27th June, 2021

Week 26/52

Source: National Museum of Australia


🍳 Cook

To further my thesis that every story about technology is better if you swap out technology for poetry...

I was recently reminded of this obscure German poem by Bertolt Brecht:

Fragen eines lesenden Arbeiters

It starts:

Wer baute das siebentorige Theben?
In den Büchern stehen die Namen von Königen.
Haben die Könige die Felsbrocken herbeigeschlappt?

Or, in English:

Who built the seven towers of Thebes?
The names of kings are mentioned in the books.
Did those kings drag those boulders?

Later:

Cäsar schlug die Gallier.
Hatte er nicht wenigstens einen Koch bei sich?

Translation:

Caesar defeated the Gauls
Was there at least a cook with him?

I encourage you to read the whole poem. And think about that next time you read a story in the media about an amazing founder and all that they have achieved. (Especially if that story is being told by the amazing founder themselves)

For all of the aspiring boulder-draggers and cooks who might be reading this, I also recommend this short presentation by Derek Sivers:

This is basically the story of every successful start-up.

So, a toast: to all of the followers who have helped transformed lone nuts into leaders and in the process helped to start a movement. 🍻


I was originally introduced to this poem by my high school German teacher (who is also a subscriber to Top Three!) Not, as you might have expected, when I was actually studying German, but many years later when I returned to school to speak. She said to me: “I know you have worked for some great companies. But, what did you actually do?” I was fumbling through an explanation: software engineer, product, strategy, investor, adviser, yada yada. She stopped me and said: “Oh, you cooked the meals”.


🪃 Return

When a business earns more than it spends, it is default alive. When it spends more than it earns it is default dead - in other words, it is dependant on the on-going support of investors to fund the difference.

This is an important concept for any founder or investor in early-stage companies to understand.

A couple of weeks ago, when talking about the different outcomes we might look for from the start-up ecosystem, I said:

Ultimately we need these companies to actually contribute more cash to the local economy than they take.

Let's think about this at the ecosystem level and consider start-ups in aggregate. When these companies are together contributing more than they receive in grants and subsidies etc we could say the ecosystem is default alive, and helping to build the economy. When those companies are taking more than they give back, the ecosystem is default dead - it only exists in this state as long as others are willing to fund it

(I suggested we think of “others” in this case using the persona of Hugh the forklift driver from Timaru).

There are now so many different parts of government (both central and local) that give cash or value-in-kind to start-ups that total amount would likely be quite difficult to calculate, although each individual company will know how much they have received.

But the other side of the equation is relatively simple to measure: it's PAYE + GST.

We could also include other kinds of tax - e.g. income tax and resident withholding tax on dividends. However those amounts are negligible - very few start-up companies are profitable, let alone in a position to pay dividends. Indeed those companies that have raised and spent a lot of capital in pursuit of growth often have significant accumulated tax losses which they can offset against future profits.1 So the time-to-first-income-tax-payment for a high-growth company can actually be many years and sometimes longer than the company exists as a stand-alone entity.

On the other hand, the two biggest expenses for a start-up are typically payroll and rent, so as soon as they have cash to spend, start-ups begin paying PAYE and GST.

(There are also secondary benefits as any money spent locally by companies on staff and expenses will then be in the economy and likely recycled. Somebody with a much bigger brain than me could calculate the multiple and analyse the overall value of this - but for today let's focus on the direct benefits)

As I've written about previously, the really beautiful thing about both of these taxes, from a policy perspective, is that the government already has full visibility to them:

Every month all registered businesses in NZ are required to submit a GST return documenting their revenues and expenses. Using the data captured by this existing system, we could easily identify those companies that are exporting, that is: spending and investing money locally and earning revenue on sales internationally. Then, if we wanted to, we could filter that list to narrow our focus on the specific types of companies we want to encourage.

Source: Picking Winners

It would be relatively easy to use this data to objectively select companies to support. Some examples:

  • We could target young companies - i.e. companies that have only recently started to trade and submit returns.

  • We could target small companies - i.e. companies with revenue under a chosen dollar threshold.

  • We could target fast-growing companies - i.e. companies with revenue that has materially increased compared to previous returns.

  • We could target companies that are currently expanding and investing for growth - i.e. companies that spend more than they earn and who have recently increased the number of people on their payroll.

  • We could target companies with a high revenue per employee - i.e. to encourage those companies that are contributing to increasing our overall productivity.

  • We could even target companies with a higher percentage of local ownership (again, all of these details about businesses are already captured by the government through the Companies Office).

The specific policy details are likely to be refined over time - in practice it would probably be some combination of all of the above (there are currently different grants and subsidies available that target each of the things I’ve listed).

The important thing is that all of these criteria could be published in advance and determined objectively, with limited additional administrative overhead. Every eligible company could quickly work out for themselves what they are “entitled” to receive.

This by itself would be a significant improvement. I prefer not to think about how much time and effort the start-ups I’ve worked with have spent on understanding the various government schemes that are available, completing grant applications and then schmoozing with officials who get to decide if those payments are approved or not.

But even better than that, as well as making it simple to filter who qualifies for subsidies it would provide a simple mechanism for actually making the payments.

Currently nearly every growing exporting business receives a GST refund direct to their bank account each month: their local expenses are larger than their local revenues, so they pay more GST than they collect and are refunded the difference. This means that any subsidy could be easily added to that refunded amount. And, as with GST refunds, could be paid in smaller monthly amounts rather than in one big hit each year, removing the rags-to-riches effect that annual grant payments can have for small companies.

This proposal doesn’t predetermine or even lock in the size of these subsidies. That would remain a political decision. But it would consolidate all of these payments in one place, where the total quantum would be much more visible than it is today. I think this is one of those situations where a bit of sunlight would be a good disinfectant. If nothing else, it would make it a bit easier for Hugh + co to understand the on-going investment they are making in the ecosystem.

The bureaucracy that we’ve built to pick winners is complicated and unnecessarily large. And, worse, it’s mostly failed to actually pick winners.

Paul Callaghan was correct, I think, when he said that our successes would come from weird niches and as a result would be impossible to predict in advance. I find it deeply ironic that after he died we named a crown entity after him, hired a bunch of people and immediately put them in charge of making those predictions.

This proposal would let us dismantle large parts of this system.

In case that makes it seem like I’m just being negative, let’s be clear about what that means:

Callaghan Innovation could get back to focusing on science and invention and making sure this is funded and supported to the level required to provide the foundation for future success. There are some amazing people in this system currently crowded out by the focus on commercialisation.

NZTE could get back to focussing on how they support exporting companies in overseas markets. This is something they have traditionally done well and have good expertise in, but which has been diluted as they try to expand their scope to help younger companies.2

NZGCP could finally be measured based on a simple investment returns, the same way as any venture fund manager should be, rather than on their much more subjective contribution to building an ecosystem or supporting the development of an angel network or "catalysing the capital market". As I’ve noted previously given their returns to date it’s difficult to imagine they would still have investor support, if they had been required to raise their capital privately.

Local government could get back to providing the infrastructure that makes towns and cities the sort of places that people working on start-ups actually want to live in. This is much more to do with mundane things like roads, public transport, libraries and recreation facilities (bonus points if you also have waste water pipes that don't flush sewage onto the streets) than funky shared working spaces, subsidised business incubator or accelerator programs or other random economic development initiatives.

(Given that GST and PAYE are both collected by central government, calculating any return on the substantial "investment" that local and regional councils around the country make into start-up initiatives is much less obvious to me. Is it just a my-town-is-better-than-your-town competition? What am I missing here?)

These are the obvious things that each of these organisations should be good at. This is how they can ultimately contribute the most value to the success of the ecosystem. We just need to flush out all of the wanna-be start-up people that have ended up inside all of these organisations working on first and second derivatives ecosystem initiatives (perhaps we could get them all working directly on start-ups instead?)

Imagine the impact that would have!

A footnote, of sorts, on capital gains...

There are no capital gains taxes on start-up investments in NZ.3

(For international readers, that's not a typo, although I appreciate that many of you will find that difficult to comprehend!)

This means that the government doesn’t benefit directly at all when start-up companies attract investment or are sold - there is no tax payable in those cases, so the value created is captured entirely by shareholders.

It's actually difficult to imagine a more investor friendly regime than this, especially when we factor in the various subsidies we’ve been discussing.

As part of reconsidering the system of grants and subsidies it would be an excellent opportunity to also think about how and when these payments could be treated not as a gift, but as a liability to be repaid (with interest?) by shareholders in the case of a successful outcome. That change would at least force founders to think a lot more carefully about how they spend this money, as it would put a cost on the capital provided.

I think this would be a sensible proactive change for the ecosystem to drive sooner rather than later, ahead of any future political debate about capital gains taxes.4

For an individual company that is default dead it’s important to show progress so that investors continue to provide the capital required to fund future growth. Likewise, for the ecosystem as a whole, we need to do a better job of demonstrating returns on this support - not just to specific founders and investors who are enriched when their ventures do well, but also to everybody who ultimately funds them.

It's been a few years since I first suggested this model, and I still like it. However I’m also still very interested in feedback from people who understand this system better than I do - what am I missing? Please let me know.


🦜 Preorder

This is a fun Lego project I’ve been following for a long time, and it seems it might finally go into production. But, only if enough of us pre-order on 1st July


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

Take for example Xero which was founded in 2006. In 2020 they reported a profit for the first time. However, they have over $100 million of deferred tax losses carried forward on their balance sheet, so it's likely still a number of years yet before they are tax payers on that account.

2

For example, NZTE previously had a program called Focus 500, which aimed to help the largest exporting companies. The problem was (apparently?) there were not enough start-ups in that list. So they expanded it to be Focus 700. I think they must have a different definition of “focus” than I do?

3

In theory if you were trading in early-stage companies then capital gains taxes would apply to your profits, but given the illiquidity of these investments that is practically impossible.

4

For example, it’s not that difficult to imagine a situation where capital gains on family homes were exempted from a future tax but capital gains on high-growth businesses were not.