Member Spotlight

National Association of Seed and Venture Funds

Preview:
Market failure in the availability of equity capital for early-stage businesses is the subject of extensive studies around the world. The OECD and others have found a positive link between venture capital investment and economic growth and restructuring. Consequently, there is a case for Government intervention to address the ‘capital gap’ and stimulate equity investment in early-stage companies. Amanda Heyworth, CEO for Playford Capital in Adelaide, South Austrailia offered this interesting perspective in a recent presentation in Portugal

Article:
Market failure in the availability of equity capital for early-stage businesses is the subject of extensive studies around the world. The OECD and others have found a positive link between venture capital investment and economic growth and restructuring.

Consequently, there is a case for Government intervention to address the ‘capital gap’ and stimulate equity investment in early-stage companies. Such intervention usually takes the form of providing investment capital, subsidising the operating costs of fund managers and/or providing tax credits for early-stage investments.

The tendency of venture capital activity to cluster in major centres is a global phenomenon which raises a second challenge for policymakers, namely ‘how to stimulate venture capital investment in smaller metropolitan and regional centres’. This is the case even in the US where around half of all venture capital financings are concentrated in the high-tech regions of California and Massachusetts. In Australia, all but two early-stage venture capital managers are located in the two largest cities, Sydney and Melbourne.
Outside of major centres, venture funds generally struggle for viability due to:

• insufficient deal flow: that is, companies with the potential to deliver A$100m (€60m) exit in a 3 to 5 year time frame necessary for a venture fund to deliver an acceptable return to institutional investors;

• a lack of appropriately experienced and skilled people: entrepreneurs, financial experts, professional service providers and mentors; and

• distance from end markets: resulting in a lack of connection with and understanding of the distribution chain and target market.

This raises a concern for policymakers because venture investing is a local business. An oft-quoted rule of thumb is that venture capital firms do not invest in companies which are located more than one hours’ drive from their premises. Long distance investing is problematic because of the need for close mentoring, the absence of local contacts and the additional time involved in travelling.

A comprehensive study commissioned by the US Rural Policy Research Institute (Establishing Nontraditional Venture Capital Institutions www.rupri.org) found that impediments to traditional venture capital investment in small metropolitan and rural areas included limited deal flow, higher costs per investment, limited opportunities for exiting deals and lack of a favourable local business environment. The study concluded “Given the clear, persistent geographic and sectoral concentration of venture capital investments, the traditional venture capital model is not likely to be appropriate for areas of the United States not already participating in the Venture Capital process.”

The study also identified success factors for non-traditional venture capital models in small metropolitan and regional economies and found there is no single best model for a non-traditional venture capital institution.

This paper outlines the Playford Capital seed fund model which is an example of a successful non-traditional venture capital institution based in Adelaide, South Australia.

Playford Capital seed fund model
Adelaide is the capital of South Australia. It is the fifth largest city in Australia with a population of 1.1 million. As a base for high-growth technology-based start-ups, it has a number of strengths:

*a highly educated, English speaking workforce;

*many professional Australians have international experience;

*it is the centre of the Australian defence/electronics and wine industries providing a pool of well trained engineers and scientists;

*it has an excellent quality of life: great weather, excellent food & wine, a vibrant sports and arts culture, good schools and affordable housing.

Adelaide has been listed as Australia’s most competitive business city by international business advisory firm KPMG. In its international survey of 98 cities, KPMG concluded that in its population bracket, Adelaide is the third most competitive city in the world for business costs.

However, Adelaide also faces some challenges. As one of the most remote cities in the world, a central challenge is our distance from major venture capital markets and corporate buyers. As with many secondary cities, Adelaide has no local commercial venture funds targeting early-stage investment. Until the creation of Playford Capital only a handful of local companies had raised venture funding from elsewhere.
Playford Capital manages a $12m (€7m) seed fund using investment capital sourced from the Federal Government and supported by an operating subsidy from the South Australian Government.

A large part of our work is to help our portfolio companies bridge the gap between the very early seed-stage investments that we make and the follow-on funding they require for success. In doing so, we address market failure in the early-stage capital markets.

Since 2001, Playford Capital has invested A$9m (€5m) in 36 companies which have gone on to raise second round funding of A$50m (€30m). This funding has been drawn from interstate venture funds (22%), international venture funds (33%) and angel investors (45%). Investors have been sourced from all mainland states of Australia, the USA, Europe, South East Asia and Japan. Playford and its co-investors represent around half of all professional early-stage investment in South Australia. Co-investment has been spread broadly across the portfolio companies and has been consistent over time.

Smaller investments than commercial venture capital funds
Playford Capital’s investment methodology has evolved with experience. It now makes several kinds of investments.

The first type of investment is a A$20k (€12k) option in promising companies which are not yet investment ready. This option agreement provides us with a first right of refusal on future capital raisings and enables us to justify spending time and effort on helping the company progress to a capital raising. Around a third of all options are later converted to larger equity investments.

The second type of investment arises where Playford Capital leads an initial funding round. In the first round, Playford typically invests A$400-500k (€240-300k) as part of a total round of A$500k (€300k) to $A2.5m (€1.5k). Playford generally leads early rounds by negotiating the terms and undertaking due diligence. It gets involved in the capital raising process by assisting with preparation of information memoranda, financial modeling, and introducing suitable investors.

In later rounds, Playford Capital is more likely to follow other investors making larger investments. Innovative growth companies frequently need several rounds of capital before they reach cash flow positive. It is crucial to our model that Playford has the capacity to make follow-on investments. This makes us a more attractive and credible investment partner in the eyes of prospective investees and investors. To date, our largest investment in one company has been A$1m (€600k).

There is scope to increase this upper bound. The capital gap in Australia is generally thought to be in the A$500k (€300k) to $A3m (€1.8m) range with Australian venture capital funds rarely making initial investments smaller than $A3m (€1.8m).

Investment selection based on commercial venture capital methodologies
Playford is owned by the South Australian Government but operates independently with complete autonomy on investment decisions. Government ownership is not essential, and the model could also be operated by a private manager entering into an investment contract with Government.
In choosing investments, Playford Capital uses a commercially rigorous venture capital investment process: the same selection, valuation and due diligence methodologies. The main differences reflect adaptions which have been made to suit regional conditions. Compared to a standard venture fund, Playford Capital:

• takes more risk: we have a higher approval rate, perhaps five times the 1% approval rate which is often cited for standard funds;

• invests earlier: half of our deals are pre-sales;

• places greater focus on execution: an essential part of our due diligence process involves jointly developing an action plan and performance milestones. This is driven by the entrepreneur but with input from Playford.

• has a wider ‘funnel’ of investments: we lead pre-venture capital rounds (for companies with potential to meet VC investment criteria) but also angel rounds (for companies with smaller capital requirements but which nonetheless have potential to form economically worthwhile businesses).

• considers a broader range of industries: we look beyond software and electronics to technical applications in local industries which have international strengths. For example, we recently invested in a company with high powered ultrasonics applications for the food and beverage industries, with the first applications being beta tested in the local wine industry.

Playford Capital endeavours to match investors who can ‘add value’ to specific opportunities. In our experience, the very best angels have relevant industry experience, useful contacts and realistic expectations which can greatly enhance the probability of success. By way of example, we recently invested in a software company which is targeting major websites with an automated search engine marketing tool. Playford Capital was able to introduce internet and advertising industry identities who have co-invested and joined the company’s board.

Skilled staff provide an uncommercial level of company support
The South Australian Government provides Playford Capital with an operating subsidy which enables it to employ five investment professionals and provide an ‘uncommercial’ level of support to both applicants and investees. This support continues for all companies which continue to show promise.

Playford’s Investment Managers are generally experienced business people who have trained on-the-job to become investment professionals. Investment Managers must be well qualified and appropriately remunerated – this is not a role which can be adequately performed by public servants or freshly minted MBAs. To be effective, Investment Managers must command the respect of entrepreneurs and investors. Acting as a company board member and CEO mentor, they can provide advice on a very wide range of issues. This is tailored for the company concerned but can include:

• strategy: preparation of business plans, financial modelling and exit plans;

• people: recruiting board & management team, planning staff structure, managing out underperformers;

• funding: offer documents, pitches, introducing investors, leading rounds, sourcing government grants;

• market: market research, market entry planning, introducing beta testers and customers;

• product: development plans, project management systems, intellectual property protection; and

• operational: financial & performance reporting; business systems.

In contrast, a small Australian venture capital fund typically operates on a management fee of 2.5% of funds under management. This provides a ‘shoe string’ budget and necessarily means that effort is focused on the stellar prospects, with little attention being paid to modest successes or poor performers.

Economic benefit
While economic benefits and ‘additionality’ are difficult to quantify, we believe Playford Capital provides the following economic benefits.

• company creation: generating revenue, exports and skilled employment. 90% of company sales are interstate or overseas.

• co-investment: attracted $6 co-investment for every $1 invested by Playford.

• training: Playford trains experienced business people to become professional investment managers.

• skills transfer: entrepreneurs and co-investors gain invaluable practical experience, far beyond anything that could be taught in a training course.

• validation effect: Playford’s decision to invest can help recruit potential staff, investors and customers.

• demonstration effect: the fact that Playford’s entrepreneurs are ‘having a go’ provides role models for others.

These broader impacts have the general effect of increasing the general quality of entrepreneurship and deal flow in the local environment. That said, Playford Capital complements rather than replaces other innovation programs such as general business advisory services, university commercialisation initiatives and technology business parks.

Playford Capital is an evergreen fund so that the proceeds of investment exits are available for re-investment in new companies. The economics of venture capital are fundamentally tough and most first time managers of standard venture capital funds report losses. The reality is that a small seed fund making risky, subscale investments is unlikely to make money. In designing a seed fund program, fund size and operating costs must be based on realistic assumptions about the size and timing of investment commitments and exits. A seed fund could realistically target preservation of capital provided it has sufficient investment capital and appropriately subsidised operating costs.

Lessons learned
Playford Capital is an example of a successful, targeted program which is attracting ‘smart’ money to South Australia. We did not create a venture fund in isolation and expect quality deal flow to emerge. Instead, we have positioned Playford as a credible local investor which provides a pathway to larger funds and angel investors. We provide an uncommercial level of business support to help companies become investment ready. This improves the probability that portfolio companies will succeed. It also provides interstate and overseas investors with a local partner and helps overcome some of the disadvantages of long-distance investment.

A seed fund is not a substitute for the long-term goal of establishing a local commercial venture capital fund able to make larger investments. Rather, it could be seen as the necessary first step towards establishing a locally-based venture fund. There is an opportunity to operate a dual fund structure with the seed fund acting as a feeder for a more standard venture fund. In this way, the seed fund model will have paved the way for establishing a commercial early-stage venture fund in a region which has not previously participated in the venture capital process.