18th April, 2021

Week 16/52

Photo by Adam Bignell on Unsplash

🎙 Sing

Imagine being brave enough to sing this particular song with this particular band in front of this massive crowd, live at Wembley. And nailing it.

29 years ago this week (😱), at the Freddy Mercury Tribute Concert…

This reminds me, I need to add John Deacon to the #QuietOnes list.

---

⛽️ Fuel

“Money is like gasoline during a road trip. You don’t want to run out of gas on your trip, but you’re not doing a tour of gas stations.”
– Tim O’Reilly

Perhaps the biggest And most enduring misconception related to technology start-ups in New Zealand is this one:

It's hard to raise investment in New Zealand, because there is a shortage of venture capital.

It's actually remarkable how widely this is believed. I think it's been repeated so many times by so many people for so long now that it has become an accepted fact, even when the recent evidence actually points in the exact opposite direction.

(For another example of this “proof by repetition” see my earlier post on the misconception that “Technology is the third biggest sector in New Zealand”)

The “because” part of this is so easily disproved. There is a massive amount of venture capital sloshing around in the world at the moment 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 and invest in them.

Over the years, I've often challenged those claiming that there is a shortage of capital 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 funds¹ and the amount of capital they are able to raise and deploy in local ventures.

Meanwhile, we've seen increasing evidence that investors from everywhere are more than willing to invest in companies started in New Zealand if they are good enough. That last bit is actually the only constraint (as I've noted before, there are only two possible reasons why you can't raise investment: the value isn’t obvious; or the price is too high).

For what it's worth, I think that the feeling that it's easier to raise capital overseas is also a myth. I sometimes hear people claiming that it's much easier to raise venture capital in the US, for example, and always wonder:
(a) have you ever actually tried to do that (I have, and I assure you it's not easy); and
(b) it's one short overnight flight away, so what's really stopping you?

That all leads me to this conclusion... I think what those folks who complain about a shortage of capital are really thinking, although thankfully still a little embarrassed to actually say out loud, is that they wish it were easier for them specifically to raise venture capital.

Indeed! But, don't wish it were easier, wish you were better.

The bigger issue that is lost in this whine is this:

A vibrant venture capital sector is a consequence of a successful start-up 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 work!

It's amazing how many would-be investors, especially “angel” investors, get this around the wrong way, and think that they are the engine pulling the venture along. It possibly also explains why the most successful investors are often former founders rather than financiers - they tend to have a better empathy with these two roles and the relative value of each.

This is actually the history of every market where there are successful venture capital funds.

As I referenced last week, the early venture funds in Silicon Valley were the original investors in the microwave and integrated circuit companies that where created during the cold war². 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 best companies.

Likewise, the reason there are many more successful 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 ecosystem³.

Take away the successful companies from either of those examples and all you have are small funds 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 there is even shorter!)

But, for today, let’s focus specifically on the comparison with Israel, because they were 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 are not well understood (at best - at worst they are misrepresented) and so continue to distort our thinking.

The New Zealand Venture Investment Fund (NZVIF) was established in 2002, as a fund-of-funds model. They initially selected five venture funds to invest in (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

Those funds each had full freedom to pick the individual companies they invested in.

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

A simplified example, to demonstrate:

NZVIF 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 Evil Global Corp, producing a return for Fund A of $30 million (the mythical 10x return!) At this point Fund A can buy-out NZVIF 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 actually works out like this, a decent deal too for NZVIF, 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 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 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. Israel now has a large number of active local venture capital funds.

So, how did we go with this model in New Zealand?

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

Of the original five funds none have taken the buy-back option. As far as I know, none is still active.

As I mentioned, there was one late addition that became the exception: Valar Ventures was reversed into this scheme in 2012, and eventually took the buy-back option.

This was quite correctly criticised at the time, for multiple reasons:

• Valar got matching funding, which was a much better deal than the “$1 for every $2 raised from private investors” deal the original funds got; and

• Valar were allowed to include pre-existing investments in the deal, including their investment in Xero, which was made in 2010, two years earlier, and which would go on to produce significant returns. It's difficult to argue that you are encouraging new investment when those investments have already been made. They would have invested anyway. They had already invested anyway.

• Valar were not really a local fund. They are no longer active investors in local ventures, and left no real legacy.

I'm not sure there are deep lessons from this, to be honest. If we offer US billionaires a deal that is too good to be true we can't be too surprised if they take the deal. The problem was VIF was getting so desperate for some success from this scheme by that point that they were inclined to offer it to Valar 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”, meaning 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 investors what their returns are, they tell you!

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

“NZVIF 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 this 2019 Treasury report:

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

Other excuses are the impact of the Global Financial Crisis around 2008 or the sub-scale size of the initial funds (the average fund size was ~$45 million).

Except that's not correct. There were more than enough successful companies started in New Zealand and funded 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.

The 2017 NZVIF Annual Report listed five other companies that had achieved a valuation of $1 billion or more by that stage: RocketLab, Pushpay, Diligent, Telogis, and Anaplan⁴. Curiously, it was completely silent about which of these companies funds backed by NZVIF had invested in. I believe the answer is: none of them.

The problem wasn't that there weren't great companies to invest in (or an “insufficient pipeline” if you prefer that terminology). The problem was the NZVIF funds didn't pick them. Ultimately venture capital is a judgement game, and their judgement was empirically poor.

The same cabinet paper I linked to above offers this remarkable explanation:

While NZVIF 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.

🤨

Do more of what works. Do less of what doesn’t.

Sadly, while we encourage venture companies to fail fast, we did the exact opposite with NZVIF. We doubled down. The funds NZVIF have backed more recently, 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 managing venture capital in New Zealand is hard work.

We still believe that today, even as we see international funds setup local offices and local Kiwisaver funds allocate a portion of their capital to this asset class. While NZVIF has been going backwards, more capital than ever is getting recycled from successful ventures that they didn't invest in. Given time that will develop into a local venture capital sector, just as it has in other places around the world.

When you repeatedly pivot and don't address the root cause of the failures, it's not really pivoting, it's fire hosing. I suppose as long as we continue to do that, then NZVIF (now rebranded as New Zealand Growth Capital Partners) will eventually be able to take credit for what's created, whether they actually contributed to it or not.

Disclosure: I’ve been an active participant in the start-up “ecosystem” in New Zealand, so I’ve got some links to nearly all of the ventures and funds I’ve referenced in this post. Specifically I was an early employee and shareholder at Trade Me in the early 2000s (when we would have loved to raise capital from some of the initial NZVIF funds), I was an early investor in and employee at Xero, I was an investor and director at Vend when we raised capital from both Square Peg and Valar Ventures and later at Timely when we raised capital from Movac, and I am currently an investor in funds managed by Movac, Blackbird and Simplicity.

---

🤐 Show

One of the traits I sometimes hear people promoting is:

Strong Opinions, Loosely Held⁵

The idea behind this are good: act with conviction, but be prepared to change your mind when you get new evidence; don't be scared to express a viewpoint, but expect to have to back it up with data when challenged, etc. I've had the privilege of working in teams that operated that way, and we got a lot done!

But it's interesting how often this ambition actually manifests as:

Wishful Thinking, Seldom Exposed

Or worse:

Loudest Reckon Wins

A good recent example of this would be the COVID vaccine programs in NZ and Australia.

Rewind a few weeks when the Australian government first published detailed plans for their roll-out, including a website where everybody could log in and see exactly when they would be vaccinated. We were envious! There were calls in NZ for us to do the same: “Why don't we have a plan?” people asked. “We need certainty!”

With the benefit of just a short period of hindsight that looks a bit silly. The detailed Australian plans were actually just hopes and dreams. The future they imagined was never real⁶.

(Now they are in the slightly farcical position of calculating a cost analysis on the basis that their now-exposed optimistic projections were the baseline).

Of course, founders of early-stage ventures make this mistake nearly every time they answer a question about their aspirations. And many investors enable them in that behaviour by continuing to ask for accurate predictions across timeframes that are just unknowable. As I've said before: Investors asking for a five-year forecast, before you have enough data to make good assumptions, are asking you to lie to them (whether they realise it or not). You should call them on it!

I feel like I give contradictory advice on this question...

On one hand, there is even some evidence to show that sharing your goals in advance makes it less likely that you will achieve them. I mostly think you're better off keeping your aspirations to yourself until you've got something concrete to point at. When you don't (and can't!) know what the future holds it's better to admit that, than guess with unearned accuracy. If you're pressed for a guess, I suggest you give a range. It's always better to under-promise and over-deliver. Etc.

On the other hand, fresh eyes on plans nearly always makes them better, so I always tell founders to share what they are doing with whoever will listen and then pay attention to the feedback they get (generally it's much harder to get people to care enough to listen to ideas than to cope with their negative feedback!)

The distinction here, when you think about it, is the difference between intentions and actions.

If you’re announcing your intentions (or worse, celebrating having them) then you’re probably better off keeping your mouth closed and your head down until you have some actual progress to point at. But, once you have a plan (or better, some early results) then that’s a good time to tell others and see what they think.

An excellent book on this topic is “Thinking In Bets” by Annie Duke. Using the earlier example, if we followed her advice, rather than predicting exactly when we think everybody will be vaccinated we would give an estimate with confidence levels - e.g. 90% confident that this will be completed by November - or upper and lower bounds - e.g. current projection is this will be completed some time between July and October. That allows people to consider your target together with a confidence level. And, in the case where you provide a range, the size of that range actually itself gives an indication about how confident you are.

So, when you're asked for a five-year revenue forecast for your brand new startup, you might reasonably say "somewhere between $0 and $500 million".

If you're on the receiving end and you get a seemingly definite projection then you can simply ask founders “It sounds like you are 100% sure of that, is that right?” The answer, in my experience, is nearly always “... actually, no”.

If we're trying for the pithy summary it might be something like:

Explicit Conviction, Revised Frequently

Unfortunately it's not quite as simple as that…

Whether it's preferable or not, the spotlight nearly always shines on those who appear most confident. We assume that those we hear from most often are the most qualified to comment. So if you want any attention at some point you need to stick your chin out (and be prepared to be punched in the face down the track I guess).

And, last word on this to Obama:

“People being led do not want to think probabilistically.”
— Barak Obama

---

Top Three is a weekly collection of things I notice in 2021. I’m writing it for myself, and will include a lot of half-formed work-in-progress, but please feel free to follow along and share it if it’s interesting to you.

1. If we're going to go down that rabbit hole then we also need to think about what proportion of fund managers (aka general partners) need to be local, what proportion of limited partners (aka investors in funds) need to be local and what proportion of companies these funds invest in need to be locally domiciled (and what that even means), which will force you to consider what happens when a local fund invests in a local company that then moves their domicile to somewhere else. This sort of nonsense is why in Australia there are government imposed limits on the nationality of companies that venture funds can invest in if they want to qualify for tax benefits on offer over there.

2. Let me link again to this talk by Steve Blank about the “secret” early history of Silicon Valley:

3. 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 Atlasssian and have grown on the back of their investments in multiple break-out ventures started in Australia, including Canva, CultureAmp and SafetyCulture.

4. We can argue another time about how “kiwi” each of these companies actually is. As I’ve noted previously it’s a complex and ultimately irrelevant question.

5. I think this blog post by Paul Saffo is where the expression originated.

6. Thank you to Lillian Grace for gifting me this line - it is one of the very best things I got from the 2020 Lockdowns.