Rocket Fuel

Perhaps the most enduring misconception related to startups in New Zealand is that it’s difficult for local startups to raise investment, because there is a shortage of venture capital. It’s remarkable how widely this is believed. It has been repeated so many times by so many people for so long now that it has become an accepted fact, even when all the recent evidence points in the opposite direction.¹ Sure, the “difficult” part is true. But the “because” part is easily disproved. The venture capital market is global. All around the world there is a massive amount of venture capital looking for a return.² The best funds invest everywhere. It’s literally their job to find the most promising ventures, wherever they are, and invest in them.³

Many of our most successful startups, including Xero and Vend, have been funded in part by international investors. That capital from overseas usually comes bundled with expertise and networks that are invaluable. This is a measure of the maturity of our ecosystem and should be celebrated rather than discouraged.

Over the years, I’ve often challenged anybody claiming that there is a shortage of capital in New Zealand to list the most impressive local companies they know who have tried but failed to raise capital. Inevitably the examples they give, if any, aren’t that impressive.

When pressed for evidence of a funding gap, the first data point is usually the number of local venture funds and the amount of capital those funds are able to raise and deploy in local ventures.⁴ Meanwhile, there is more and more evidence that investors from everywhere are happy and willing to invest in companies started in New Zealand if they are good enough. That quality filter is nearly always the real constraint.

There are two possible reasons why a startup can’t raise investment:

1. The value isn’t obvious to potential investors; or
2. The price is too high.

The good news for any founder is that the strategy required is the same in either case: build momentum, prove we can sell repeatedly and create a business that makes money. If we do that, we will have no problem selling the company or raising capital if and when we decide we want to.

It’s also a myth that it’s easier for startups to raise capital overseas. When I hear people claim that it’s much easier to raise venture capital in the US I always wonder: (a) have they ever tried to do that? (I have, and I learned how hard it is); and (b) most of the potential investors based in the US are one overnight flight away, so what’s really stopping them?

Those who complain about a shortage of local capital might wish it were easier to raise venture capital, from investors who won’t ask difficult questions. Indeed! We’d all like that. But don’t wish it were easier, wish you were better.

The engine & the tender

The bigger issue lost in this whine about whether we have enough local venture capital available to local startups is this: venture capital funds are a consequence of a successful startup ecosystem.

Consider a steam train. In this metaphor the startup is the engine. The investor is the tender – the small carriage that is hooked immediately behind the engine and carries the coal that fuels the engine. The two parts are codependent, but the engine does all the hard work. The engine needs the tender’s fuel to keep moving, but the tender doesn’t get anywhere on its own. It continues to astound me how many aspiring startup investors get this relationship around the wrong way, and imagine that they are the engine pulling the venture along. It also explains why the most successful investors are often former founders themselves.

The early venture capital funds in Silicon Valley were the original investors in the microwave and integrated circuit companies that were started in the 1950s and 60s. The simple reason funds like Kleiner Perkins, Sequoia, Bessemer, Accel, Benchmark, Index Ventures (and many others) are well-known today is that they invested early in the companies that grew and became successful.

The ingredients to recreate Silicon Valley are simple:⁵

1. An established world-class research university, staffed with entrepreneurial professors and managers who bridge academia and business.⁶
2. A cold war, which prompts the government to fund substantial military R&D.
3. Tax incentives to attract existing wealthy private investors.

Easy! Let’s not pretend that there is willingness or capability to recreate any one of those inputs in New Zealand, let alone all of them.

This same pattern is repeated in every location around the world where there are established venture capital funds. For example, Australia’s venture capital ecosystem has grown due to successful exits from companies like Seek and Atlassian, which provided the capital for new funds like Square Peg and Blackbird. These funds have then invested in and helped cultivate the next generation of startups, like Canva, CultureAmp and SafetyCulture. And Vend! Without those initial successes, there would be fewer Australian funds today. In recent years large superannuation funds in Australia have also become significant investors in these venture funds, helping them to scale. In New Zealand we’re at least a generation behind because we’ve been so tentative on compulsory superannuation.

Putting aside sibling rivalry, the fact that Australia is doing so well in this respect is actually great news for Kiwi founders, because the flight across the Tasman is even shorter than to the US.

Picking winners

The New Zealand Venture Investment Fund (VIF), more recently rebranded as Elevate NZ Venture Fund, was established by the government in 2002, as a fund-of-funds model.⁷ The lessons from this multi-decade long experiment are not well understood at best. At worst they are blatantly misrepresented, which we’ve seen is the worst way to be wrong. And so this myth about a lack of capital continues to distort our thinking.

VIF initially backed five local venture funds.⁸ Each received public money to invest with full freedom to select which startups to back. The fund managers had a sweet deal: they could buy back VIF’s investment within the first five years at a cash rate.

A simplified example, to demonstrate: VIF gives Kiwi Fund $1 million. Kiwi Fund raises another $2 million from private investors. Kiwi Fund invests that $3 million in Venture Ltd, which goes on to great things and is eventually sold to Global Corp, producing a return for Kiwi Fund of $30 million (the mythical 10x return). At this point Kiwi Fund can buy-out VIF by repaying the original $1 million with interest, leaving the majority of the remaining $29 million to distribute to the Kiwi Fund partners and private investors.

That result would be a wonderful outcome for the managers and investors in that fund. But also for VIF, given their raison d’être. Even without a proportionate return, they would have helped to jump start a local venture fund that will hopefully go on to great things over many years to come, attracting further private investment on the back of that track record, and recycling capital, all without needing further support.

This model replicated the “Yozma” scheme, established in Israel from 1993 onwards, which is now a case-study government intervention in catalysing a venture capital sector.⁹ With relatively modest government investment, venture capital investment in Israel increased 60-fold, hundreds of very successful companies were created, nearly every fund they supported took the buy-back option, and the government support for the scheme was phased out only a few years later having achieved its purpose. As a consequence, Israel now has a large number of active local venture capital funds.

How did this model work in New Zealand? Our initial results were at the complete opposite end of the spectrum, and we’re still flailing away today, decades later, hoping that might change. Of the original five funds none of them took the buy-back option, meaning none achieved even modest returns on their investments. As far as I know, none are actively investing.

In 2012, a sixth fund was added to the VIF mix: Valar Ventures was reversed into the scheme, shortly before they invested in Vend. This decision was quite correctly criticised at the time, for a number of reasons: they were not really a local fund; they got dollar-for-dollar matched funding (a better deal than the original five funds which were asked to raise $2 for every $1 they got from VIF); and they were allowed to include pre-existing investments, including their lucrative investment in Xero.¹⁰ It’s difficult to argue that VIF encouraged new investment by underwriting investments that have already been made. Valar would have invested anyway. They had already invested anyway. VIF offered a fund backed by a US billionaire a deal that was too good to be true. We can’t be too surprised they took it. The bigger problem was VIF getting so desperate to pick winners that they made the offer in the first place.

What were the returns on the millions invested in those five initial funds? VIF has been reluctant to release details.¹¹ No doubt the reason for this is “commercial sensitivity”. Somehow we set up a scheme where the results are private even though the money invested is public. However the silence says a lot: you don’t typically need to ask successful fund managers what their returns are, they volunteer them.

These were the aggregate results reported to cabinet in a paper dated December 2018 and publicly released the following year:¹²

VIF has been critical in catalysing the capital market. Since 2001, it has invested: $125.2 million through VIF, with 11 venture fund managers, into 99 high-growth firms. The internal rate of return (IRR), up to September 2018, is -3.29%.

I struggle to see how a negative rate of return can be described as a “catalyst”.

Why did this all fail so spectacularly? Well, it depends who you ask. According to a 2019 Treasury report into early-stage capital markets:¹³

Early returns for VIF were low mostly due to an immature market with an insufficient pipeline of opportunities.

Other excuses given are: the impact of the global financial crisis around 2008 and the sub-scale size of the initial funds (the average fund size was around $45 million).

That doesn’t stand up to scrutiny. There were more than enough successful companies started in New Zealand and funded by others during this timeframe that have gone on to produce amazing returns for their investors. Trade Me, Xero and Vend are three examples. The 2017 VIF Annual Report listed five other companies that had each achieved a valuation of $1 billion or more by that stage: Rocket Lab, Pushpay, Diligent, Telogis, and Anaplan.¹⁴ Curiously, it was completely silent about which of these companies the funds backed by VIF had invested in. I believe the answer is: none of them.

(We can argue another time about how “kiwi” each of these companies is, too. That’s a complex question.)

Given this list of companies that have been successful without needing support from VIF, can we assume that they focused instead on startups which might not have existed without the funding boost? That logic is alluring, but also wrong. The entire purpose of VIF was to jumpstart venture capital funds. Top funds must invest in the best companies to generate strong returns and become self-sustaining. Intentionally investing in the “next layer down” is self-defeating. It’s also revisionist. The intention from the beginning was always to invest in the best companies. They just didn’t.

The problem wasn’t an “insufficient pipeline”. The problem was the funds VIF supported didn’t invest in the best companies. Ultimately venture capital is a judgement game, and their judgement was empirically poor. Ignoring that, the 2018 cabinet paper offered this remarkable post-rationalisation:

While VIF was often not directly responsible, it nonetheless incentivised the market, got the ball rolling, put New Zealand on the map, and “paid the school fees” of many fund managers.

School fees! Failures happen, but not acknowledging when things haven’t worked is the very worst way to be wrong. Real failure is missing the opportunity to learn and improve on the next iteration.

The cream of the crop or the leftovers?

Remarkably, even that is only half the story. The second chapter is the Seed Co-Investment Fund (SCIF), which is a separate government fund established in 2006 to invest in ventures at the seed and startup stage of development (at the very beginning). This fund has also more recently been rebranded as Aspire NZ Seed Fund.¹⁵

Where VIF was set up as a fund-of-funds, investing in venture funds, SCIF was able to invest directly in startups, but only alongside “accredited investment partners”. The idea, presumably, was this would reduce the effort required to filter investments because SCIF could just pick partners to work with and those partners would validate all the investment opportunities and, vitally, do the heavy lifting of working with the founders to help them grow after the investment was made. The recurring pattern is assuming somebody else is doing the hard work. Originally SCIF required matching private funding, but this constraint was relaxed in June 2020 to allow SCIF to instead invest $2 for every $1 of private funding.

The goal was to create a pipeline of companies that could eventually be picked up by the later-stage venture funds VIF was funding.

There are two layers to assessing the impact of this: What is the return on the investment? And, what contribution has it made to the ecosystem?

Once again, it’s difficult to answer the first question using publicly available information. According to the cabinet paper mentioned above, as at September 2018 SCIF had invested $58.8 million and achieved a return of just 4.38% per annum. The 2023 annual report shows the amount invested has nearly doubled, to $112.1 million. The fund has invested in 269 startups, 99 of which have already been written off. The current valuation of the remaining 170 investments is $149.3 million. While the report does not calculate the return on capital invested on a percentage basis, these results suggest this hasn’t improved much.¹⁶

It’s no surprise they don’t publicise their returns – after all, 4.38% per annum is a shockingly low result, given the risks and rewards involved in early-stage investment. By comparison the same amount of money invested into simple index funds would have more than doubled these returns (NZX50 returned about 9% per annum and S&P 500 in the US returned close to 8% per annum over the same period).

Again, there have been more than enough amazing early-stage investment opportunities available over these years. These results suggest that SCIF has missed nearly all of them. I’d love to see a breakdown of these results by partner, so we could see how much has been invested alongside each accredited investor and what the specific returns have been. If this information were public I suspect it would show the results have been unevenly distributed, with worse returns from some dragging down the overall average. If that’s true, it would be in the interest of the better partners to have the results published.

The primary beneficiaries of SCIF from an ecosystem perspective have been so-called (and self-described) “angel networks”, which have proliferated all over the country with this support. There are now groups in Auckland, Tauranga, Taranaki, Palmerston North, Wellington, Nelson, Marlborough, Canterbury and “Mainland”.¹⁷ It’s interesting, looking at the websites for these groups, how many of them describe themselves as “one of the leading groups” in the country and how few provide actual numbers to back that claim up.

An angel network is an easy way for a group of high-net-worth people to invest together in a portfolio of startups. These groups are often promoted as an opportunity for successful business people to “give back” to the startup ecosystem. SCIF amplifies their investment. The concept sounds great on paper: convene a group of people who are interested in investing (current groups apparently range in size between 20 and 200 people) and invite founders to come to the group to pitch for investment. The group chooses the founders they like, then the haggling starts. Anybody who has watched Dragons’ Den or Shark Tank knows how this works.

But who benefits from these angel groups? What barriers do they remove? And can we objectively measure their effectiveness in fostering successful startups?

Many aspiring angel investors mistakenly assume there are lots of impressive but unfunded startups who will be desperate for their capital. They expect founders to jump through a lot of hoops for relatively modest investment amounts. In reality, the best founders are highly selective with their early investors, targeting those willing to invest substantial time in addition to money, and contribute more value than they capture in order to build their reputation long-term. In New Zealand the credible early-stage investors are all well-known and easily reached. The best founders are happy to approach them directly, skipping the “startup busking” step entirely.

This means the investment opportunities available to angel groups end up being those that are otherwise unfunded – they are funders of last resort. They don’t take the cream of the crop, they only see the leftovers.

Welcome to Happy Valley

When we scratch at the surface of the angel network model it becomes obvious they are not founder-centric at all. They are predominantly designed to help potential investors who struggle to connect with credible founders and who are reluctant to make their own investment decisions.

When angel groups place themselves at the centre of the startup universe it only highlights how few of their members have ever been founders. There is something about the dynamic of an angel group that seems to make investors feel more confident, while at the same time making them more lazy. I’ve seen this pattern over and over in investment rounds involving groups: everybody assumes that somebody else is doing the work to validate the opportunity, meaning that in reality nobody is.¹⁸ Typically in each group there are one or two key individuals to whom everybody else looks for leadership and tends to follow. It must suck to be them. A great way of measuring the health of an angel group would be to look at the number of people who lead investments versus those who attend mostly for the wine and fellowship.¹⁹

Post-investment, this pattern of lack of respect for founders and decision-making-by-committee manifests in other unhealthy ways. Too many angel group members invest immaterial amounts and so struggle to commit much of their time to the ventures they’ve backed. They watch from the sidelines and learn little from the process.

Angel investors often complain that their portfolio companies struggle to raise follow-on funding. A better metric is what percentage of the companies they have backed actually merit further investment – for example, do they have revenue over $1 million and growth of 200–300% per year? If that data were public we could compare the follow-on rates of angel-backed startups versus those without angel investment, which would reveal whether angel groups truly add value. When I look through the list of founders and companies that have been backed by angel groups over recent years there are just too many that are unlikely to ever get venture funding. That should have been more obvious at the outset.

Ensuring there is somebody who is willing to do the work to validate the size of the opportunity and then roll up their sleeves and do what is needed to help the company realise their potential is the difference between success and failure for early-stage investors.

The trick to angel investment, it seems, is to be wealthy enough to be able to do it, but not smart enough to be objective about the true potential of the companies you invest in. Regrettably the standard angel experience seems to be: make a few small investments that struggle, find out that it’s much harder than it looks, become reluctant to continue to invest the time and money the venture requires, then bail on the whole thing having made very little positive difference to any founders at all. That’s the opposite of “giving back”.

I have to admit, I find nearly everything about angel groups baffling. I don’t even understand the name. If you call yourself an angel investor, that’s a negative tell to me. I don’t have wings so I’m happy to just call myself an investor. I don’t think the job title needs any embellishment. I call this the Happy Valley effect (after the Wellington suburb which is home to the landfill): if you give yourself a special name to indicate to everybody that you’re special, you’re probably trying to deflect attention.

Most angels would be better off investing via venture funds. That would also have the benefit of increasing the size of the local funds, and might solve the problem that VIF has tried and failed to fix, without needing government support. The next level after that is becoming a director or advisor for one venture. Of course, that means being picked by founders based on the contribution you can make in the future, rather than the cheque you have written in the past.

Fuel, oxygen & heat

To light a fire three things are needed: fuel, oxygen and heat. To create a vibrant venture capital sector the required ingredients are available capital, founders with insight who are willing to start great companies to invest in, and investors with the judgement required to predict which companies could be great before this is obvious (keeping in mind that most startups are not great). Unfortunately Meat Loaf can’t help us in this case: all three elements are necessary.²⁰

I started working on startups around the same time as the government started offering investors incentives via VIF and SCIF. Through that whole time the real shortage, as it always has been and probably always will be, is the finite number of great companies to invest in, and in the people with the judgement to tell them apart. When a venture goes badly and fails we say, “Investors lost $X.” But when a venture goes well and is sold we never say, “Investors found $Y.” Perhaps we should.

We’ve focused on fuel so much and for so long, we forgot that for a blaze we need oxygen and heat too. We need to put this myth behind us, so we can start to focus on the real constraints. Everybody who thinks that raising capital is hard should just wait until they try to spend it efficiently. It’s never going to be easy for any startup to raise capital. There is a good reason for that. The returns from any early-stage investment are extremely uncertain, so only particular types of companies are attractive to venture investors. Most startups never get to that stage. We need to stop blaming an imagined shortage of capital for that reality. We should understand that some companies are able to raise all the capital they need, while others will struggle. If we want more funded startups then we need to create more companies with the characteristics investors look for.

Investors are always going to take advantage of subsidies and underwriting if they are available. We should stop offering them, at least until we can better articulate the public benefits and collective return on that investment. The private benefits are more obvious and now well proven, but by themselves definitely don’t justify the cost of incentives. We already have one of the most generous tax environments for early-stage investors in the world. We should push back on anybody who says they need even more incentive to invest.

For example, imagine a system where we incentivise startup investors by waiving all tax on capital gains. Unlike subsidies currently paid in advance, this would mean that taxpayers don’t take on any of the up-front risk. Plus the benefits flow mostly to the investors who generate the outcomes we say we want by successfully turning startups into high-growth companies. This system would be trivial to implement. The capital gains tax on startup investments in New Zealand is already 0%. We just need to turn off the subsidies!

In the meantime perhaps a quid pro quo to no capital gains taxes could be a requirement that results achieved by venture funds and angel groups that receive government support are public, so that we all get a more accurate picture of what’s happening. In the absence of that at the moment, many of the publicised successes are not as great as founders and investors in those companies represent. Meanwhile many of the biggest wins go under the radar.

We’ve also got to stop pretending that the residential property market is to blame for the level of investment into startups.²¹ Property investment has no tax advantage over venture investment. There are no capital gains taxes for investors in either case. The reason most people prefer property is because it is lower risk and investments can be leveraged via mortgages. It would require significant incentives for venture investors or disincentives for property investors to shift this mindset.

Rather than swinging at non-existent tax differences anybody advocating for startups should focus on the downsides of high house prices: ²²

Rampant house price inflation is not wealth creation, it is poverty creation as it makes homeownership less accessible to everyone

Remember, that “everyone” in this case includes all of the people who we need to choose to live and work (and pay tax) in New Zealand. In any case, if we are waiting for the substantial structural problems with the housing market to be solved first, we’re unlikely to ever get started.

Fire hosing

When we are inspired by what has worked overseas we also need to understand their specific context. Immediately prior to their venture capital boom in the 1990s, during which it launched its influential Yozma programme, Israel experienced a massive immigration boost. The population increased by 28% in 10 years, and a large number of those arriving were qualified scientists, engineers and mathematicians from the former USSR who played pivotal roles in many of the early successful ventures and venture funds.²³ Another important factor often overlooked by those making comparisons is their compulsory military service. Because we can’t recreate that in New Zealand we’re unlikely to replicate their results. Instead, we need to consider our own context, and play to our own strengths. Think back to our pre-mortem questions: imagine a future historian writing about the successful New Zealand technology ecosystem. What are the natural advantages they will highlight?

We need to be honest about the results we’ve achieved. Otherwise it’s difficult to do more of what has worked and less of what hasn’t. Sadly, while we encourage startups to fail fast, we did the exact opposite with VIF and SCIF. We doubled down.²⁴ Multiple times.²⁵ When we repeatedly pivot and don’t address the root cause of the failures, it’s not really pivoting, it’s “fire hosing”.

The newer venture funds VIF has backed have fared better. But they’ve been fighting against the headwind of those initial failures, which not only lost money, but sent the signal that raising and deploying venture capital in New Zealand is impossibly hard work. It’s a myth many still cling to, even as international funds like Blackbird set up local offices²⁶ and local KiwiSaver funds like Simplicity and others dip their toe into allocating a portion of capital to this asset class.²⁷

Investing in startups is mostly about judgement. The venture funds that survive are those which invest in the rare companies that become big successes. While there have been venture capital funds in New Zealand for a long time, very few managers have produced remarkable returns for their own investors. More recently, some local funds have had successful exits, and as that capital is recycled those funds will grow and flourish. This is exactly how it’s supposed to work. Given time, that will be the catalyst for a local venture capital sector to bloom, just as it has in other places around the world. And VIF will eventually be able to take credit for what’s created, whether they really contributed to it or not.

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