Australian Venture Capital – Can We Escape From Past Failures? Ian Maxwell
Ian A. Maxwell is a veteran Technology Entrepreneur and Venture Capitalist. He is currently CEO of BT Imaging, Chair of Instrument Works and Co-Founder of Accordia IP as well as a partner at Zetta Research and an Adjunct Professor at RMIT. He has a PhD in Chemistry and has either founded or worked at Memtec, Allen & Buckeridge, Redfern Photonics, Sydney University Polymer Centre, James Hardie, Viva Blu, Enikos, Wriota, RPO and Instrument Works. You can connect with him on Linkedin au.linkedin.com/in/maxwellian
Disclaimer: I would like to say that in what follows any resemblance to real venture capitalists, public servants and entrepreneurs, living or dead, is purely coincidental. If anyone I know is reading this article I would like to say that you are, of course, the exception to any broad generalizations that I may make in this article.
I have been asked many times for my opinions on why the Australian Venture Capital (VC) sector has failed. The answers to this question are pretty complex and often I get the feeling that a listener might not get the full picture. Hence I decided that this is a subject worthy of an essay.
Firstly though, has Australian VC actually failed? I find that it’s always worthwhile testing the hidden hypothesis in a question such as the one posed here. People often anecdotally claim things to be true without ever providing evidence for their assertions. However in this case it is pretty easy to validate the hypothesis.
For example, an Australian Venture Capital Association Limited report (see http://ict-industry-reports.com/wp-content/uploads/sites/4/2013/10/2009-Evolution-of-Venture-and-Private-Equity-Capital-in-Australia-AVCAL-Apr-2009.pdf) shows that all 37 Australia venture capital funds between 1985 and 2007, many of which included government funds, had an average return on capital of minus 5.4%. Even the upper quartile of funds only averaged 3.3% return, whereas venture capital is not deemed successful until it returns 20% on capital, due to the high risk factors associated with this investment class. Indeed fund managers typically do not share in fund profits until the 20% hurdle is reached. Returns on Australian VC funds have not improved since 2007, in fact just the opposite.
Looking through the industry reports I noted a 2013 effort (see http://ict-industry-reports.com/wp-content/uploads/sites/4/2013/09/2013-Economic-Impact-of-Venture-Capital-in-Australia-AVCAL-May-2013.pdf) which extols the economic impacts of Australian VC. You can read this article as an attempt to get our government to continue investment into the VC sector on the basis that, although a financial failure, the VC sector creates all sorts of positive economic impacts for the country. The key quantitative claims in this report are:
- “VC-backed firms make up only 0.01% of GDP but 10% of all business R&D expenditure in Australia”. I would comment that R&D expenditure is an input and I would rather see a measure of outputs (e.g. revenues or profits). The truth is that a large fraction of the R&D expenditure in Australian start-ups has no economic return as highlighted by the poor return on VC investment.
- “Top VC-backed companies Cochlear, ResMed and SEEK alone employ nearly 7,000 people”. There has to be a statute of limitations on using these old companies as icons of VC investment. They were all started in the last millennium; in 1981, 1989 and 1997 respectively. The reason these companies are listed is that there has been no VC-backed equivalent success stories of similar scale since 1997.
- “Australian VC-backed companies accounted for $4b in assets and $2.8b in sales in 2011”. Yep, and that a good fraction is from the three companies listed above.
- “VC-backed companies make up a fifth of ASX healthcare market cap”. Now that is not something I would boast about. This sector is zombie-central.
Ok, now I have got that out of the way, I think we can happily assert that the VC sector in Australia has been a financial failure and that it also has had somewhat dubious economic impacts. So why is this?
The answer lies in four key categories; the investment model, the people, the deal flow, and investment scale. I will discuss these in order.
The Australian VC Investment Model
The investment model that has been attempted to be introduced by most VC’s in Australia has been the Silicon Valley ‘General partner/managed funds’ model. Implicit in this approach has been a desire to re-create a mini-version of Silicon Valley here in Australia. Well this hasn’t worked and I doubt it ever will. Silicon Valley exists to serve the whole world, and not just California or the USA. Deals and entrepreneurs flow to Silicon Valley from all over the place, including Australia.
Silicon Valley VC is very ‘fashion-driven’ – in any given decade there are the industry sectors of choice where deals are being done and then there is everything else, where they simply won’t invest. The reason for this focus is due to Silicon Valley’s continued desire to invest in only high-growth industries and low-capex technology plays where they can get a more guaranteed return on their investment. Also Silicon Valley VC’s are very reluctant to leave the herd else they will look pretty silly when a deal goes south. Historically, areas of interest have included semiconductor, software, photonics, pharma, cleantech and the internet (the one that is still going strong).
The semiconductor sector is a good case study – there were once hundreds of investments into fabless Semico companies designing new chips for various applications. If successful these companies would be acquired for many times their revenues in the high-growth bubble-like market of the day. Today of course the semiconductor market has settled back to slow single-digit growth rates because the world has been saturated with chips. Merger and acquisition (M&A) values are down and VC investments into this sector are now quite rare.
If Silicon Valley VC has the capital and the machinery to invest into the key segments du jour then what role does a local Australian version of a VC industry serve? The claim of the local VC industry is that they can serve to either compete with Silicon Valley (which is ludicrous) or act as an intermediary, where the seed capital to get companies up and running is sourced locally and then the successful companies can transition to the more highly capitalized US market. This latter claim, while it has appeal, is also mostly false. It is my experience local investment is both under-scale and under-skilled, and hence any VC seed capital into an Australian start-up usually serves to slow that company down and delay its transfer to a more sensible domicile.
One key aspect of the Silicon Valley investment model is that typically 2% of funds under management go directly into the pockets of the fund managers every year, for up to ten years, quite independently of their performance. This makes this model very lucrative even if the funds are never profitable. Many of you will realise that this is a very dangerous structure in ‘rent-seeking’ Club Australia.
I would argue that the local copy of the Silicon Valley investment model simply hasn’t worked but it is far easier to point out the model’s deficiencies for the local environment than it is to suggest a useful alternative; more on this later.
Another cause for the failure of Australian VC is the people.
In the US, after a few years of working in a specific industry and then after achieving a high quality MBA, an individual may join a VC firm as an Associate. Then after working their way up to Principal they might become a partner or leave to create their own VC firm if they have forged a good reputation. Alternatively a successful CEO, after selling a company, might join a VC firm as a venture partner, essentially seeking the next big deal. All individuals in US VC firms will normally have a single-sector focus where they are extremely well-networked and can qualify people and opportunities with a high degree of success.
Contrast this with Australian VC firms where virtually no-one have gone through this apprenticeship program. Most are former entrepreneurs and finance or corporate types. Entrepreneurs think that because they have been on the receiving end of venture capital that this makes them qualified to manage VC funds. This is like you or I arguing that because we went to school we are qualified to be teachers. The financial & corporate types drift down from the top end of town into VC for many reasons but mainly because it looks like a cushy ten year gig with guaranteed income, where they can use their existing networks to extract investment funds from unwitting limited partners (LP’s; investors in VC funds). Of course the financial types are even less qualified to manage VC funds than former entrepreneurs since they usually have had no contact with start-ups or any experience in a tech sector. And corporate types, while sometimes having worked in a tech corporation, usually have very little appreciation for what it takes to create a company from scratch as opposed to being a little cog in a big machine.
Another problem with Australian VC is that it is a small segment and there is not enough deal flow for any investment manager to focus on a single sector. As a result we have a bunch of ‘generalists’ who know a little bit about a lot of segments. This often makes their investment decisions very dubious. In the US a typical partner will have a very good personal relationship with the key M&A decision makers at the half a dozen corporations that will eventually line up to buy a start-up that the partner is about to invest in; this is rarely the case in Australia.
Of course if the VC’s are singularly unqualified for the job so too are the entrepreneurs that they invest in. This is a case of the blind leading the blind. If I was forced to list the single most important thing in any investment decision I would have to respond that it is the CEO of the company. The right person will make the most of every opportunity. It takes skill, energy and luck to make a start-up successful. The right person brings the skill and the energy – and the right investment manager can identify the great entrepreneurs with one eye closed and at 100 paces at dusk. And the wrong investment manager, with fund-lifetime constraints forcing them to invest quickly, will forever make compromised decisions as to the types of deals and the types of entrepreneurs that they invest is, and this is what usually happens in Australia.
The lack of quality deal flow in Australia is a case of the ‘emperor’s clothes’. The myth that is propagated through our media is that there are endless high quality tech opportunities in Australia but what is missing is investment capital, usually followed by calls for government to supply more of this, free of charge. Arguments for the high quality deal flow are usually accompanied by a nod to the usual chestnuts, being the Hills Hoist, the Victor lawn mower, the ute (my personal favourite), Resmed, Cochlear, and more recently Atlassian (which was originally bootstrapped by the founders and then later received US venture capital; what they are still doing here is a mystery). Statistically speaking one cannot make an argument for an investment class (like VC) based on statistical outliers like Resmed or Cochlear; any argument has to be based on mean returns because all financial markets and their players regress to the mean over time. And our mean return on VC investment is negative which highlights the low quality of our deal flow.
My personal belief is that the claim that we have endless high quality tech opportunities in Australia is utter bullshit (sorry there is no softer noun that portrays my thinking on the matter). We are in fact very short on quality deals in Australia. Recall that a quality deal has to have many rare properties; it has to solve a verifiable and large problem or create a verifiable and large opportunity, the entrepreneur needs to have a track record in an industry as well as in start-ups, the technology must be genuinely novel, the sector has to be in high-growth with bubble-like exit values (high multiples on revenue or EBITDA) at the time of exit, there has to be a source of highly qualified people to employ, there has to be local investors (at least two) who get it and have networks in the industry, collectively the VC’s need to be able to put tens or hundreds of millions of dollars into the deal and not choke it with under-scale investment, there has to be a large local market, there has to be a large local exit opportunity or two, and the list goes on. You may now understand why a smart entrepreneur will take his or her deal to Silicon Valley! And also why I argue that we are short of high quality deals.
Even if you only measure deal flow by the quality of the technology or technology inventors I would argue that we under-perform in Australia. One reason for this is that our university sector is incentivized by their grant schemes to cluster their research efforts into highly competitive technology segments where they can get high citation counts for their papers, but also where innovation is very hard to achieve solely because of the crowded nature of these areas. Additionally our academics are not employed by any measure of their entrepreneurial nature; just the opposite in fact. Another reason why we have a low number of technology opportunities it that our private sector is dominated by corporations that are users of technology rather than vendors of technology; this means there are few spin-outs or people leaving our corporate sector with relevant technology development skills or insights into what problems are truly worth solving.
I have mentioned this above, but typically Australian VC is awfully under-scaled. VC’s funds exist as small as $20m. After subtracting management fees, this might mean that such a small VC fund can at most invest $1-3m into a single deal. Well there aren’t many modern tech start-up opportunities that can be successful at that scale, and what we find is that these small VC funds end up choking their investees as they look to avoid dilution and keep control in subsequent larger funding rounds. That is, there is a bias in the Australian VC market towards trying to fluke high-value exits with small investments and a lot of praying.
A part of the problem in the Australian VC market is that a large slab of the limited partner funding has come from government sources. I recently talked to a public servant whose reply when asked why the government keeps investing in sub-scale Australian venture capital firms, after 30 years of losing substantial amounts of government cash was ‘Well, it took 40 years for Silicon Valley to take off’. He failed to note that Silicon Valley always had profitable venture capital firms from the get-go and that the US government played a minimal role in its development.
More recently Australian superannuation funds have finally realized how unprofitable the Australian VC sector is and have pretty much completely pulled out. This is proof, if still required, that Australian VC sector has failed. It also means a further shrinkage of the average VC fund size in Australia (of those remaining) because of a greater reliance of small government schemes like the IIF scheme, thus further guaranteeing failure of this investment sector.
I believe that government should not invest into VC funds because they make very bad LP’s. This is because they are not driven purely by a profit motives, they are also driven by policy requirements with any number of political overtones and also a fear of negative publicity; this leads to all sorts of weird constraints on those VC fund managers accepting government funds. If government insists on trying to create a tech sector then more useful activities could include creation of incentives via the selective removal of the myriad of government taxes and regulatory hurdles, or via repayable loans. I also argue against government grants of any type, R&D or otherwise, to business – all financial input from government should be loans repayable by businesses once they achieve a pre-agreed capacity to repay the loans from profits derived from the investment of any such loans.
Government stimulation is best placed into comprehensive development of plans to create new industries, and in this context the development and early implementation of policy framework, selection of technology sectors for national focus, acquisition of key intellectual property to be later on-sold to private enterprise, creation of tax breaks on new ventures and also for their investors, R&D tax schemes, ‘export-only’ patent box schemes, delayed-repayment loans for business development, initiation of local consumption through government purchasing (only on products that are not otherwise available) and also the development of local consumption schemes (to create early local customer demand for emerging product niches).
Is there a VC Opportunity in Australia?
Just recently I have talked to a few people who are convinced that there is an opportunity for a new VC model in Australia, with the inherent assumption that the prior failures of Australian VC has been due to the investment model. They are, in my opinion, deluded patriots. But good on them for their optimism and I for one don’t want to talk them out of their efforts. Rather I would like to frame the problem comprehensively so that they don’t waste their efforts solving non-problems and ignoring real ones.
So is there any role for a local VC market? Just possibly there is, but probably only in segments where the local VC market is not competing with Silicon Valley. This might appear to be counter-intuitive since Silicon Valley obviously picks the highest return market segments. However because they just about ignore all other sectors any future Australian VC sector would be well placed to target these lower return segments simply because they are less competitive. Who knows, we might also be able to attract foreign deal flow to Australia! I have said it before we need to get over the idea that any local tech sector has to be based on proudly developed local innovations.
This statement then flies in the face of the fact that about 99% of all current start-ups in Australia are internet deals. But our internet start-ups are competing with Silicon Valley equivalents with 10-100 times the funding; statistically speaking, what chance do our start-ups have? I would say to the entrepreneurs of our internet start-ups; if you really want to make it big then please get on a plane to Silicon Valley and don’t come back.
What about the investment model? Clearly we don’t have the LP’s to invest into managed funds so we may as well get entirely away from the managed funds concepts. In fact I think any new model should not have management fees at all just so that we can be assured that the managers are incentivized by profits rather than guaranteed salaries. Recently I have heard of groups trying to promote investment funds by equity crowd-funding, by corporate partnership and by alternative stock exchanges. Other ideas also exist. I have absolutely no conviction that any of these models, by themselves, solves all existing problems. Typically what these new investment models do is access money that is easier to get and possibly requires a lower return on capital than typical VC LP funds; that is these new models are targeting ‘dumber’ money. Trust me on this; dumb money leads to dumb outcomes. The possible exception is corporate partnerships – but we hardly have any corporations that are global vendors of technology solutions. So it would have to be foreign corporations; this is starting to look hard.
The people will define themselves. Those promoting these new investment models will only be successful if they have the ‘right stuff’ anyway. And they won’t be successful unless their new model provides sufficient investment funds for their startup opportunities. They need to have excess capital so that they can break through walls and solve as many of their problems as possible just with capital. Remember this might mean more than $50-100m per deal.
And government? To be honest I think government is best advised to stay right away from the sector. Although they are well intentioned, every time that they promote funds to VC, a raft of the usual characters swarm around to extract that money as their own stipend. Government is probably best placed by removing the very hurdles to new business that they themselves have created with legislation. Just starting and owning a business in Australia is ridiculously complex and expensive.
Having said all that, I still come back to the problem of the lack of high quality deal flow in Australia. This is the biggest hurdle that we have to face if we want a thriving tech sector and an accompanying investment model.
Our university segment is not a source of reliable deal flow, and this won’t change unless we create an alternative university sector with a primary focus on commercial outcomes. Our corporations are primarily users of technology and not vendors of technology; maybe someone could usefully create a database of our corporations that are most actively focused on selling technology solutions to the world, and round these up as part of an investment model. Our government of course could do something very unusual, like creating an Asian-style five year plan to create a whole new industry from scratch; that might promote some deal flow. Or we could look to source deal flow from overseas and import technology opportunities much like we import ‘Australian’ sports stars from the developing world.
I am sure that some readers might have other ideas for deal flow that I have not thought of.
As a final note, I am pretty sure there are those that will find this article offensive. I could have written it five years ago; I only do so now because it is petty clear that the 30 year old experiment into recreating a little Silicon Valley in Australia is just about over. We have to look to the future if we want to create a thriving tech sector in Australia, and we can only do this successfully if we are honest about what has failed in the past. So please please forgive my offence; I too may be a deluded patriot.
 For more details on this see http://www.scribd.com/doc/162429121/Australian-Manufacturing-a-Framework-for-a-New-Future
As always we would like to hear your views on Venture Capital in Australia
Spot on article! Well done. Sad reading but true. I do believe there is hope long term as entrepreneurs are getting more and more savvy, but it is still comparing grade school football to the pro league when compared to the Silicon Valley. Interestingly the valley formula is hurting too with the Series A crunch looming large: http://www.youtube.com/watch?v=tM1gX2iLQ_k
Marty Looksmart was a bubble exit that was simply an extreme outlier. Silicon Valley makes its money by actively betting on and promoting bubble markets. They just work very hard to get their timing right - that is to sell their companies before the bubble bursts. I saw this first hand in the fiber optics bubble in 2000; quite a few Valley VC's I dealt with were actively promoting and investing in companies that they had no faith in whatsoever - they just wanted to get in and out quickly while the market was acting irrationally. They actually thrive on irrational markets. Champ Ventures at least had the intelligence to get out of VC and into PE after the Looksmart exit - they knew it couldn't be reliably and repeatably replicated. If anyone else looked at the Looksmart exit and thought they should then get into VC then they couldn't have looked too smart because they were already too late; and this underlines my comment (in my article) of the quality of the people. I agree that Australian VC is missing out on this bubble. I think this is because there aren't any LP's that believe in the fund managers to make money, even in a bubble. The good guys fled to PE or overseas ages ago. The government has had a negative IRR on all the money it has put into VC. That is a fact. Trying to argue that they should continue to do this because this is better than grants to the automotive industry which have zero return is an odd argument to me. And the problem with this argument is that, while money is still pumped in by government, the inherent structural problems of Australian VC are not being addressed and the government still promotes the formation of yet more new fund managers with little experience in VC and with under-sized funds (e.g. through the IIF program). It really is a case of the emperor's clothes. I would like to see evidence that Australian Super has gone back into VC. No fund manager I know is getting new funds up. The super funds pulled out because they were sick of negative returns and illiquid ten year commitments. I doubt that they will ever come back to Australian VC whilst it is trying to copy Silicon Valley (badly). Where there is interest in VC the super funds go straight to the US. I know of cases recently, for example, where groups that have been awarded IIF funds have had to pull out for a lack of LP funds - it's hard to argue the Superfunds are supporting VC if this is the case. I do not believe that repayable loans mess up funding. Recall that these loans are only due if the company is successful (like HECS where students only repay loans when they have income). Most AusIndustry grants have historically had repayable clauses in the contracts, for example if the company left Australian domicile. In my experience these clauses were not reflected in balance sheets nor did they impact funding rounds. Generally speaking repayment of loans in certain circumstances is simply reflected in the cashflow scenarios for the company (prepared by investors in due diligence) and they impact the pre-money valuation of a round. And that is it. Repaying loans based on success of projects funded by these loans is simply a nice problem to have. My statement that 99% of start-ups are internet companies is in fact true. Just go and count them. In Surry Hills, where I am, there are at least 200-300 web and internet start-ups - it is simply amazing. I can't even go to the pub and have a single beer without walking away with one or two business cards. Most of them have never contemplated talking to a VC. Whether or not they have raised money is not the point; even to get started these guys have invested their own money. What they need is a source of capital to re-invest in marketing and promotion so they can go global and 'viral'; right now there is no local source of that capital. And that biotech space looks like a very moribund segment by comparison - these are capital and time hungry companies that often list early and then become the living dead on the ASX. Looking forward I don't think we have had enough success in this market to sustain investor interest . Especially when those deluded enough to invest in tech can target the internet guys. regards Ian
From my perspective firstly there are a few things missed in this essay that mean the problem is worse: - One golden deal, Looksmart, was missed out. In my experience this one more than any other has driven the blind enthusiasm for the sector amongst some. Note that this business has since exploded. - The VC industry’s constraints, culture and capabilities also mean that it is unresponsive and lacks agility. For example, the industry is not in a position to make money from the ‘bubble 2.0’ we are now experiencing. - The definition of success is a very low bar. Even when investments make decent IRRs they lack scale enough to matter in any way. But there are also some points that I disagree with. - The Government has not lost substantial funds in this sector. As a result of its programs the Government has been in nearly every deal and so has had some substantial wins. The net loss represents a low level of investment when compared to the industry assistance provided to other industries from agriculture to automotive to aerospace and many others. - The pull-out by super funds hasn’t happened as described. The funds pulled back for about a decade but have recently come back in again. This has not been due to improvements in VC returns but rather due to structural changes in their industry and a drive to differentiate. It will not last. - Ian advocates Government providing loans to start-ups as the only form of support. While this appeals from the point of view of removing corporate welfare I’ve seen these programs in action and they tend to inhibit further equity raising as they stuff up balance sheets. - The view that ‘99% of start-ups are internet’ isn’t true when you look at those that have raised money. Australia is actually overweight in biotech when compared to the rest of the world and underweight in internet.
The author has made some valid comments, but I am not as pessimistic on the future of Australian success in technology commercialisation as we have world class talent and ideas. Many successful Silicon Valley companies like Apple, Microsoft, Google, etc started as two guys in a garage with a good idea. The cost of doing a startup have come way down and we are seeing the emergence of a new breed of global internet companies based in Australia such as Atlassian. They have been able to attract and maintain high quality talent that you could not attract and keep in Silicon Valley even at even double the cost. The fact is since the end of the dot com boom, US VC's have under performed the stock market returns and if you exclude the top 4 or 5 US VC' firms, the rest has been loss making. So I don't think there is anything special about US VC's. Perhaps the early Aussie VC's were not as successful as few have ever done their own technology start-up company, perhaps lacked product visionaries, or were too risk adverse. Australian entrepreneurs do face many challenges their counterparts do not face. Lack of early stage risk capital and a small risk adverse market are areas where I believe government support is necessary if we are ever going to develop an entrepreneurial culture. Tax incentives for angel investors would be a good start. Risk adverse Australian government agencies seem to only buy from large multinational IT companies. Perhaps setting quotas for Government purchasing from SME's like what has been done in the US defense department for many years may encourage more successful Australian IT companies with the government as a customer. My parents moved to Silicon Valley (Cupertino) in 1968 before the name "Silicon Valley" even existed. When Intel was formed in 1968 it might has well have been located in Australia as it was far away from the US east coast where the big computer companies such as IBM were located and the investment capital was in New York, not Santa Clara county. I am optimistic with that Australia has the talent to create world class technology companies. The question is whether there is a passion and desire to make this happen or will we be lulled to sleep as long as the mining boom continues?
My own experience raising capital leads me to believe that we have an unhealthy obsession with checklist-style investment criteria. The first feedback I remember receiving was "your product is awesome; come back when you get more advisers on your board". This approach is unhealthy, dangerous in fact, as it creates a false sense of security in the investors' eyes, based on the perception of having reduced risk (by bringing the grey-hairs in). Overall I feel that investors are becoming lazier, relying excessively on others doing the due diligence work. Perhaps this is why they are seeing negative returns. The dealflow might not be that good to start with, but neither are the investors who don't bother crunching their own numbers.
One does not have to agree with everything in this article to be able to agree that this is a pretty awesome piece of historical analysis.