New Zealand venture capital desperately needs a hit—an investment that pays back, big time. Without it, our venture capitalists struggle to fund creative Kiwi companies. Mike Booker discovers why we’re sadly used to hearing ‘no’
Venture capitalists are used to taking a long-term view—their horizon is usually six to seven years out.
Just as well.
In early 2008, VC fund managers were already struggling to get the cash they needed to maintain the rapid growth of the small, precocious and risky companies in their portfolios. Then the international finance crisis hit. From its rock-bottom vantage point, the local VC industry could see the rest of the financial sector plummet in its direction. At least the VCs could sink no further.
“We’re no worse off,” says Stuart McKenzie, general partner of science and technology VC specialists Endeavour Capital. “We didn’t have much to begin with. You can’t subtract something from nothing.”
VC veteran Jenny Morel of Number 8 Ventures is less sanguine. “How do you measure the difference between hard and harder?”
New Zealand sorely needs a healthy VC market. McKenzie describes it as the “missing bit” of New Zealand’s innovation system. “We have the people, we have the IP, but the big hole is capital.” Think of it as the petrol in the engine, the air in the lungs, the fight in the dog.
And even more, we need a couple of unheralded New Zealand-based billion-dollar companies to come virtually out of nowhere. Such big companies from smaller countries— Nokia in Finland, Ericsson in Sweden and Acer in Taiwan—have given a massive boost to those economies, not just as net contributors to national GDP but as feeders to the next generations of innovators and entrepreneurs. Out of HP grew Intel. Out of Intel grew Cisco. Out of Cisco grew … you get the idea.
At the moment, the odds of a budding star getting the money its needs to bloom are nowhere near as good as they need to be. Which makes the next year in the VC market look like the most important yet.
It’s not the humming VC scene that then-Minister of Research, Science and Technology Pete Hodgson had in mind in 2001 when he announced the launch of the now $200 million government-backed New Zealand Venture Investment Fund (VIF). In the heady, post-Knowledge Wave burst of innovations, enthusiasm was high for the government to step in where the market had failed.
Even now, seven years on, the New Zealand industry is small. In 2005 New Zealand’s VC investment was 0.04 percent of GDP, compared with 0.12 percent for the top quarter of OECD countries.
Hence the need for white knight Hodgson and his trusty steed, VIF. The VIF normally invests up to one-third of the total capital (to a maximum of $25 million) in each of the VIF Venture Capital Fund partnerships with private sector fund managers. These managers must raise matching capital from private sector investors.
VIF Venture Capital Funds are typically worth between $30 million and $60 million and are expected to run for up to ten years before terminating and distributing the profits to investors. The VIF has two pots of money: the $160 million Venture Capital Programme (which had $85 million committed and $35 million allocated at the end of June) and the $40 million Seed Co-investment Programme aimed at early stage businesses.
Initially, VIF worked. For four or five years, VC fund managers had been successfully establishing new funds to support many of New Zealand’s best and brightest companies. VIF invested alongside six private sector fund managers: BioPacific Ventures, iGlobe Treasury, Endeavour Capital, No 8 Ventures, TMT Ventures and Pioneer Capital Partners. There are a couple of VC firms not tied up with the VIF, notably Stephen Tindall’s K1W1. Private sector fund managers have chipped in with $160 million in private capital, taking the total of VC invested to about $253 million, according to the Venture Capital Monitor.
The 45 companies receiving VIF investment include some of the country’s great business hopes such as Proacta [see ‘Sweet science’, Idealog #13, page 62). Endeavour Capital has notched up one exit—collaborative learning technology company Ectus—which McKenzie says returned fivefold on its original investment when it was sold to Norway’s Tandberg in 2005.
But the party ended when funding came to a grinding halt early in 2008. Cash started to dry up thanks to a slowing market; some gnarly scraps involving institutional fund managers didn’t help either. McKenzie says the situation is compounded by the current global credit crunch as investors are happy to sit on the sidelines waiting for assets that are cheap now to become even cheaper tomorrow.
The resulting shortage of VC cash hits home in a number of ways. Fund managers find it hard to get financial backing for new funds and most VIF-backed funds are near fully drawn, or have finished making new investments. Their remaining capital is earmarked for existing portfolio companies.
It’s taking fund managers 18 to 24 months to raise capital for a new VC fund after the VIF has indicated its investment support. VIF funding of $35 million has been allocated to two funds, but remains uncommitted as the fund managers seek matching private capital.
Morel says the New Zealand VC industry’s lack of size is holding back both the industry and the companies it supports. “We all get hung together. You can’t do business properly unless we do it on a proper scale.”
New Zealand VC funds are too small to reach break-even point. “This leaves us in a situation where we are desperately trying to cobble together funds, which often means there is not good structure in the funds.”
Morel says many of the VC funds are now chasing investors for new funds because their first funds weren’t rich enough to put aside cash for the future needs of the companies.
Another consequence of small funds is the difficulty in attracting offshore investors. “At the moment our funds are too small for the levels [offshore investors] invest in. That means we can’t partner properly.”
For example, when a UK investor offered to put US$4 million into OpenCloud if No 8 could match it, Morel recalls that it had to say, “We can’t do $4 million.”
McKenzie makes a tough comparison: imagine two companies in the same sector, with roughly the same product and roughly the same market. One in the US attracts $20 million. The Kiwi company has just $2 million. “I worry about our ability to compete,” he says.
With the manner of a practiced investor, VIF chief executive Francesca Banga urges patience. “It’s a 15- to 20-year journey we’re on, and we are about five to six years into it.”
And progress has been made. The first cohort of VIF-backed series A seed funds was launched in 2002 and 2003. All this money has been spent or is committed and VC fund managers are now attempting to raise series B and C funds to support the expansion of companies in their portfolios. It’s an industry truism that it’s easier to do the hundredth VC deal than the first. To get from the latter to the former requires patience and a steady nerve.
Two government moves have strengthened the industry. Of most immediate importance was last May’s axing of tax and liability rules that had put the New Zealand VC industry at a disadvantage when it came to attracting international investors.
It took the industry four years of lobbying to persuade the government to draw up legislation allowing VC and private equity investment funds to be established as limited partnerships, a standard investment vehicle for international investors. The lack of a limited partnership option meant these investors often saw New Zealand as ‘too hard’.
The other positive government move for the industry was the introduction of KiwiSaver, though it may take some time for funds from this source to flow through to the VC industry.
“KiwiSaver will be really important, but it will take time before it will [have an] impact,” says Banga. “In Australia, it was five to ten years before the compulsory savings scheme started to have an impact on the private equity market.”
But while regulatory changes can help, New Zealand Private Equity and Venture Capital Association executive director Colin McKinnon says the most important ingredient for the future health of the VC industry in New Zealand will be its people.
The industry needs funds managers who will inspire investor confidence through the quality of their investment choices and ability to nurture young companies through to a successful exit from their funds. These managers should be part of a vibrant network that includes capital markets, serial entrepreneurs, serial institutional investors and a financially literate public.
He too recommends patience. “We will have a vibrant VC industry when all the planets align; it is a matter of time. We will get results. What we don’t know is how good the results will be, and we cannot know this until some exits are achieved over the next three years.”
Ironically, the major beneficiaries of all this investment are likely to be our cousins across the ditch. That’s because Kiwi financial institutions—as opposed to companies and individuals—have failed to join the VIF party. Indeed, VIF’s current Statement of Intent describes difficulties raising capital from local institutional investors as “the number-one limiting factor in developing a sustainable industry”.
“It’s going to be the Australian funds that [will] benefit from growing New Zealand companies,” says Banga.
In 2006 it was estimated that over 55 percent of VC and private equity investment in Australia came from institutional investors. In New Zealand the figure was about ten percent.
“New Zealand sorely needs a healthy VC market. Stuart McKenzie describes it as the “missing bit” of our innovation system. “We have the people, we have the IP, but the big hole is capital.” Think of it as the petrol in the engine, the air in the lungs, the fight in the dog”
Only one New Zealand financial institution, ACC, has taken the plunge into VC. The corporation currently has $32.2 million in VIF funds, about 0.31 percent of its total investments. It has also committed another $12.7 million, which remains undrawn by the funds that may, for example, be earmarking capital for existing portfolio companies.
The great hope of the VC industry is the $15 billion New Zealand Superannuation Fund, which independently invests government contributions towards future superannuation payments. It has been extensively lobbied by the industry to open its purse strings, so far without success. Matt Whineray, general manager private markets at Guardians of New Zealand Superannuation, says VC “sits at the more risky end of the private equity spectrum, relative to, for example, expansion capital and buyout opportunities.
“The venture capital market in New Zealand is relatively small and young compared with the US and European markets. This presents even higher perceived risks to investors like us because of the lack of investment diversity available and a track record of investors.”
But McKenzie says the Super Fund’s reluctance to get into VC is creating a blockage with offshore investors. “They know about the Super Fund—it’s of a size that registers internationally—so with offshore investors often the first comment they will make is, ‘Is the Super Fund in?’
“We’ve had two US investors saying, ‘Come back when the Super Fund is in.’ They use the Super Fund as a proxy.”
McKenzie, as you’d expect, has faith in VC as an investment class. It delivers, he says, but the absence of the institutions leaves everyone stuck in neutral.
McKenzie says this reality, combined with the shortage of VC cash, drives VC fund managers towards picking companies where value can be added without spending much cash. “Drug companies create a whole lot of money while spending a whole lot of money.
“We are trying to do a lot with a little.”
Didn’t Lord Rutherford say something like that?
Go for broke
Raising money is hard—and it’s a real distraction from creating a great product. Before phoning angels and pestering VCs, ask yourself: do we need the money?
Sometimes, says Jason Leong, the answer is no. Leong is co-founder of Dunedin startup PocketSmith, which is currently beta-testing its online financial forecasting tool. “A lot of budding entrepreneurs don’t understand they don’t need VC money to get going,” says Leong, “and starting PocketSmith is proof it’s possible.
“PocketSmith is in many ways an experiment for us—a chance to do the bootstrap thing, build something neat and get a community of users. Maybe make a small impact on the world! The three of us are keen on being independent, and if we can pull this off without needing venture capital, we’ll certainly do it.”
It helps that capital costs are low. PocketSmith is built on open-source software like Ruby on Rails. If PocketSmith is a hit the company will need more cash—but it’s easier to raise money with a product than an idea, and the founders can usually keep more of their company.
“Rather than give 25 percent of your company to some developer, or seek $250,000 for your first round of seed capital, just pick up Rails and learn,” says Leong. “Build the prototype and validate the idea with real users. Business plans are all well and good but, more than likely, the business will turn out quite differently to how it was originally envisioned. We’ve had to re-think PocketSmith’s strategy, and we’ll continue to do so as we probe for opportunities. It’s all about being agile.”
Not that the PocketSmithers aren’t interested in investment. They’re inspired by Y Combinator, the brainchild of US entrepreneur Paul Graham. Y Combinator typically invests only US$5,000 in a company plus $5,000 for each founder, and asks for just six percent of the company in return. “They don’t invest a lot, but the environment, culture and connections are what’s compelling,” says Leong.
Although PocketSmith’s application to Y Combinator was turned down—“the international thing was an issue”, says Leong—they’re trying a similar idea with The Distiller, a network of Dunedin entrepreneurs. “The focus will be mainly on how to get entrepreneurs from idea to prototype stage and we’ll start by sharing our experiences and connections, as well as matching up entrepreneurs with developers. High on the list of priorities is to shake the misconception that it takes a significant amount of cash to start up. If the concept works, we’ll see a proliferation of web prototypes for great ideas that can either stand on their own, or be a good start for seeking that first round of VC money.”
But first, they need to ship PocketSmith, and Leong is hopeful they’ll do that without needing external investment. “While it remains to be seen whether or not we’ll be a success, my gut feel is this is the right way to go.”
Send me an angel
Take a dearth of venture capital money, add a small community of serial entrepreneurs with intermingled histories, slap on a dash of Kiwi do-it-yourself mentality and what do you have? In Wellington, you get a host of young, dynamic startups whose founders, employees and investors are interlinked like an intense game of Twister.
Wellington gets kudos as the home of the highest number of web startups per square kilometre in New Zealand and a walk down Lambton Quay shows why. Within the space of a few kilometres you have a veritable who’s-who of web business: from publicly listed Xero to über-success Trade Me to the startup trying to revolutionise manufacturing, Ponoko.
So what makes Wellington, formerly seen as a drab, grey enclave of civil servants, lead the charge for new business? Partly it has to do with geography; the hilly constraints of Wellington results in a concentration of commerce within a small area. Other cities have weaker bounds and thus startups are very dispersed—anyone who’s had to attend meetings with several Auckland startups in one day can attest to just how spread out they can get. Coffee to has a part to play in this process, too—Wellington pioneered good coffee in New Zealand and coffee still has a valuable role to play in lubricating the matchmaking required for angel investments, the most common way for Wellington startups to find their feet.
Common usage defines angel investors as individuals who are affluent and provide capital for business startups, usually in exchange for ownership equity. But if that’s what an angel investor is, much more telling is the story of why they become angel investors. Wellington’s angels—not the only angel investors in New Zealand, but easily the most visible—all tell a similar tale. They’ve all built business from zero (and many have built several businesses from zero) and they have a genuine desire to help new entrepreneurs with both the cash and with the lessons learned through their own businesses. Personal relationships, trust and shared ambition are key. As founder of Xero and angel investor in many local businesses, says: “What’s important is that the young guys get money in the door so they can build experience and execute.”
Rowan Simpson is another good example of an angel investor. After launching his own startup (which he eventually sold to Trade Me) and cashing out his shares when Trade Me was sold to Fairfax, Simpson has been an active angel investor, giving the benefit of his money and experience to startups in such diverse areas as stock valuation, gaming and business planning.
Of course, every tight community has its negative aspects and the Wellington angel scene is no different. Some entrepreneurs with weaker links to the networks bemoan the attention that is lavished on those within. Their perception is that knowing the right people is more important when seeking angel funding than actually having a good product, and wish the attention would be spread more evenly.
Notwithstanding the concerns of a few, the number and variety of Wellington startups shows a high level of interconnectedness. Both the angels themselves, and the funded and advised entrepreneurs, believe this connectedness is one key element in their individual success, and the success for the Wellington scene as a whole.