A Financial Model Explaining Why Venture Capitalists Struggle with Nanotechnology Startups

After building a financial model for a generic nanotechnology startups, this blog quantifies the financial issues venture capitalists have finding a reasonable payout within time.

The venture capital community is a financial intermediary. Venture capitalists (VCs) collect money from wealthy institutions and individuals and invest it into early stage companies. A fund is only the sum of dedicated capital and the VCs are responsible for returning an above market return to the investors into that fund. Every VC has their niche and return profile, but the typical fund lasts about 10 years. Now the risk profile of any one company is high, but the VC mitigates that risk by investing in multiple companies. So, if a VC invests in 10 companies from a fund usually; 4 are failures, 3 are OK and 2-4 pay enough to support the fund’s expected return. With this investment scheme, VCs typically look for at least a 10x return on their money within the 10 years the fund is open.

Many people have discussed the challenging investor environment for hard technology companies. Some call it The Innovators Gap other note a number of challenges. But no one has tried to quantify the problem with VC investment in nanotechnology. So, I put together a financial model for a nanotechnology startup and stacked it up against VC’s expected payoff. The analysis that follows shows a pretty big hurdle for investment. Namely, nanotechnology startups have a really hard time reaching 10x within the 10 years time horizon.

Phases to Technology Start-up

Generally speaking, every startup goes through the same three phases. First there is early research and development. Here, the company uses investor money to develop a process and product. They do this without revenue from customers. This development phase gets the technology to a point where it is ready for customer engagement. The next phase is customer engagement. This phase usually takes 2-3 years but gives time for customers to try your new stuff and integrate it into their product. There is testing, product integration and supply chain verification. It is worth noting that every startup I have worked with has assumed their product will take less than 3 years for a customer to qualify. Every one of these companies has been wrong. Thirdly, and most importantly, there is revenue ramp. This is an exciting time where the team’s hard work is finally realized. This last phase is also the most stressful and challenging time for a growing company. Customer expectations are high and the results are real. This phase ramps fairly quickly for a materials startup. Invested capital is leveraged quickly and financial success start to drive the direction of the company. At a high level, these three phases drive the life of a materials startup.

 

The phases to a nanotechnology startup

 

Now, for this article we are simply looking at the finances of a nanotechnology startup. We aren’t getting into false starts, leadership issues, or fundraising issues. We are just focusing on time, margin, capital requirements, and exit multiple. Now, I have put together dozens of financial models for startups and have lived the life of a materials startup. So, I can say that this model is a good general representation of a start-up company. Yes, every start-up has its own challenges, and you can point them out in the comment section of this article.

In a broader sense, I am here to help build empathy and understanding for the challenges VCs face when deciding to invest in a materials company. If you understand why a VC says no, you are better equipped to guide them to yes.

 

A General Model for a Nanotechnology Startup

The financial models are built around a “typical” nanotechnology startup. This company will spend 8 years in R&D at an gradually increasing burn rate from $115k per year to $1.5M per year. During this time no revenue is realized. There is a three-year customer engagement period. During this time initial capital investments are made to build-our process capabilities. R&D is held constant but overhead and customer engagement costs are increased to the operating expenses. Some revenue is realized for the trials, but the amount is nominal. The revenue ramp period is met with exponential growth where revenue increases to $12M within 5 years of operations. The company is cash-flow positive by year 4 of revenue ramp, or year 15 from founding. Gross profit increases from an initial 45% to 85% over the first 5 years of operations. This is due to improvements in efficiency and economies of scale. R&D costs are gradually decreased over time while SG&A is gradually increased as the company builds out. An additional $10M capital infusion is required before the company is able to support $20M in revenue. This is for equipment purchases and increased labor costs. Depreciation is included in the model, but it does not have a major effect due to our using EBIT multiples to calculate exit valuations. Below are some graphical representations of the companies revenue, GP, and cumulative cash flow.

Revenue COGS and GP for a general nanotechnology startup

Cummulative cash flow and capital investment for a nanotechnolgy startup

Speed of Commercialization

To study the impact of speed, we expanded from 1 “typical” model to 4 models that range in speed to market. The primary difference in the models is the time spent in the R&D phase. The cost structure is kept essentially the same. The chart and graphs below compares the 4 models.

Model Name

Years spend in R&D

Years to Reach $30M Revenue

Fast

3

15

Medium Fast

6

18

Medium “typical”

8

20

Slow

11

23

Revenue Ramp Comparison for Speed to Market for a nanotechnology company.png

Other Variables

Beyond these four models I also looked at; gross margin, capital requirements, and EBIT exit multiple. These parameters heavily influence the payout timeline for a company. The table below summarizes the ranges of entry.

Model Name Range
Product Margin 40% to 90%
Invested Capital $2M to $100M
EBIT Multiple 8x to 24x

Exit Multiple and Timeline

In the Venture Capital world, a 10x return on invested capital is the golden standard for success. A 10x return means that the liquidation event results in a venture team receiving 10 times the money they put into the company. For simplicity I am assuming the VC group owns 50% of the company equity and the company has not pulled in any debt to finance the operation.

Exit multiples are relatively straightforward for the materials space. Based on a public database from NYU, we have assumed an exit multiple of 17x EBIT, similar to the specialty chemical space.

This analysis looks at the number of years it takes a typical nanotechnology startup to meet the 10x multiple for a VC investor.

 

Model Results

Time in R&D

Between the fast and slow ramp models, the payout timeline for a venture group ranged between 16 and 31 years. The time to payout increases exponentially with year sin R&D. This implies that there are additional costs incurred with delayed customer engagement beyond simply the cost of operation.

Year to 10x payout veruss years in research

 

Model Name

Time in R&D

Years to 10x Payout

Fast

3

16

Medium Fast

6

20

Medium

8

22

Slow

11

31

 

Product Margin

Surprisingly, however, time in R&D was not the largest driver for VC payout. Long-term product margin plays the largest role in company valuation. Increasing gross margin from 40% to 90% resulted in a 9 years increase in exit timeline. This means that every 10 points increase of margin resulted in roughly 1.7 year decrease in exit timeline. Between the fast and slow models, exit timelines ranged between 11 and 30 years. While product margin is a critical component for long-term success, it is often the hardest to quantify early in a start-up’s development. This only highlights the need for early technoeconomic modeling (TEM).

Year to 10x payout for venture capitalist based on product gross profit

 

Years to 10x Payout

Product Margin

Fast

Medium

Slow

40%

21

27

30

50%

18

24

27

60%

16

22

25

70%

15

21

24

80%

13

19

22

90%

12

18

21

 

EBIT Multiple

The next largest driver for exit timeline is the exit multiple. In this case I varied EBIT multiple between 8x and 24x. These cover the entire range of possible exits for healthy companies in the materials and chemical space. Within this range, we found that for every integer increase in EBIT multiple, there was a 0.4 year decrease in exit timeline. This is an interesting insight into the value drivers for VC’s. Usually exit multiple is a larger value driver. Instead, it appears that incubation time and revenue ramp of nanotechnology start-ups negate the impact of EBIT multiple. That, or the EBIT multiple range for materials startups is overly narrow due to the age of the industry.

Year to 10x exit for venture capitalist based on EBIT exit multiple

 

Years to 10x Payout

EBIT Multiple

Fast

Medium

Slow

8

20

27

31

12

17

24

28

16

16

23

27

20

15

22

26

24

14

21

25

 

Capital Requirements

Finally, I assessed the effect capital investment requirements have on time to payoff. Looking at capital investments between $2M and $100M. Similar to EBIT multiple, we found little impact on years to a payoff. Based on the linear regressions of the trends, I found that an increase in investment of $10M resulted in roughly a 1-year increase to exit. While initially surprising, this only means that the investment payoff is least sensitive to investment amounts. Hard to say if this is encouraging or discouraging to VCs though.

Years to 10x exit for venture capitalist over range of capital investment requirements

 

Years to 10x Payout

Capital investment ($MM)

Fast 

Medium

Slow

2

13

18

21

10

15

20

23

50

20

25

28

100

25

29

36

 

Comparison of Sensitivities

To summarize these findings, I have included the chart below to help compare and quantify the effects each variable have on VC payout. As you can see, the largest impact is product gross margin, while the least is EBIT Exit Multiple.

Comparison of relative sensitivies to VC payout for typical nanotechnology startup

The 10-year Payout Problem

Taking a step back for a minute, there is one glaring problem for a VC. None of these payout timelines fit into the 10-year investment horizon for a VC fund. That’s a real problem. Furthermore, the most ideal situation, where a company only spends 3 years in R&D, ramp revenue quickly, product margins are 90% and realizes a 24x EBIT multiple, a VC will be able to meet their 10x return in 12 years. In my experience, no nanotech company has accomplish that scenario.

So, what does this mean?

First, it means that VC should not fund research projects. That may be obvious, but the venture model to date has focused on pre-revenue companies. What venture capitalists haven’t realized is that a nanotechnology company that is pre-revenue is still a research project.

Second, the company’s exit multiples increase quickly as soon as they start generating revenue. This is where VCs love to help companies accelerate in this way. It creates a win-win. Not to mention most of the technical risk has been decreased at this phase. This means that the valuations can be higher as well. Look at the plot of exit multiple by year after generating revenue.

Comparison of Exit Multiple after Revenue generation for nanotechnology startup

 

Summary

This has been an in depth look the investment profile and payoff for a venture capitalist into a generic nanotechnology company. Obviously, this is a grim picture of what many nanotechnology entrepreneurs are facing. It also highlights the concerns VCs face when vetting a nanotechnology company.

A key takeaway is that VCs may want to start looking at post-revenue companies. Some may say a post-revenue play investment is for private equity. I disagree. A nanotechnology company that is just getting out of the gates is not established enough for a private equity company. There is a second valley of death here that materials startups have to get through. VC actually fit the investment profile better than private equity for nanotechnology companies below $5M in revenue. Ramping revenue quickly still requires large capital infusion, building out the leadership team, operational excellence, and more sophisticated forms of customer engagement. VCs are great at that stuff.

The next article will look at new go-to market strategies and investment models that decrease hurdles for a nanotech startup and help companies get across the valley of death.

That’s all for now! Thanks for reading!

Thoughts on this article? Please post comments and questions below!

 

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