Dragons and Unicorns: turning business fantasy into reality

FanDuel was associated, if only by implication, with rare negative headlines last week when authoritative US media outlets including the Wall Street Journal reported that FBI, Justice Department and state law enforcers were investigating the legality of the fantasy sports sector and its relationship to gambling, although it was FanDuel’s rival DraftKings whose customers were said by the Journal to have been contacted by authorities.

There are questions about the accuracy of the reports, but it might be supposed that even unsourced rumours of closer official interest in the sector in which the Edinburgh-based company is grabbing more and more market share might worry one of its main investors. Not at all: “We are seeing the growing pains associated with an extremely high profile and very fast growing business” is Anderson’s response.

Being able to cut through the noise – positive and negative – is just one of the skills Anderson has acquired in a career that, for all his modesty - “we tend to let our companies speak and through that we get any credit we deserve” – makes him one of the most respected figures in Scotland’s budding tech start-up sector. With exceptions like FanDuel, the companies he deals with are usually B2B players and not yet household names. Scotland’s economic future relies on a healthy pipeline of investable companies that can keep Pentech rooted up here, rather than drawn away to London, where much of the Pentech partners’ time is already spent.

Anderson reveals that Pentech is about to follow the success of the overwhelmingly successful second, £45m VC fund that includes FanDuel, with the launch of a third fund, believed by some close to the sector to be around 40 per cent larger and is “looking for interesting early stage projects to scale them internationally.”

The occasion provides a good opportunity to look at why Anderson and colleagues Craig Anderson (no relation), Mark Moens, and Sandy McKinnon occupy such an important place in Scotland’s tech start-up scene.

The Pentech difference, as he describes it, is not very complicated. Unlike many of those who speak the jargon of the tech start-up “space”, many of whom have emerged from the world of business services such as chartered accountancy rather than business, the Ayrshire-born technologist’s real-world “operational experience”. He built up and sold off his own software tools business early in his career (see panel), and also has wide and varied international corporate experience.

Anderson describes how he only became a business financier in 2000 because he “couldn’t really think of another new technology business to start”.

“There was a gap in the market for a venture capital business where the folks who were involved had operational experience and had been through the process themselves.”

“There’s definitely a place for people from legal or CA backgrounds, but its better if you have a lot of operational experience to help chose the companies and help them develop in the earliest period they are trying to establish the product.”

In the heady days of the turn of the century, the “peak craziness” he concedes, of first tech bubble, Pentech pulled together its first VC fund.

“It raised 2001 and that of course is when the bottom fell out of the technology sector. Raising an early stage fund at that time with people who had never run a VC fund was quite an achievement. We raised £22m so it was a small fund, and out of that we made 11 investments in early stage software businesses throughout the UK.

“We raised 70 per cent from institutions, the European Investment Fund who are a very active fund of funds. Pentech also had SWIP, as they were at the time, now part of Aberdeen Asset Management, and F&C now subsumed by Bank of Montreal. The fund was topped off with some high net worth private investors as well.”

Although the timing was off, given the bursting of the tech bubble at the time, Anderson’s own hard-won experience, as throughout his investment career, supplied any missing credibility.

“The idea that having a group of people who understood technology taking a product to market definitely resonated so the process took a year to get the whole thing together”

Anderson now looks back on Fund One as “an expensive learning experience”.

“The companies we invested in were quite costly to get off the ground, they were deep intellectual property enterprise software companies, requiring fairly expensive sales and marketing infrastructure to get the first customers and prove the business. Our approach was - and still is - you should give companies the least amount of money at the beginning to prove the business and only once you’ve proven it do you give them money to scale the business.”

“That’s really the core DNA of what we do: to use our skills to identify companies that we think are quite interesting, with interesting products, and could do well on a large market and then prove the business as cheaply as possible.”

“We didn’t do a good enough job really in Pentech Ventures Fund One, and then of course 2007 happened when the bottom fell out of the market. One of our businesses was wholly focused on the financial services sector and all of a sudden their sales went to zero. There are challenges when you’re a small fund as that was, you don’t really have enough capacity to deal with the shocks that appear in the economy.”

While the progress of Fund One was “definitely not what we hoped for” there was enough of it that by 2007 was good enough to allow Pentech to raise its £45m Fund Two, the one that contains FanDuel, along with other companies like Maxymiser (cloud-based market testing software, sold to Oracle), Acunu (data storage platform), Nutmeg (“wealth management for the masses”), Secret Sales (ecommerce discounting for brands), and Semetric (online music analytics), which has of course been a very different story.

“Out of that second fund we made 12 investments, using the same approach, choosing companies that we believed had interesting products, generally early-stage companies that we believed could help prove their business fairly modestly without too much capital.”

“That fund is performing very well, even if we didn’t realise all the value of the 12 businesses we have invested in we have now sold half of them. We have done a good job of acquiring interesting businesses.”

Just how well is not divulged at this stage, nor are the identities of some of the purchasers of companies that have been sold off under confidentiality agreements, some to household name tech giants.

“We have got five portfolio companies left, we anticipate that we will have exited our [Fund Two] portfolio, certainly the bulk of it by the end of 2017, so over a ten-year period we would be disappointed if our net internal rate of return (IRR) isn’t upper quartile compare to the gold standard which is US venture, which makes us one of the leading VC funds in Europe, and we expect the performance to be upper decile by the end of 2017. That’s quite good, though it's venture, so lots can go wrong.” Anderson won’t be drawn on percentages, but a top 10 per cent fund would equate to an IRR of around 40 per cent.

“Quite good” is a characteristic understatement from Anderson, who remains calm even when talking about the astronomical growth (and likely “liquidity event”) of FanDuel which promises very rich pickings indeed. Pentech also narrowly missed the chance to consider investing in Skyscanner by a matter of months, leaving the field open to the public-sector spin-out Scottish Equity Partners, a near-miss about which he is characteristically philosophical.

Given the close attention and oversight – for example his regular visits to start-up incubators like CodeBase in Edinburgh - does he think that, led by our unicorns, that Scotland’s tech start-up sector is on the verge of acquiring the kind of critical mass that attracts stand-out international attention?

“It would be great if all our portfolio companies were in Scotland, and I definitely hope that with Fan Duel and Skyscanner, companies that are making great progress, when they get their major liquidity event, the result will be a large number of reasonably wealthy, tech-savvy people who have been through start-up-to-exit in those companies. That’s bound to have an impact on the eco-system here which would be fantastic.”

The employees who do really well will be the young tech entrepreneurs whose experience is just amazing. If you think about the growth they’ve seen, the process they have gone through to win customers, the partnerships they're signing, all of the steps they’ve taken to take their company from zero revenue as FanDuel’s was four years ago to where they are today [an estimated $2bn in gross revenue this year, with estimated profit of $200m (£130m)].”

Undoubtedly the liquidity event will be great for Pentech’s profile as well, as VCs tend to benefit from the “halo effect” of a portfolio company that performs well.

“Entrepreneurs tend to like to do business with VCs who have had spectacular successes, because to have that success you have generally built an amazing network of other investors and partners and you’ve seen a lot and been through the process.”

Will Scotland’s outstanding successes act as a magnet for future tech unicorns and a crowded VC marketplace? Anderson is convinced that critical mass will be easy to come by. As it is, Pentech and Eddie Anderson’s own corporate citizenship, giving advice and talks to Scottish start-ups is clearly very significant in giving depth to the tech business community here, as others in the start-up eco-system attest.

But location in Edinburgh is a lifestyle choice rather than an essential part of the business plan, as London is where most of the Fund Three companies will be based, and where the investors are as well.

“If we saw 15 or 20 portfolio companies were based round the corner here in Edinburgh that would be great, if they were all based in London that would be fine too. We are led by where the good opportunities are, we don't really mind.”

The hope has to be that the good opportunities continue to be here, as Scotland’s excellent academic base, smaller-scale angel investors, and growing private and public support infrastructure suggest that they should be. More skilled and battle-hardened VCs would be a boon to Scotland’s start-up world, and losing the ones we already have would be step in the wrong direction.

Steady Eddie: a profile

Originally from Ardrossan, Anderson studied Applied Physics at Strathclyde, moving directly into software. Working for BT’s research department he “naively” set up a software tools company Objective Software Technologies with money raised from angel financiers Archanges. A modest success, the firm pulled off some licensing deals, including one with a NASDAQ company Wind River Systems, to whom the business was sold in December 1998 for $7.5m “enough to pay off the mortgage”. He continued to work for them, running development teams in Scotland, Austria and California, before forming Pentech in 2000.

The six steps to getting to a dragon to invest in your company

Out of every 150 companies that approach Pentech Ventures looking for funds, only one of them is likely to leave the meeting punching the air. Asked to describe how he makes that decision, Anderson describes it as "70 per cent objective or analytical and only 30 per cent subjective".

Here are the "tests" he applies:

1. Does the product resonate? Does it sound interesting and does it fit a need, based on our knowledge of the ecosystem that the product is trying to find a place in?

2. How much would it cost to get one user to use that product?

3. How much is that user likely to spend over their lifetime using the product?

4. How many potential users are there out there?

5. Do the dynamics of the business change if you are trying to get a million users to use the product?

6. The subjectivity part: Presuming that all these fundamental numbers stack up, then does this team have what it takes to actually make it happen