The funding gap in our tech sector

The 2018 TIN Report was released recently by the Technology Investment Network, and it confirmed the continued growth of New Zealand’s technology sector. Total revenue for the top 200 technology companies (the TIN200) was $11.1 billion, an increase of 11% over the past year. Most of that revenue – nearly $8 billion – was in exports, with North America and Australia the biggest markets.

I attended the Wellington launch of the TIN Report last week, where a big topic of discussion was how NZ tech companies can scale up. The report highlighted that tech companies in the $2-$10 million annual revenue range tend to have “negative profitability” as they attempt to scale up. These mid-level companies also find it difficult to attract talent, due to what the report calls “a highly constrained labour market” here in New Zealand.

These issues, claimed the report, highlight “the importance of New Zealand’s VC and Angel markets to cover the profitability gap in companies’ early stages.”

The problem is, we don’t have much of a venture capital market. In the recent past, startups like Xero, Vend and 90 Seconds have gravitated to overseas VC firms to raise the required capital to scale up. We’re talking millions or tens of millions of dollars in capital, not the tens or hundreds of thousands of dollars that angel investors typically put into an early stage business.

The good news is there’s a thriving angel investment network in New Zealand. The TIN Report noted that angel investment has been outpacing TIN200 revenue growth, “averaging 21.8% growth between 2015 and 2017.”

While that’s very encouraging for early stage companies, the reality is that angel investment growth has little impact on those currently in the TIN200.

The lowest ranked company in the TIN200, Crossover, had revenue of $2.7 million. There are another 57 companies on the list with revenues between $2-10 million. Many of those companies will be looking for ways to scale up beyond $10 million. A few very ambitious ones will be aiming to get to Xero’s level ($406 million).

Since angel investors generally put their money in right at the start of a company’s growth trajectory, most of the 58 companies in that $2-10 million bracket won’t be seeking further angel funding. If they do want to raise capital to fund growth, it will need to be from VCs or private equity firms.

TIN managing director Greg Shanahan acknowledges that NZ tech companies will likely need to look offshore for post-angel investment.

“Great work is being driven by the likes of NZTE, local development agencies and the local angel investment networks to help connect growing tech firms with these global investors,” Shanahan told me. “These efforts need to be supported and built upon so we can see more $1B NZ tech firms in the future.”

The figures in the TIN Report suggest, however, that our leading tech companies are either reluctant to find – or struggling to get – follow-on investment. Just 11.5% of the TIN200 has been funded by private investment, which the report defines as “investment from VC, PE [Private Equity] and organised Angel groups.”

A staggering 56% of the TIN200 are privately owned, including the top company Datacom – which is majority owned by kiwi rich lister John Holdsworth. 17.5% of the TIN200 are foreign-owned (such as Fisher & Paykel Appliances, number 2 on the list) and 15% are public companies (such as Xero, ranked fourth on the list).

Why is it important to increase the number of TIN200 companies with private investors? Because those companies have by far the highest growth rate.

The report states that investor-fueled companies achieved revenue growth of 19.2% over the past year. Public companies also grew at a good rate, at 16.1%. By comparison, the revenue growth rate of privately owned companies (9.6%) and foreign owned companies (4.3%) is far less impressive.

In that respect, it’s surprising to me that only about one in ten of the TIN200 have gotten external investment to fuel higher growth. Especially considering there is no shortage of offshore funding available.

“There are plenty of VC investors in the US and Asia chasing too few quality deals,” Shanahan said. “They’ll tell you there is plenty of next stage or Series A money out there for the right companies.”

Shanahan thinks kiwi entrepreneurs need to have more self-belief and market themselves to gain access to VC capital.

“They need to be thinking like the owner of a company that could be a billion dollar company someday. They need the ambition, drive and persuasion to reach out successfully to offshore VCs.”

It’s also important to reach out early, according to Suse Reynolds, an active angel investor and Executive Director of the New Zealand Angel Association. She pointed out there’s help available in the form of NZTE’s capital markets team, NZVIF and experienced angels.

“Any venture that wants to scale internationally and scale fast is going to need growth capital,” Reynolds told me. “If that’s the aspiration for your venture, you need to be thinking about this from the outset of building the business – or at the very least as soon as your first angel round is closed.”

Ventures also must think carefully about what else they need from VCs.

“Fundamentally, you need to be thinking about what capability that capital is going to buy,” Reynolds said. “So this means thinking strategically about who is going to provide you and your venture with the best connections and expertise to help make that next leap in value and impact. It’s not really super relevant if that capital is sourced from New Zealand, Australia, USA or Asia.”

While I agree with that last sentiment, one undeniable advantage overseas VCs have over local investors is their network. VCs in places like Silicon Valley and London are capable of making valuable introductions in big markets, and they can more easily connect young entrepreneurs to experienced ‘been there done that’ business people. So I asked Reynolds if NZ VC firms can ever hope to provide the same level of networking value?

“Absolutely yes,” she replied. “NZ VCs are always on planes. They are super savvy to the need for connections. And many of them have been at it for some time and are very experienced.”

It seems odd to quibble with the lack of growth investment in our mid-tier tech companies, when the TIN Report states the overall sector increased revenue by 11% over the past year. But there does seem to be a glaring gap between angel investment at the early stage of a startup, and the VC level funds required to fuel growth at the mid-stage of a tech company.

Filling that gap would drive even more growth for our tech ecosystem in the coming years. It’s time for New Zealand to get serious about VC investment.