a recovery in the property market in the US and bought a delightful seaside home in a sleepy resort in Florida called Cocoa Beach. It is next to Cape Canaveral, famous as site of numerous rocket launches since the 1950s, and less than an hour from Orlando airport. I'm pleased to say house prices there are improving, so it looks as if my bet may pay off.

While there, I couldn't resist also buying a closed freehold restaurant called The Surf Cocktail Lounge, once famous as a haunt of off-duty astronauts. This classic establishment is at the heart of Cocoa Beach's downtown and opened in 1948, before there was even a town hall or traffic lights. It went bust because the most recent owners borrowed too much money from the bank, and I purchased it out of bankruptcy.

Over Easter, I attended a meeting of several key downtown landlords, who all want to see this rather faded district revamped. City officials went too and indicated an extraordinary enthusiasm for any sensible development plans that will bring more life, jobs and investment to the area.

It was a hugely encouraging experience and a reminder of why the US is such an entrepreneurial country. There, public servants appear to welcome private money and, rather than burden business with regulations and restrictions - as do planners in Britain - they try to do whatever they can to make improvements happen.

Given the sunshine, the friendly locals, a reviving American economy, and the chance to help transform a whole neighbourhood, I am seriously considering doubling up my exposure and making The Surf the go-to venue in 2014 for cool Floridians. I will let readers know how the scheme unfolds.

Luke Johnson is chairman of Risk Capital Partners

This diary appeared in the May edition of MT

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