As you may know from previous posts, I think tech VCs get a bum deal in Australia. They get picked on primarily due to your average startup’s pretty poor understanding of the local funding industry. I recently had the chance to catch up with Mike Zimmerman, General Partner of Technology Venture Partners (TVP), one of Australia’s leading venture capitalists.
Maybe it was because Mike was on holidays in the US when we spoke or maybe it was some other reason, but this was a far more open and honest discussion than I could have hoped for. It was also a much longer conversation than I thought he would have time for so I’m going to break it down into 3 posts.
In this, Part 1, we focus on clearing up some common misconceptions about VCs.
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To kick things off Mike wanted to clear up a couple of misconceptions about local VCs.
The first is that they are risk averse. 80% of TVP’s deals are pre-product and pre-revenue, which goes against the often heard complaint that VCs are only interested in businesses that are already making money.
The second is that there’s lots of money to go around and VCs are holding out. This misconception would appear to have its roots in the fact that Australia is the world’s 4th largest funds market (mostly due to you and your super) with well over a trillion dollars under management. The logic follows that venture capital as an asset class should be easily accessible (they’re only asking for a small %, right?) and that part of that could easily be directed towards tech startups. But that isn’t the case.
Just like startups, VCs have to raise money. In the VC world, people who commit the capital to invest are called Limited Partners (LPs). In Australia, there are only a small number of Limited Partners who invest in Venture capital and they are, in most cases, the super funds. In general there is a very small allocation to venture and not a lot of people to go talk to on the VCs fundraising short list. This small number of potential suppliers means that – just as is the case for startups approaching the small number of VCs in Australia – if a few people say no, you are unlikely to get funding.
The problem is that venture capital is seen as relatively risky as an investment compared with stocks (thought that may have changed over the last couple of days), bonds and real estate, and is still building its track record as a way for super funds to make great returns. Consequently, it will take time for LPs to get more comfortable with the risks. Silicon Valley has had over 40 years to do this, with quite a few massive wins along the way. In Australia it’s been more like 10 years – with a tech wreck along the way — with fewer and smaller wins to date.
The long and the short of it is that there’s a supply chain for money to get from your mum and dad’s boss to your local tech startup and currently leading VCs like Mike are frustrated that the supply chain isn’t working efficiently.
That having been said, there is some money around and, as was mentioned earlier, leading VCs like TVP are investing 80% of the time in pre-product / pre-revenue companies. So an obvious question is why aren’t there more tech startups, or should I say, web startups, being funded?
To understand that we need to look at the numbers.
Leading US VC, Fred Wilson recently explained (and Mike confirmed the numbers are in the ballpark, if a little high, for Australia as well) you need to make 3-4x gross returns to get make 2.5x net returns for LPs on their investment (Fred states that this is the minimum acceptable return).
The discrepancy between gross and net in this case is because of various fees, including management fees (between 1.5-2.5% p.a.) and the “carry” (the carried interest on profits that most funds take, which is typically around 20%), VCs take for managing the investment. It may sound like a lot but when you compare what people who manage the super funds and other investments are earning, it’s not really that extraordinary.
So, that 2.5x net is equal to just over 10.5% pa return on the LP’s promised capital over a 9 year life span. Not exactly stunning returns for a pretty risky and fairly illiquid asset over 9 years, especially seeing as you could be guaranteed that amount, virtually risk free, by throwing it in a term deposit at a bank.
So again, let’s look at the numbers – TVP might have a $100M fund to invest – so they have to turn that into $300M once you take into account their management fees and the carry in order to make the minimum acceptable returns for their LPs. Part of the way they do this is by making larger bets (they simply don’t have the resources to manage hundreds of smaller investments). By larger I mean down to about $1M at the small end with approximately $5-$10M average investment per portfolio company and targeting say 10-15 companies in a portfolio. They also have to believe each investment can be a big winner. For example, if TVP is to make the $300M, it must turn every $5-$10M it invests into $20-$30M and knowing that most companies don’t make it, each successful investment must be worth even more. So assuming TVP owns 25% of 10 successful companies, each company must be exited for at least $120M to make a successful fund.
Now all of us would probably like to believe our companies will be worth $120m but the reality is almost all of them won’t. So as much as we’d like someone to pop $5M into our startup, the truth is that we almost certainly don’t need it and the VCs can’t always make the return they need from it.
This doesn’t mean that there are no other options. In fact there is an excellent option that is working all over the world – a strong Angel network to 1) invest in exciting but smaller opportunities, and 2) kick things off with pre-VC funding… and that’s where my discussion with Mike soon headed…
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Stay tuned for “Part 2 – Angels” of this 3 part series
