Coming up for air

Emma talked to her friend Robert who met her dad Michael who rang his mate Matthew who persuaded his girlfriend Liz to back Oxygen. Take a deep breath and dive into the Internet...
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The Independent Online

So, what's the best way to get rich on the Internet? Three years ago, you probably wouldn't have asked the question. Two years ago, the answer was "buy stock in a Silicon Valley company"; last year it was "buy stock in a UK Internet flotation". This year, the response - at least for the moment - seems to be to invest in incubator funds, those companies which themselves put start-up capital into Internet fledglings, and then aim to reap the gains when those float on the market.

So, what's the best way to get rich on the Internet? Three years ago, you probably wouldn't have asked the question. Two years ago, the answer was "buy stock in a Silicon Valley company"; last year it was "buy stock in a UK Internet flotation". This year, the response - at least for the moment - seems to be to invest in incubator funds, those companies which themselves put start-up capital into Internet fledglings, and then aim to reap the gains when those float on the market.

The year started with a boom for Oxygen Holdings, the latest Internet investment fund, which on Friday saw its 2p placing price on the Alternative Investment Market (AIM) shoot up to 57.5p, valuing it at about £218m, compared to the £2.2m raised by the placing. (Excitement died down suddenly yesterday when the shares were trading at 35.5p, having fallen 15 per cent .)

You can see that there should be some very strong logic behind backing "incubator" companies. Providing they are run correctly and the companies they back successfully reach a flotation, they should reap many times what they have sown. Some start-ups will sink before they have a chance to float; but that's the nature of business.

But the incubator benefits from the balance of success over failure. Thus stocks in the incubators should bring similar benefits. Even better, you get to invest in the Internet hits of the future without really trying too hard; you leave the hard business of picking winners by proxy to the incubator's managers.

But is Oxygen's rocketing value really the result of insightful investors following this sort of logic, and making a long-term investment?

It is worth noting that the initial share placement was all with institutions, where the placing was successful despite the fact that it was on the AIM and came from a company with zero track record.

That is not how Emma Edelson, whose joint brainchild the company is, sees it. Aged 25, she is a Cambridge graduate who spent two years working for Mark McCormack's International Management Group (IMG), where she was part of a team drumming up sponsorship for the Millennium Dome. She had kept in touch with a friend, Robert Jenkin, who worked briefly at Deutsche Bank and then left to set up his own Internet company, Yellow Turtle (a portal for investor information). The two got to talking one day when, as Ms Edelson puts it, "we saw a gap in the market for student entrepreneurs which we felt was underfunded".

But where is a young woman with a big idea to go? Fortunately, Ms Edelson didn't have to go further than the family dinner table. Her father Michael is already a hero of sorts to some stock market investors for turning the Knutsford shell company from a tiny, unnoticed stock into a vast engine which for a while threatened to take over any number of targets. "He's always looking for new investment vehicles," Emma says. "But he would never have agreed to have become involved in Oxygen if he had any doubts."

She took the idea to him last summer, and they agreed that the idea had potential, investing between £100,000 to £250,000 in young Internet start-ups. The comparison the company draws is with the companies which initially backed brands like Yahoo! and Excite in the US, now famous Internet-wide. They were begun by students who had world-beating ideas far ahead of the game (in Yahoo's case, when there was barely a Web to speak of). That is now Oxygen's unique selling point: it aims to fund students with Internet ideas.

But three people with a good idea do not a market hit make. So Mr Edelson took out his own contacts book. He got in touch with a business friend, Matthew Freud, spin-guru of the PR company Freud Communications (which has repeatedly proven very successful at getting high-visibility publicity for clients such as Chris Evans's Ginger Group and ex-Spice Geri Haliwell). Mr Freud then drew in a friend, Elisabeth Murdoch, daughter of Rupert. Mr Freud is now a non-executive director at Oxygen, Ms Murdoch on the investment committee. A strange pair to have involved in something for students? "They believe in the value of the Internet," says Ms Edelson.

But did people really analyse the prospectus and weigh up the skills of the management team, or did they just feel the heavyweight nature and potential for press coverage and decide that visibility is all, even when it's for a company where visibility does not matter that much, but the skill set does? Is Oxygen just another company feeding gas into that Internet stock bubble that we hear so much of?

Brian Tora, of brokers Greig Middleton, thinks not. "Why should the bubble burst?" he asks. "What we are seeing is a very very rapid shift from one style of doing business to another. It's not like the railways in Victorian times, where the investment happened more slowly and vast amounts of capital were tied up in physical goods.

"This is all about intellectual capital taking advantage of change, trying to second-guess where it will all go in the future. That makes Internet companies maybe less vulnerable to sudden setbacks, because they don't have vast sums tied into plant or equipment.

"There's a phrase around which I rather like and agree with: the market serves to adjust the balance between demands for capital from yesterday's industries and tomorrow's industries. That's why Internet companies have no problem raising money, while engineering companies, for example, have ratings which are just derisory."

By that logic, putting money into the companies which will put money into tomorrow's companies should be the most lushly-funded around. And the numbers do bear that out - though bear in mind that we are only talking about a snapshot.

Among the "incubator" funds existing or announced are those from Alan Sugar's Viglen (whose January confirmation that it was setting up such a subsidiary doubled its capitalisation to £226m, and incidentally led to an investigation into the share dealings of Mirror editor Piers Morgan), Internet Indirect, New Media Investors, Blakes Clothing, Jellyworks, and just this week Hawkpoint and LEK, respectively a corporate finance house and an international strategy firm. And those are quite apart from the less well-known ones which have been chugging along in the background for a while - such as Apax Partners, the newer eSouk.com, Continued on page 2Atlas Ventures and the mysterious International Media Products Group (IMPG), which put £10m into Student-Net. These companies can tap into and so foster millions of pounds of venture capital funding for Internet start-ups.

This should all be good news, surely. For years, the most common wail that one heard from British entrepreneurs was that it was impossible to get venture funding, that the institutions which held the purse strings in Britain were too parsimonious to back truly spectacular ventures.

There have been many tales of Britons who headed for the West Coast, following the twofold logic that it was simply easier to get risk funding there and that having a Silicon Valley address did wonders in terms of opening doors around the US and in Britain too; whereas even a Cambridge address means "you can't get the top people to meet you," as Mike Lynch, head of the software corporation Autonomy (which started in Cambridge, but then reinvented itself as a West Coast company in order to get the big US deals) notes.

So yes, Internet incubators must be welcomed on that basis alone, and especially if you subscribe like Mr Tora to the view that the drain of funding from heavy engineering towards people who offer to deliver hand-picked organic vegetables ordered online is "the past funding the future".

But pause for a moment. The problem is that there are no hard financial facts to work from. There are no statistics about Internet incubator funds to use as a guide to the future.

Nor is there much of an investment record to determine whether the underlying Internet stocks will thrive or not. Again, we have to abstract slightly, and say: what is the best thing to compare this with?

There, a handy answer appears: the computer industry. Any Internet companies relies on computers and software, so their growth must be intertwined. And software companies, which sell such a pure form of intellectual property that only computers can interpret it, have to be a pretty good guide to the future.

Here then are the hard statistics compiled by Regent Associates recently. Its index of 402 listed Internet stocks in the US and UK showed a valuation (before the recent market dips) of $996bn (£622bn), with revenues of $28bn and losses of $4bn.

Now, to survive with those stock valuations for the next five years, they would have to achieve a price/earnings (PE) ratio of 40, a profit margin of 10 per cent and growth of 70 per cent annually.

So, can that hat-trick be done? Has it been done before? The PE ratio target is not unfeasible; a number of the bigger computer and software companies manage that easily.

The profit margin would be standard for an industrial company, and looks very modest in the computing field.

The killer is the growth rate: such a rapid expansion would be more than the five-year growths of Regent's top listed stocks, including Dell Computer (66 per cent), Microsoft (56 per cent), Misys (44 per cent) and Sage (43 per cent). To manage such growth brings its own problems, which frequently leads to dramatic failure.

For this reason, Richard Holway, who specialises in analysing British software and services, predicts that "the [dot com] bubble will burst by the end of the second quarter, because compared with established businesses they cannot deliver the goods or the profitability as well".

Mr Holway told an audience of chief executives and investors last month that, "Many [of these companies] will fail before a single penny of profit is made."

If that sounds worrying, bear in mind the further proviso that most companies aiming for fast growth will fail long before they reach the stock market. But those are the sorts of companies that incubator funds are aiming to invest in.

Within Internet start-up companies, the talk is often of one's "burn rate" - how quickly you are using up your seed capital. Paradoxically, in Silicon Valley it is seen as crucial to have a high burn rate, because of the "first-mover advantage", where being first onto the Net gives you the best chance of having an edge over your rivals. Oxygen could be just the right sort of company to give British start-ups a really bright burn rate.

But Ms Edelson is not buying the Porsches and ocean-going yachts just yet. For one thing, her contract means she is locked in to the company for the next three years. "It's paper money," she says of her apparent riches. "It won't change my life. I'm totally realistic about that. We have a hard job ahead."

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