Why VC firms now take start-ups seriously
It appears that the ‘lean’ spirit of modern entrepreneurship has finally inspired the Australian venture capital industry to invest in early stage start-ups – a trend is set to increase due to the accelerator boom.
Last year the number of small investments in early stage companies eclipsed the number of bigger deals in the market, according to VC industry group Australian Private Equity and Venture Capital Association Limited (AVCAL).
Firms spent about $85 million on start-up, seed, and early stage companies last year – such as leading tech ventures Shoes of Prey and Styletread – which constituted just 4% of the overall spend but represented 61% of the 212 deals.
This represents a far cry from the commonly-heard refrain that Australian venture capital firms are either unaware or not interested in what’s going on in the start-up world. Indeed, some frustrated entrepreneurs have even reluctantly quit Australia because they weren’t able to catch the eye of local investors.
But things could be changing. One of the most active firms, Starfish, shelled out about $30million for stakes in seven new companies in 2012 - double its average run-rate of four companies a year.
Partner Tony Glenning, who joined the firm in 2010 to lead the mobile/web tech investments, said Starfish has no intention of slowing down.
A decade ago VC firms would spend millions of dollars on an idea represented on dozens of PowerPoint slides, according to Glenning.
The majority of an investment was consumed by large infrastructure costs, and it could be years before the company's future was obvious.
Today it's possible for a venture capital firm to invest as little as $500,000 on a developer whose application is used by thousands of paying customers. In the space of weeks, or months, the return on investment is clear.
Investing in early stage companies is much safer these days.
"Because starting a business is so capital efficient, it is easy to make smaller investments and see how the companies develop,” Glenning says, who sold his company Tonic Systems to Google in 2007.
“Previously the first cheque might be $3 million to $5 million, and a lot of that was going to buy servers and infrastructure.
“Now the first cheque can be up to $1 million, if you wanted, and that’s actually still growth capital because the developer has an actual product ready to go, but just need a sales team or marketing to scale it up."
Enterprise is the new consumer
Glenning led Starfish’s investment in Sydney start-up ScriptRock earlier this year, as part of a $1.5m investment round led by Facebook and PayPal investor Peter Thiel.
ScriptRock develops the tools that allow technology professionals and corporates to easily test and deploy new applications across a range of different systems. It was founded by three IT contractors that directly observed the pressure point in some of Australia's biggest corporations.
Co-founder Mike Baukes, who recently relocated to Palo Alto, believes the company is riding the crest of a turning tide of investor sentiment: from consumer-plays to enterprise.
"As far as I’ve seen there are four key factors that are driving investment in Australia," Baukes says.
"One: Enterprise is a good place to be, whereas previously targeting enterprise customers would mean the death of a start-up.”
"Two: You don't need as much money to get started.”
"Three: Accelerators are creating good investment prospects.”
"Four: If a founder has experience in their target domain, they've worked in the industry and aren't fresh or going in blind, then that's usually a good indication."
He said in recent months - particularly after the market's disappointed response to the Facebook initial public offering - there has been a huge increase in the number of investors that have indicated they want to play the enterprise game.
Accelerating the cash
ScriptRock came to being when it participated in the Startmate accelerator program.
The accelerator model to quickly scale an idea into a business has become a permanent feature of the start-up landscape. They usually invest $20,000 for a 7.5% stake of a start-up aligned to the holy trinity of execution, investment, and people.
Startmate and PushStart are two organisations that nurture entrepreneurs over an intense three-month mentor and development program, which culminates in product demonstrations to a range of investors. Starfish also invested in inaugural Startmate graduate BugHerd last year.
Even though the programs have only existed in Australia for the past two years – Startmate has just selected its third group of participants, while Pushstart will take in its second round next year – Glenning believes that accelerators will keep the firm busy.
"I would imagine that you could keep investing at a similarly active rate, assuming funds are available for the foreseeable future, just because the quality is so high at the moment," Glenning says.
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Glenning says companies need to demonstrate certain qualities to justify their expense.
“Have you finished your product? Is it in the market? Have you proven out the business model?,” he says.
“What's the cost of customer acquisition versus lifetime revenue of customer versus overheads to deliver on your promise?”
“Basically we need to have some comfort that even if the business isn't profitable now, it will be after these metrics are proven. That's the stage where we most prefer to invest – when the founder can answer these question.”
The $40million firm OneVentures has invested in six start-ups - including the University of New South Wales spin-off SmartSparrow. The fund’s founder Michelle Deaker says that accelerators and angels develop a company’s business prospects.
"It is synergistic," says Deaker, whose firm was assembled with the help of the government's IIF funds matching program.
"We often invest with angels or post an angel round."
"We see it as a positive that an angel or an accelerator may get in and work with a young company to begin to take out risk elements in the business whether technology, team makeup or business validation with customers prior to our investment."
The entrepreneur and the egg
Last year Startmate, Pushstart, and Melbourne's AngelCube mentored 20 businesses, approximately 50 entrepreneurs – almost four times the previous year.
This growth will be boosted next year by the Singtel Optus Innov8 seed program and others. The investors have taken notice.
Melbourne's Adventure Capital has invested over $1 million since it was founded early last year. Startmate founder Niki Scevak and former MLC advisor Richard Baker reached into the deep pockets of Atlassian co-founder Mike Cannon-Brookes and Southern Cross Ventures, among others, to establish Blackbird ventures and capitalise on this opportunity.
ScriptRock’s Baukes believes that the new players will provoke the more established players into action.
“With Blackbird coming out of nowhere a lot of other funds have noticed a potential competitor going for really early stage and they’re going to want a slice of the action,” he says.
Scevak adds: "Venture capital is a service industry, servicing entrepreneurs who are starting these types of companies. The main constraint is the number of founders starting these particular types of companies.”
"It’s not the case that if there is more venture capital then there will be more start-ups I think it’s the other way around: as people start more start-ups, there will be more venture capital. So as the number of companies that have started increases so too will be the amount of venture capital available."
However, it might be some time before the established venture capital firms catch-up to the likes of Starfish, and OneVentures, who closed their ten-year funds before the global financial crisis – around the same time many investors shut their wallets.
"It's been a tremendous advantage over the last two years," Starfish's Glenning says.
"In the last 12 months Australian companies raising money couldn't go to that many people. Therefore Starfish is in a fabulous position because we get to see pretty much all the deals."
Five VC questions that Tony Glenning says every start-up should answer:
- What are you selling?
- Who is your customer?
- How do you acquire the customer?
- What's the value of the customer?
- What are your overheads?