Rocket Fuel

Perhaps the most enduring misconception related to startups in New Zealand is this:

It’s difficult for startups to raise investment in New Zealand, because there is a shortage of venture capital.

It’s actually 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 of the recent evidence actually points in the exact opposite direction.¹

The “difficult” part is true. But the “because” part is so easily disproved.

All around the world there is a massive amount of venture capital looking for a return. And, the venture capital market is global. The best funds invest everywhere. It’s literally their job to find the best ventures, wherever they are, and invest in them.

Most, if not all, of the startups we celebrate as our biggest ecosystem success stories 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 those 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, are not actually that impressive.

When pressed for evidence of a funding gap, the data that is usually used to quantify this is the number of local venture funds and the amount of capital those funds are able to raise and deploy in local ventures.²

Meanwhile, there is more and more evidence that investors from everywhere are more than 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 reasons why a startup can’t raise investment: the value isn’t obvious to potential investors; or the price is too high.

For what it’s worth, I’ve learned that the feeling that it’s easier for startups to raise capital overseas is also a myth. For example, some people claim that it’s much easier to raise venture capital in the US, and when I hear that I always wonder: (a) have they ever actually tried to do that (I have, and can assure you it’s not easy); and (b) all of the potential investors based in the US are one short overnight flight away, so what’s really stopping them?

That all leads me to this conclusion… those who complain about a shortage of capital are really thinking, although thankfully still a little embarrassed to actually say out loud, that they wish it were easier for them specifically 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 that is 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, not a cause.

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 co-dependant, but the engine does all of the hard work! The engine needs the fuel to keep moving, but the fuel doesn’t get anywhere on it’s own.

It’s amazing how many aspiring startup investors get this relationship around the wrong way, and imagine that they are the engine pulling the venture along.

It possibly also explains why the most successful investors are often former founders themselves, rather than financiers - those who have been there themselves tend to have better empathy with these two roles and the relative value of each.

This is actually the history of venture capital in every location around the world where there are lots of venture capital funds.

The early venture funds in Silicon Valley were the original investors in the microwave and integrated circuit companies that where built during the Cold War.³ The simple reason funds like Kleiner Perkins, Sequoia, Bessemer, Accel, Benchmark, Index Ventures (and many others) are well known today is simple: they invested early in the companies that grew and became successful.

Likewise, the reason there are many more venture funds in Australia than in New Zealand (we might say they punch at their weight?) is because they have had more small funds and family offices invest in companies that have grown to be huge and that has created an ecosystem. Two examples: Square Peg, which was the cornerstone investor in Vend, is funded by many of those involved in the great success of Seek; and Blackbird, which now operates a dedicated NZ fund with partners based in Auckland was initially funded by the founders of Atlassian and have grown on the back of their investments in multiple break-out ventures started in Australia, including Canva, CultureAmp and SafetyCulture.

Take away the successful companies from any of those examples and all you have are investors with hopes and dreams.

(By the way, 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!)

But, perhaps the most important comparison for us to consider is Israel, because they have been the inspiration for the New Zealand government’s attempts to jump start a venture capital sector here, starting in the early 2000s.

The lessons from that experiment are not well understood (at best - at worst they are misrepresented) and so this myth continues to distort our thinking…

🛗 Elevate

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.

Five local venture funds were selected to top-up and underwrite (actually six funds, because one was added subsequently, but we’ll come to that in a moment):

• TMT Ventures
• Endeavour Capital
• No. 8 Ventures
• iGlobe Treasury
• BioPacific Ventures

The lucky managers of these funds each had full freedom to pick which individual startup companies they wanted to invest in.

It was a very sweet deal for them - basically at any time during the first five years of their fund they could choose to buy-back the investment that VIF supplied, and in return only had to pay a cash rate for that option.

A simplified example, to demonstrate:

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

As I said… a sweet deal for those funds. But, actually, if it works out like this, a decent deal too for VIF, given their raison d’etre, as they 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 was an intentional and shameless copy of the “Yozma” scheme, established in Israel from 1993 onwards, which is now a case-study government intervention in catalysing a venture capital sector: with relatively modest government investment, venture capital investment there increased 60x, hundreds of very successful companies were created, nearly every fund they supported took the buy-back option, and 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.

So, how did this model work in a New Zealand context?

Our initial results were more-or-less at the complete opposite end of the spectrum, and we’re still flailing away today, more than 20 years 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 is still actively investing.

The late addition was the exception: Valar Ventures, a fund backed by PayPal founder and Facebook investor Peter Thiel, was reversed into the scheme in 2012. This decision was quite correctly criticised at the time, for multiple reasons: they were not really a local fund, they got full matched funding (a better deal than the original five funds got) and they were allowed to include pre-existing investments, including their investment in Xero, which would go on to produce significant returns.

It’s difficult to argue that we encouraged new investment by underwriting investments that have already been made. They would have invested anyway. They had already invested anyway.

I’m not sure there are deep lessons from all of this, to be honest. We offered a US billionaire a deal that was too good to be true. We can’t be too surprised he took it. The bigger problem was VIF was getting so desperate to pick winners by that point that they were inclined to make the offer in the first place.

What were the returns on the millions invested across all of those initial funds? I’ve been asking for details on that since 2012 and I’m still waiting. 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. But, silence actually says a lot: in my experience you don’t need to ask successful fund managers what their returns are, they tell you!

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

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 per cent.

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

So, why did this all fail so spectacularly? Well, that seems to depend on who you ask.

According to a 2019 Treasury report:

Early returns for VIF were low mostly due to 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 ~$45 million).

Except that’s just not correct either. 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 that I personally worked on and invested in, for example.

The 2017 NZ VIF Annual Report listed five other companies that had each achieved a valuation of $1 billion or more by that stage: RocketLab, Pushpay, Diligent, Telogis, and Anaplan.⁴ 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.

Given this list of companies that have been successful without needing support from VIF, it might seem sensible that the government support would be focussed on those startups who might not have existed without the funding boost.

The logic of this is alluring, but also wrong. The entire purpose of VIF was to jump start venture capital funds. To succeed over multiple cycles those funds need to invest in the best companies. So attempting to invest in the “next layer down” is actually self-defeating. It’s also revisionist - the intention from the begining was always to try and 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.

The same cabinet paper referenced above offers 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! Yikes!

👼 Bless

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, five years after VIF, to invest in ventures at the seed and startup stage of development (i.e. at the very beginning). This fund has also more recently been rebranded as Aspire NZ Seed Fund.

Where VIF was set up as a fund-of-funds, investing in venture funds that select companies to support, SCIF was able to invest directly in companies, but only when investing alongside “accredited investment partners”. ⁵ The idea, presumably, was this would reduce the effort required to filter investments because SCIF could pick the partners they wanted to work with and then the partners would do the work to validate the investment opportunities and, vitally, the heavy lifting involved in working with the founders of these early-stage companies to help them grow after the investment is made. The recurring pattern here is assuming somebody else is doing the hard work.

The goal was to create a pipeline of companies that could eventually be funded by the later-stage venture funds VIF was trying to bootstrap.

So, there are two layers to assessing the impact of this:

• How has it performed as an investment fund (i.e. what is the return on the investment)?
• What contribution has it made to the ecosystem (i.e. what other derivatives have been developed with support from SCIF)?

It’s surprisingly difficult to answer the first question using the information that is available publicly. According to the same Cabinet Paper referenced above, as at September 2018 SCIF had invested $58.8 million into 215 ventures and achieved a return of just 4.38% per annum. The results in the years since then don’t suggest this has improved significantly.⁶

Perhaps, given this, it’s no surprise they don’t publicise their returns. 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 ~9% pa and S&P500 in the US returned ~8% pa over that same period).

Again, there have been more than enough amazing early-stage investment opportunities available over these years. But, 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.⁷

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”. 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!

They are all “accredited investment partners” and so had their own investments amplified by SCIF investing alongside them.

An angel network is an easy way for a group of high-net worth people to invest together in a portfolio of startups. The purpose of these groups is often presented as an opportunity for successful business people to “give back” ⁸ and contribute to the startup ecosystem.

The concept sounds great on paper: You 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 choose the founders they like and then the haggling starts.

Anybody who has watched Dragons Den knows how this works, right!

So, consider our impact assessment questions:

Who are these groups designed to help and how? What constraint do they remove?

Taking the cream of the crop or getting the leftovers?

Startup Busking v.
Repeatedly pitching to angel investors, in an effort to raise immaterial amounts of capital.

In my opinion the biggest mistake aspiring investors make is assuming there is a large population of impressive but unfunded startups out there who just don’t know how to find the capital they need. And that, as a result, founders will be willing to jump through the various hoops these angel groups require them to navigate in order to get investment. And, watching founders try, there is a significant amount of faff involved in pitching and due diligence relative to the modest amounts of money available.

In reality, the best founders pick their investors carefully, and you have to work hard to be the sort of investor they will choose to work with.

This works in both directions, because the best investors also realise that while contributing more value than they capture means being willing to invest more time and money, that will eventually pay back in the longer term as a result of the reputation that builds.

New Zealand is small and the credible early-stage investors are all well known and easily reached. In my experience, the best founders are happy to approach these investors directly, skipping the “startup busking” step entirely.

This means the deal flow available to angel groups ends up self-selecting for the worst opportunities from those that remain otherwise unfunded - i.e. they are funders of last resort, only seeing the leftovers.

Who’s doing the work?

It gets worse. When you scratch at the surface of the angel network model it becomes obvious that they don’t really put the founders or the startups at the centre 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.

In my opinion, the way angel groups place themselves at the centre of the startup universe only highlights how few of their members have ever been founders.

There is something about the dynamic of an angel group that makes investors feel more confident, and yet at the same time makes them more lazy. I’ve seen this pattern over and over again in investment rounds involving groups: everybody assumes that somebody else is doing the work to validate the opportunity, meaning actually nobody is.

Typically in each group there are one or two key individuals to whom everybody else in the group looks for leadership and tends to follow. It sucks to be them!

A great way of measuring the health of an angel group would be to look at the number of people who actually lead investments vs. those who attend mostly for the wine and fellowship.⁹

Post-investment this pattern of lack of respect for founders and decision-making-by-committee manifests in ways that are also unhelpful to founders. Too many angel group members invest immaterial amounts and then struggle to justify committing much of their time to the ventures they’ve backed – so they end up watching from the sidelines and learning very little from the process.¹⁰

It’s common to hear angel investors complaining that the companies they have funded are struggling to raise their next round of capital. The often overlooked but more relevant question is: how many of these angel-backed companies are big enough and growing fast enough to justify that next round (i.e. with revenue > $1m and growing at 2x or 3x per year)?

This again suggests a simple metric we could use to assess the value-add from angel groups individually - what percentage of their ventures have raised further capital from new investors? It would also be relatively easy, and revealing, to compare that to a control group of ventures who didn’t raise their first round from angel groups.

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 very unlikely to ever get venture funding. That should have been more obvious at the outset.

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

Diworsification

Lastly, but perhaps most importantly for founders, there seem to be very few people in these groups who are prepared to really back any one venture.

In fact the opposite. One of the publicised benefits of an angel group is the portfolio approach they promote. Members are encouraged to spread their investment across a number of startups, in the assumption that most of them will fail, some others will break even, but a small number will be big winners that return their overall investment.

I’ve written a separate essay explaining why diversification doesn’t work for early-stage investors, which I’d encourage you to read if you’re interested in the details:

But, to summarise…

The purpose of diversification is to narrow the range of possible outcomes - that is, by spreading your bets you eliminate both the worst outcomes and the best outcomes.

This approach makes a lot of sense when you’re investing in larger public companies. The average market return is often good enough.

This approach makes no sense at all when you’re investing in startups in the early stages, when the return on each investment can range from “you can now buy your own island” (very rare) to “you lose all your money” (much more common) and, importantly, the average is also “you lose all your money”. Diversification just eliminates the possibility of the island outcome, without reducing the likelihood of losing everything.

More than that, there are two other things investors need to be true in order for diversification to work: you need to invest in a lot of companies; and you cannot afford any selection bias in the companies you pick.

We’ve already seen that neither of these things are true for angel groups - there are only a small number of local companies for them to pick from, and there is an obvious selection bias because the best ventures are often not available to them.

Perhaps if an angel could invest in hundreds or thousands of companies, the portfolio approach would work. But when they are spread across just a handful of local companies then the most likely outcome is that all of them will bomb. And if, miraculously and despite them, one of them does turn out to be a winner, their win will not be as big as it could have been because they didn’t invest enough in that one.

The trick to angel investment, it seems, is to be smart enough to be able to do it, but not smart enough to be objective about the true potential of the companies you invest in.

Welcome to Happy Valley!

Unfortunately this seems to be the standard angel experience: 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 required to support the ventures on-going and then bail on the whole thing having made very little positive difference to any founders at all.

I have to admit I find nearly everything about angel groups baffling.

I don’t even understand the name. For me, seeing somebody label themselves an angel investor is a negative tell.¹¹ I don’t have wings so I’m happy to just call myself an investor. I don’t think the job title needs any other embellishment.

We might call this the Happy Valley effect (after the lovely Wellington suburb which is home to the landfill and recycling centre): if you give yourself a special name to try to indicate to everybody that you’re smashing it, you’re probably not smashing it at all.

This is my advice to nearly everybody who invests via angel groups: start by investing via venture funds instead.¹² That would also have the benefit of increasing the size of the local funds.

If, after that, you still feel like you want to “give back” then the next level is putting your hand up to be a director or advisor to one venture. Of course, the challenge then is you need to be 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 we need three things: fuel, oxygen and heat.

To create a vibrant venture capital sector we need spare capital, founders with insight who are willing to start great companies to invest it 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 Meatloaf can’t help us in this case: all three elements are necessary.

I started working on startups around the same time as we started offering investors incentives via VIF and SCIF. Through that whole time it has remained dogma that the main thing holding us back is a shortage of local venture capital. It’s been deeply unhelpful.

The 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.

We’ve focussed on fuel so much and for so long, that 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. If we think that raising capital is hard wait until we try and spend it efficiently!

It’s never going to be easy for a specific startup to raise capital. There is a good reason for that. The returns from any early-stage investment are extremely uncertain. This means that only particular types of companies are attractive to venture investors. Most startups never get to that stage.

We need to stop blaming a non-existent shortage of capital for that reality. We should understand that some companies are able to raise all the capital they need relatively easily, while others will always struggle. If we want more startups to be funded then we need to create more companies that match what investors are looking 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 (unless we still believe in the trickle-down effect).

We already have one of the most generous environments for early-stage investors in the world, including a 0% capital gains tax. We should push back on those who say they need even more incentive to invest. This will reduce the noise and increase the signal.

For example, imagine a generous system where we incentivise startup investors purely 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 those investors who generate the outcomes we want by successfully turning startups into high-growth companies.

This would actually be easy to implement. The capital gains tax on startup investments in New Zealand is already 0%. We just need to turn off the subsidies!

(Perhaps we need to consider that a quid pro quo of no capital gains taxes could be a requirement that results are public, so that everybody can have a more accurate picture of what successful exits look like. In the absence of that at the moment, many of the exits that get publicity are not as great as founders and investors in those companies represent, and at the same time many of the biggest wins go mostly under the radar.)

Speaking of tax on capital gains … We’ve got to stop pretending that the residential property market is to blame for the level of investment in startups. Property investment has no tax advantage over venture investment. There are no capital gains taxes on either asset class. The reason investors generally prefer real estate is because it is lower risk. It would require significant incentives for venture investors or disincentives for property investors to shift this. 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.

We need to stop copying what has worked overseas and wondering why it doesn’t work here. Unless we can recreate the specific context of other countries we’re unlikely to replicate their results. Instead, we need to think about our own context, and play to our strengths.

We need to be honest about the results we’ve achieved. Otherwise it’s difficult to do more of what’s works and less of what doesn’t. Sadly, while we encourage startups to fail fast, we did the exact opposite with VIF and SCIF. We doubled down. Multiple times!

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 have backed subsequently, including Pioneer Capital and Movac, have done better. But they’ve been fighting against the headwind of those initial failures, which not only lost money, but also sent the signal that raising and deploying venture capital in New Zealand is impossibly hard work. We still incorrectly believe that, even as international funds set up local offices and local Kiwisaver funds allocate a portion of their capital to this asset class.

Investing in startups is mostly about judgement. Those managing venture capital funds qualify to compete in the next round by investing in the rare companies that go on to become the big successes. While there have been venture capital funds in New Zealand for a long time, there have been very few that have produced remarkable returns for their investors. More recently, some local funds have had successful exits, and as that capital is recycled those funds will grow and flourish. This is how it’s supposed to work!

Given time that will be the catalyst for a local venture capital sector, 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 actually contributed to it or not.

But, more than all of that, we’ve got to stop treating raising capital as the pinnacle of success for a startup. It’s like applauding the pilot for refuelling the plane. They’re not even off the ground yet! The goal isn’t to burn aviation gas. Yes, we need to put fuel in the tank, but we also need to build wings. Because the goal is to fly somewhere. And land! Then go again and again. We should celebrate that when it happens.

We need to stop behaving as if capital is our constraint. Rather than complaining about how difficult it is to raise venture capital, we need to start being honest about why it’s hard. Then we can work on being good enough to overcome those obstacles.

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