Oct 2014
We cannot solve our problems with the same thinking we used when we created them.
– Albert Einstein
The universe is not a thing that’s going to push us around… We are going to bend the universe and command — and demand — that the universe become what we want it to be. Just decide what it’s going to be, who you’re going to be, how you’re going to do it. Just decide. And then, from that point, the universe is going to get out of your way.
– Will Smith
It’s well noted how difficult it is for a startup to raise funding in Australia. But the reasons why this is so are less clear and convoluted. One of the main and often overlooked causes is because it simply isn’t a very good investment. There are better places for money to go such as mining, retail, healthcare and property. Those are fields where Australian companies lead the world and generate great returns.
At last count the number of Australian billionaires was 35. Of those the number that have made their money in mining is around 10, in property is around 5, in retail is around 5 and in healthcare is around 3. Roughly two thirds of all of them. The number of Australian billionaires that have made their money in technology is 0. Therein would be the crux of the problem. It is why institutional capital would rather back mining companies than technology companies. They perform better.
There is also a common line of thinking that the US has more venture capital, therefore they produce bigger companies. This seems inexact, as if it is misplacing where the causation lies. In 2010, $22 billion dollars was invested into 2,749 companies by US venture firms. While in Australia, that number was $111 million invested into 124 companies. Two orders of magnitude less. Taking into account the order of magnitude difference in populations, and it is still one order of magnitude less than it should be.
But this is perhaps a lagging indicator. Capital chases great opportunities. The 3 largest venture funded companies of the last two decades in the US are Google, Facebook and Amazon representing 400b, 183b and 186.9b respectively for a total market value of nearly 770 billion dollars. In that same period, the 3 biggest venture funded companies in Australia are REA Group (better known as realestate.com.au), SEEK and Atlassian representing 6.3b, 5.7b and 3.5b respectively with a close 4th being Carsales.com.au at 2.3b for a total market value of 17.7 billion dollars.
We create roughly 2% of the market value of our US counterparts.
Put another way, for a country with 1/10th the population, we create roughly 1/43rd the value while also spending 1/100th what they spend and fund 1/20th the number of companies. If we reverse this, the US is spending 100X more than we are, to fund 20X the number of companies and getting 43X more market value from only 10X the population.
So a lot of the rhetoric proves to be an underperforming asset class complaining that not enough people are pouring money into it even though it is underperforming. But rightly, they shouldn’t. People don’t like to invest in things that don’t yield a good return. Competing with something provably better than you seems to be a losing strategy. When it begins to perform, money will flow into it. That’s how investing works. This is not to say money should stop being invested. But perhaps the allocation of it should be better managed. More funding is almost a universally better thing to have.
But where does this funding come from? We don’t yet have the terminal velocity of large pools of founders who have exited their companies and can invest it back into young companies as Silicon Valley does. And the professional financiers, the Australian VC industry has underperformed for decades. So largely we depend on already rich people. Except we can’t really rely on them either.
Because culturally who we think is good is actually wrong. For example, a lot of the investable capital is controlled by legacy business families who just inherited their wealth. And it’s common to see these legacy business families celebrated for their business acumen, but if you dig into the data, you see they are actually terrible. In Australia one of the most famous and our canonical example is the Packers. Today the Packers are worth nearly 3 billion dollars. But if you benchmark and measured their returns against the general stock market, the same benchmark all private equity and venture capital funds hold themselves to, they have consistently underperformed for generations.
Which is to say, if Frank Packer 3 generations ago put his money into the stock market and his son and grandson, Kerry and James Packer did absolutely nothing. They would have been financially better off, with a net worth of nearly 14 billion dollars. Which means the following generations of Packers have wasted 11 billion dollars worth of appreciation. They are secretly terrible. It is the same with their rivals the Murdoch family and nearly every legacy Australian business family. You see the same phenomenon in every country with famous people who inherited their wealth. In most cases, despite what media outlets publicise, they have almost always hemorrhaged capital.
But just because conventional funding is hard to come by doesn’t mean capital is hard to come by. You just need to know where to look and what to look for. Where are technology companies thriving in Australia? We only need to look at the ASX to see a number of technology companies near the top.
SEEK, realestate.com.au, carsales.com.au, SMS Management and Technology, FairfaxMedia (with News.com.au, OMG, Lawyers.com.au, Business.com.au, Drive.com.au et al) Aconex, iiNET, FOREX, Wotif.com, Oakton, Technology One, MelbourneIT, UXC, MYOB, Health.com.au, Pepperstone, Freelancer etc. All Australian. All pushing market capitalisations in the billions or with hundreds of millions in revenue. Then come the medical ones like Cochlear, Resmed, Mesoblast and Nanosonics.
Most started in the last 2 decades. At last, we found them.
Adding to that are hundreds of private Independent Software Vendors (ISVs for short) in the same market cap and revenue ballpark that nobody has ever heard of. They operate in unsexy spaces that aren’t cool to write about. Things like ISYS Search, makers of enterprise search software or Fred IT Group, makers of dispensing software for pharmacies or Best Practice Software, makers of Best Practice, a popular medical practice clinic management software or LEAP Legal, makers of software for small law firms.
There are hundreds of examples of these. All very successful that few people have heard of. Then come the consumer focused ones that people have heard of. Companies like The Catch Group, AfterPay, NextDC, WiseTech Global, Vocus, Tyro Payments, Campaign Monitor, BigCommerce, RedBubble, Envato, Iress, Menulog, Catapult Sports, Platfora and Canva. All with market caps in the hundreds of millions of dollars. All Australian. All successful.
So it’s not that we don’t have them, they just operate differently. And there is a divergence of what people are reading and how they are viewing the landscape. What I think is happening is people read about US venture capital and startups, a place that made famous the idea of technology entrepreneurship, and using US centric models in their own environment. And this is throwing an exception.
Matt Barrie, CEO of Freelancer advocates a startup not even bother trying to raise late stage capital in Australia. They should do a seed or A round. Then they should make that last for a long time, till profitability and just go public when they need to do a growth financing. And he’s right. That should be how startup funding in Australia operates. The angel investor who breaks from the pack and follows that model will yield excellent returns.
Interestingly, that’s exactly how it used to work back in the 80s and 90s before the dot com bubble and before Sarbanes-Oxley was introduced. Microsoft, Apple all raised early rounds of funding which lasted till they IPO’d. They also went public well before reaching maturity. There wasn’t really such a thing as a private growth round of funding. Now a lot of that value is extracted by the private sector who regularly do growth rounds of capital, filling the need where previously public markets would be used for. Now the public market is used as an exit.
Investors fund private companies and then leverage the risk onto the public. They already capitalise on most of the appreciating value and the bones are given to public markets who don’t experience anywhere near the same growth rates or stock appreciation. This was a side product of legislation known as Sarbanes-Oxley that was originally intended to protect the public. But it accidentally made it too difficult for a company to even go public in the first place. And so private institutions stepped in to take up the slack and were rewarded handsomely. But Australia doesn’t have Sarbanes-Oxley. And we have a lower IPO listing requirement.
In many ways the public markets in Australia are used in exactly the way public markets are intended to be used for. As a capital raising event. In the US, most companies use public markets as a liquidity event. To sell of the shares they are holding, not for the company to raise more money to expand faster. Going public sooner also means you will benefit from the valuation and revenue multiple sooner.
The average market capitalisation of a publicly traded company is about 12 X EBITDA + the growth rate + book value of assets. In Australia, the regulation before going public is that you need to have 3 profitable years with 1 million in net profit or a market cap with sales of at least 10 million.
Interestingly, the ASX famously raises more money each year than the NASDAQ and has a lower listing requirement that is focused on profitability. The catch is, in general, the ASX doesn’t like speculative investments like the NASDAQ does. The NASDAQ frequently values companies at astronomical premiums on their revenue and often doesn’t care about profit. It’s because there is such an abundance of capital and so few other areas which have high performing returns that investors compete fiercely. This competition creates situations where even failing companies can have market caps in the billions.
Juxtaposed to this, companies that do well on the ASX have economics grounded in, let’s say, reality. It’s heavily focused on profits. So the formula would be something like: growing top line revenues, growing profits, key advantages, low industry volatility, unlikeliness to lose market share, huge growth potential. Complicated business models or losing money or being unprofitable for a long time before going public doesn’t really work here. In that sense Australia has very sophisticated public market investors and fairly mediocre private ones.
The economics in Australia are geared towards rewarding profitability not just growth. Somebody should teach that to Australian entrepreneurs. They should change the trajectory of their companies to aim for a seed or an A round of funding, They should use that to reach the traction levels required to list with sustainable and growing profits. Then they should go public on the ASX. In doing so will sacrifice many of the benefits of being a private company but make fundraising much easier.
The side effect of this will be fivefold. 1) Entrepreneurs will own a larger part of their business because they raised less money. 2) The companies need to be structured in a certain way that is focused on earning and growing revenues and profits. 3) The initial round of funding needs to be stretched not spent. It needs to last until the company is in a position where it can go public which can take a long time. 4) Investors will receive better returns because of the valuation multiples public markets confer. 5) Companies going public will be earlier. It doesn’t mean they are any less great. Which means the general public and middle class can participate in the wealth creation instead of small numbers of already very rich people.
The alternate model that is popular is the exact same thing but instead of going public, they receive a growth round of funding from international private investors. This model is what is common in the US. Though this is the exception and is more difficult. It usually only occurs for companies that can reach a global audience from a central fixed point. Companies like Atlassian who can make and sell their software to anywhere in the world from anywhere in the world.
The scenario this does not work for is entrepreneurs looking for a quick flip. To start and sell their companies quickly or to cash out early. In that sense it is a very purist form of entrepreneurship. The company has to be in business for a long time for the value to materialise. It also means business models that do not meet a similar criteria aren’t going to work here. That doesn’t mean they won’t work but just not here. It will be a longer and more arduous road. They are better off to leave for the US where they will find investors and capital more aligned to their needs.
Now how do entrepreneurs raise that seed or A round? A rule of thumb is usually this is under a million dollars and they will need to sell almost a third of the company. And because Australian private investors are largely unsophisticated, the company will have to be further along. That means the product will need to have already been built with traction, users, sales, engagement etc. Some number that is going up and to the right.
Sophistication in an investing sense is almost synonymous with targeted speculation because the earlier an investment is made, the better the returns will be. By the relative, Australian investors who are less sophisticated will stop and wait till the company is further along.
Thus for companies with significant traction, it is not difficult to raise money here. So if you’re struggling to raise money, it’s because it’s too soon. You need more impressive numbers. What that means is Australian entrepreneurs will have to struggle and go further with less money.
And you can’t look at the US and hold it up as the model we should aspire to. Because they never had the largest mining boom in history. The relative strengths and weaknesses of each environment is different. You’d think Australian angels would capitalise on this but I don’t really see it happening very much.
The real difficulty is finding that rare entrepreneur who can grow a company to an EBITDA run rate of 10m+ or 3 profitable years of $1m+ using only an angel investment or seed round. It’s hard, but not as hard as trying to become a unicorn like in the US. This is probably balanced by the increased liquidity a public market would provide. An investor could sell stock whenever they wanted.
Update 2021
This essay was a little bit before its time and in the last 8 years, the number of Australian technology billionaires is now 10. Concentrated in 3 companies – Atlassian Canva and Afterpay. Just those 3 businesses increase the amount of market value created by Australian technology businesses by close to $200b. Those 3 businesses are worth more than almost the remaining entire technology sector in Australia and displays first hand the power law distribution in this industry.
Since it was written private markets have also matured, the number of active VC funds managing over $100m in Australia was less than 5 – now there are dozens. And there is a much more robust private funding market as well as public markets. It used to be that to raise growth funding, there was nowhere to go. Now there are dozens of firms built around supporting that stage in the growth cycle. And many of the overseas US firms have started investing locally in Australia. Adding to that Super Funds and Family Offices are allocating money to VC as an asset class. This has resulted in for the first time in many decades, VC is a profitable asset class with a positive rate of return in Australia again.
What’s also interesting is the total number of billionaires has increased to over 50 and much of the Australian technology wealth have followed a similar trajectory of IPOing when they were smaller as capital raising events. Making the essay conclusion still as applicable today as it was then.