Unlocking "unprofitable beasts" and why they need more patient capital
Written on the 19 September 2018 by Matt Ogg
Companies are staying private for longer than ever before with abundant capital on offer, but the flipside is that sizeable global funds are entering the Australian market earlier to make their mark on the startup community.
Meanwhile, local public equity funds are often unable to do the same due to mandates that don't allow investments in unprofitable companies.
This was one message from Blackbird Ventures partner Samantha Wong (pictured) while speaking at the CSIRO's D61 + Live showcase today in Brisbane, where she took part in a panel that addressed the country's 'impatient capital' dilemma.
"It's no longer tenable to just sit back and wait for companies that have traction and tick all your checklist to then decide to invest in those companies. It's too late; you are literally just a commodity at that point," Wong said.
For Wong's venture capital firm, which has invested in 47 companies through three funds and a further 65 through an accelerator, this engenders a need to help companies sooner and prove that value that can be delivered by being locally-based with a global outlook.
This dynamic has led to a tectonic shift in startup funding and how growing enterprises assess the trade-off between staying private and listing on the stock exchange.
"Some are postponing listing for over a decade. The average used to be five to seven years," Wong said.
"There is not really a compelling reason for a fast-growing private company to go public when the capital is available in private markets. The consequence for private venture funds is that secondary markets are available for us to sell limited partnership stakes into.
"So it's possible that the company doesn't have to achieve an exit within that 10-year timeframe, or a 12-year timeframe, but the fund's investors are able to."
"What we want here is more Atlassians"
Budding entrepreneurs may have their preconceptions about what venture capitalists are after, but Wong recommended speaking to them rather than assuming all operate on the same principles.
"I think the other weird paradox is that even though venture funds technically have an obligation to return capital within a certain timeframe, I see much more impatience on the side of the people who theoretically have endless timeframes to return capital, being family offices and angels," she said.
"What we want here is more Atlassians. Atlassian was a 17-year overnight success story - we don't get to build the next Israel or Silicon Valley if we pursue 10 mil, 50 mil, 100 mil exits.
"We need to have a longer-term horizon, be willing to be more patient and more ambitious and in the same proportions, and that's how we'll build a really outstanding ecosystem here in Australia."
But Atlassian opted for listing on the NASDAQ rather than the ASX. So what is it about listing in the United States that could make it more attractive than listing here?
"I think it's a real challenge in Australia, and it's a systemic one in that a lot of the funds that are public equity funds, their mandates don't allow them to invest in unprofitable companies," Wong said.
"You can't blame them for sometimes not knowing what to make of these unprofitable beasts. It doesn't make sense for them to allocate resources to build up the muscle and expertise internally to do something that they're not allowed to do in the first place.
"So that leaves a whole bunch of highly qualified and intelligent analysts unable to look at that segment of the market."
She mentioned WiseTech Global (ASX: WTC) and RedBubble (ASX: RBL) as a couple of fantastic Australian-listed tech companies, but the ASX also has its share of "pretty fraudulent terrible companies" as well.
"I don't really see much changing there until you have more companies that are profitable that are on the ASX, or more funds changing their mandates to allow them to invest in companies pre-profitability on the ASX."
David Burt, the new ventures manager and co-founder of the CSIRO's ON program, offered his thoughts on the challenges faced by companies on the ASX when they are still in the pre-profitability stage.
"If there's not the analyst coverage of stocks, then the amount of people who are going to be interested in potentially investing in you just plummets and you're left with a large group of people who get really excited about any expectations that might be set in usage or adoption of technology," Burt said.
"If you disappoint on expectations once or twice, you'll actually be fielding a lot of enquiries directly from investors. You'll have an investor relations overhead that starts to ramp up. You'll find it very difficult to do further placements on the market."
No forgive and forget on the ASX, but super funds have been a game-changer
He said the process could be very unforgiving, and it was much easier to manage expectations with a smaller group of investors through an angel investment syndicate.
"But if backdoor list onto the ASX or do a fresh IPO, you might have 100,000 retail investors and maybe 20 per cent of them have nothing better to do than write you an email or call the sales number on your website to try and talk to someone about why their investment is now under water," Burt said.
"Until you comprehensively explore what the private capital markets look like I wouldn't go to the ASX pre-profitability."
Wong said it was common to enter debates with US investors about whether or not to relocate to Silicon Valley, but Australia has a lot of benefits in that trade-off.
"Being able to say the Australian government will pretty much give us back 50 cents in the dollar to invest in talent and product, that's pretty hard to argue," she says.
"The availability of excellent world-class talent, people who stick with you for more than 12 months who cost somewhere from half to a third of what Silicon Valley engineers cost, those are really compelling.
"I think the big change that's happened is yes, the government's done more but actually super funds have gotten in the game. Host Plus alone has put nearly $1 billion into Australian venture capital, and by virtue of that Australian startups in the last five years. That is a game-changer for an ecosystem."
Burt mentioned that aside from venture capital, there were also capital raising opportunities from public entities like the CSIRO, and of course federal and state government grants. But regardless of where the money comes from, even if your business doesn't have revenue you still need to demonstrate progress by other means.
"It's measurable units of progress. It's not just de-risking a technology but de-risking a business model as well," he said.
Wong mentioned assessing pre-profit companies could be done in many ways with leading rather than trailing indicators, for example technical cycles or proof points with beta customers or pilot projects.
"What I guess we would say is definitely patient capital is a must, but that doesn't mean that you can't produce proof points along the way," she said.
River City Labs chief executive Peta Ellis claimed what the business community needed was more highly ambitious founders.
"We really need the driven founders who know what it takes to drive a company, to grow it and scale it globally and know that it's not a short game, and we also need the investment to support that kind of thinking as well," Ellis said.
"I think competition is excellent so you get people working on better ideas, they're solving bigger problems and I think even having funds investing earlier and being a bit more competitive in seeking out opportunities and finding backable founders can only be good for the sector."
Ellis highlighted the relevance of storytelling about investment returns to draw people into the sector and "unlock more patient capital".
"It means we get to progress more but it also means that there are more companies receiving investment, which means they can grow and they can recycle back and continue to educate the ecosystem as they go," she said.
"Founders learn through founders by watching their journey."
Keys to success: "A lot of tenacity and grit, and huge amounts of optimism"
After the panel discussion, Business News Australia spoke with Wong about the key tenets that help guide her investment decision-making. When you think of startups risk is certainly something that comes to mind, so we asked the venture capitalist how often she'd been burned by investments.
"The hit rate is generally 50 per cent will die or just return capital and 25 per cent will do OK, maybe two to three times capital, and then 25 per cent hopefully will shoot the lights out," she said.
"So yes, we have had companies die - we fully expect them to and the important thing is that they had a go, and we'd be happy to back them all again if they had a big mission and we believe in it.
But why do these companies die? Is it just the nature of the market or how they've been run?
"The truth is a bit of both. A lot of the time we believe this fallacy that founders can control everything that's just not true," Wong replied.
"Markets don't evolve the way we expect them to sometimes or on the timing that we expect them to sometimes. Regulations don't change in the way we expect, products turn out to be much more difficult to build than we expect.
"That's risk capital, that's what venture capital is all about; it's taking a bet that some of these big ideas will pay off and inevitable some don't."
Conversely, what are some common traits shared by successful companies?
"They've all been pursuing a mission. They would be doing what they're doing even if they weren't getting paid," Wong said.
"They are not motivated by the money but they are motivated by the sort of blind ambition to achieve what they need to achieve; solving the problem for the customer.
"A lot of tenacity and grit, and huge amounts of optimism."
And what are the red flags that she looks for?
"Some of the red flags are inability to take on feedback from a variety of people, an inability to hire, an inability to scale themselves as the company needs - I'd say that's probably the number one thing," she said.
"In the beginning founders do absolutely everything. They're HR, they're office management, they're sales, they're marketing, they're product development, etcetera.
"Learning when to take a step out of each of those roles and perform that higher function and bring in the right people at the right time is often a trap."
She emphasised thinking deeply about values and mission in the beginning, and baking that into the recruitment process while taking Culture Amp surveys quarterly or at least half-annually. This gives managers an idea of whether everyone is aligned with the mission and whether they feel important.
"You also have to be prepared to fire when you know it's not working out you generally know within a couple of months," she added.
She said around a fifth to a quarter of Blackbird's investments were in pre-revenue companies, and that's a percentage that has actually risen over time as the group has become more involved with earlier stage investments.
And which investments are the most exciting at the moment?
"For me personally I'm fascinated by synthetic biology and biology as the next IT system. In particular I really love the whole alternative or clean protein area of interest," she responded.
"That is growing meat in labs rather than animals; plant-based meat and plant and synthetic protein-based dairy products.
"It's all pretty sci-fi but it's coming to market faster than I think most people recognise and has huge impact potential in terms of reducing greenhouse gases and lots of other benefits as well," she said.
She claimed that the world's growing population could simply not be fed by using current farming methods.
"My view is improving yield four per cent doesn't move the needle in terms of what we need to produce to feed the growing population," she said.
And how does Australia's development compare to the rest of the world in the alternative meat and dairy product space?
"We have a lot of raw ingredients. We don't have scientists becoming entrepreneurs to fully exploit the opportunity," she said.Never miss a news update, subscribe here. Follow us on Facebook, LinkedIn, Instagram and Twitter.
Business News Australia
Author: Matt Ogg