Small and developing businesses face an uphill struggle raising venture capital.
This paper analyses the lack of availability of venture capital investment for Australian developing businesses. Australia has a large body of highly qualified people who undertake research in this country; in academic institutions, on their own account and in industry. Annual government support for R&D currently runs at more than $2bn. Apart from "pure" research which does not have a commercial end in view, these experts and the business people with whom they ally themselves face special problems raising the capital required to carry their ideas and technological innovations through to development and commercialisation. The difficulties of raising capital are not confined to "R&D" companies. Investment in the establishment and expansion of small business enterprises is also problematic.
Both these types of companies would greatly benefit from the ability to raise equity capital more easily and with less expense.
Australians seeking to raise capital operate in difficult macro-economic circumstances. These include high real interest rates compared to our overseas competitors; the resulting high cost of capital; a small local market in which to sell the end product which often necessitates an earlier commitment to costly international marketing; an unbalanced tax regime which fails to reward investment in risk; and consequently the attitude of Australian providers of equity and debt capital, both institutions and private individuals. The importance of strong national saving and its effect in fostering the growth of small developing companies is thus advanced.
A very large number of reports from both the public and private domain have analysed these problems over the past ten years. The purpose of this paper is to move beyond mere analysis and to make practical suggestions to improve the venture capital market. It acknowledges that the necessary macro-economic changes will take a long time to effect; and therefore recommends measures which can be put into effect quickly.National Savings
Low national savings exacerbate the problem.
There has been much recent expert analysis of Australia's savings problems. The 1993 Fitzgerald Report is an outstanding example. Written at the end of a severe recession, it noted that national saving as a percentage of GDP was 16%. While it has since increased slightly, the underlying structural rate of national saving has sunk to about 18% of GDP, down from an average of 23% of GDP over the past three decades. Fitzgerald concluded that, "The national saving goal should be higher - to restore the underlying national saving rate over the coming decade to 23% of GDP - ie to lift it by about 5% of GDP - and to lift the efficiency of our investment to best practice".
The Australian Institute of Company Directors has repeatedly advocated reducing the budget deficit and it supports the new government's efforts to do so by cutting public expenditure. But, in isolation, the elimination of the budget deficit will not fill the 5% gap between savings and investment.
Of the two types of private sector saving, the Fitzgerald Report confirms that business saving is driven mainly by business profitability and expectations of future growth. Hence, it is difficult to influence otherwise. More subject to immediate government policy is household saving. Here, the previous government has already introduced measures to boost compulsory superannuation. However, that is expected to raise overall savings as a percentage of GDP by only 1.5%. Significant further measures to boost private sector saving in other ways are therefore required.
In June, AMP suggested that Australia was still dissipating its savings at an excessive rate and that "the nation is close to the position it was when the 1986 banana republic statement was made". This would be of less concern were it not for Australia's very large foreign debt and high current account deficit.
If economic growth is a fundamental tenet of Australian government policy, then vigorous and well-directed investment is its prerequisite. Capital required for such investment can of course be sought at home or abroad. Government and industry will in general first approach the local market, subject to local investment attitudes and shortage (and therefore cost) of that capital. If the local market is insufficient, resort will be had to foreign savings. This will in turn increase foreign liabilities and will therefore commit an even greater proportion of the national income to servicing that foreign debt and equity, and so
expose the country increasingly to changes in commodity prices, investor sentiment and other external shocks;
increase the riskiness of Australia's bonds which will adversely affect local interest rates;
deplete local capital markets which will cause a further reduction in the availability of Australian capital for investment in this country; and
force the Government to slow economic growth to keep it within limits imposed by the increasing cost of debt-servicing and rising imports.
The Fitzgerald Report forcefully makes the point that Australia cannot continue to finance the investment needed for continued growth by the progressive drawdown of foreign capital. It advances the "twin imperatives" of raising both national saving and national competitiveness in order to fulfil the key objective of growth. National saving is expected to recover slowly but not to the long-term levels referred to above. If investment increases faster in the current post-recession period, the resultant gap, the current account deficit funded mainly by debt, is expected to increase.
In relation to the annual savings shortfall of 5% of GDP, an $8bn reduction in the budget def-icit will assist by about 1.5% of GDP. The superannuation measures will match this. A further 2% reduction is therefore required to bring savings back to the long-run level of 23% of GDP.
It is acknowledged that greater domestic saving is a prerequisite to continuing strong growth in the Australian economy. And in regards to venture capital, the short point is: if national savings are low, investment in venture capital for small businesses is largely unavailable.The importance of SME's
SME's represent the keystone to Australia's economic future.
There is now considerable acceptance for the proposition that growth in employment comes mainly from small and medium sized enterprises (SME's). Given a set of employment rules without unreasonable restrictions and costs in employing and dismissing staff, it is these firms which hold out the promise of reducing unemployment. This is not to say that they will be better able than large firms to retain staff in the face of another recession, nor that all SME's show high employment growth rates. In fact it is likely that only a few will display dramatic growth. One US study carried out between 1981-1988 showed that all employment growth was attributable to SME's, but that only 10% of those companies grew in that period. The rest were static; and furthermore 70% of the growth came from 0.5% of them.
Not only are SME's seen to be the engine of employment growth: the Chief Scientist, Professor R.O. Slayter's discussion paper to EPAC of September 1991 (91/108) notes that the establish-ment of new businesses is an essential element in a dynamic and growing economy. Small businesses are not fettered with traditional large firm attitudes to innovation and R&D. Start-up companies play a major role in diversifying the industrial base and frequently it is they who develop and commercialise research from publicly funded institutions. This lack of constraint applies equally to entrepreneurs developing their own ideas and technology. These companies play a vital role in maintaining a competitive edge in the industries in which they operate.
The Bureau of Industry Economics report, "Small Business Finance" of September 1991 confirms that typically, fast growing SME's have great difficulty in obtaining external capital. By the very nature of their activities, many years may elapse before they make their first profits. Few of the creative men and women behind these SME's have sufficient personal financial resources to complete the development of these ideas. While public grants are available in some circumstances, debt finance is of course often quite inappropriate for these firms. Providers of patient equity finance - venture capital - must therefore be fostered.The venture capital market and current attitudes
Two elements to the market: Business Angels and Institutions
Current estimates of the size of the Australian venture and development capital market vary. One key body, the Australian Development Capital Association Limited (ADCAL) believes that, as at 30 June 1995, funds under management in this category totalled $1.86bn. However, this comes closer to $2bn when a further $54m from government seed capital schemes is included. The scale of venture capital available from private individuals cannot be ascertained
Of the $1.86bn under management, $330m was raised during the 1994/95 financial year. This compares with Britain which last year invested 2.5bn. in venture capital, or 42% of all venture capital in Europe.
Venture capital emanates from private individuals, both directly through so-called "business angels", and indirectly through managed funds, referred to as "institutions". While the term "business angels" might imply an element of charity, these individual investors are highly commercial in their orientation. The venture capital funds are also supported by those institutions which allocate a proportion of their total funds under management to venture capital investment.
In assessing current attitudes to the venture capital market, both elements need to be considered:
Business Angels - Direct Investment
(b) Institutions - Indirect Investment
(a) Business Angels - Direct Investment
A recent analysis, "Financing growth: Policy options to improve the flow of capital to Australia's small and medium enterprises" (NIC/Marsden Jacob & Associates, August 1995) identifies the restrictive conditions under which venture and development capitalists operate. It raises two points of particular interest to the early-stage investor:
(i) The existence of an equity finance gap between $0.5m and $2m, this latter figure generally being the minimum investment threshold for professional funds. The costs of assessing and monitoring an investment are not directly proportional to its size. Thus, prevailing costs and fee structures render this exercise unprofitable for institutional funds - in the absence of extraordinary gains.
(ii) The difficulty in finding and obtaining the commitment of investors, whether at the pre- or post-$0.5m stage. Investments of less than this size are usually the province of individuals who are by nature private animals. There is of course a connection between the amount of capital sought and the development stage of the company and this affects the nature and extent of the research and enquiries undertaken. Companies which require seed or early-stage capital are often not susceptible to the same financial analysis as an enterprise with a nearly established product or service, or where there is an active trading record. It is quite simply too early to foretell the development path of the technology or its final destination. The oft-quoted "three key determinants, management, management and management" are vital to each. But the early-stage investor probably undertakes a less intense due diligence. Business angels make their investment choices free from some of the strict guidelines often laid down by in
stitutions. Thus they will not be constrained by such factors as:
The size of the investment. An investee company may seek less than an institution's minimum threshold.
Rigid management criteria. A private investor may be prepared to commit to an investment where it has neither the depth of management experience nor the number of managers preferred by an institution. For example, a technology company which sub-contracts its R&D and which is the brainchild of a sole operator will no doubt deter many professional fund managers, who may have an investment prerequisite of at least two entrepreneurs working together, both with a proven track-record. A private investor may have special knowledge of that type of R&D; or the industry to which it relates; or more time in which to develop the required degree of trust with the entrepreneur.
Investment horizons. It may for all practical purposes be impossible to predict accurately the length of the commercialisation process (and it may also be a hazardous exercise predicting the precise nature of the end-product). These uncertainties may prove insurmountable difficulties for the institutional investor.
Illiquidity. Private investors with patient capital are more likely to accept the lack of a ready market for their shares for an unknown period of time. See David Lewis' remarks below.
These factors increase the risk of such investments. With this in mind, the Institute recommends the introduction of tax-incentive measures aimed specifically at the private investor or business angel. Outlined on page 12, these measures are intended to redress the risk/reward imbalance of venture capital investment.
As an example of the potential benefits which can arise, the UK has set up an "Enterprise Investment Scheme" under similar circumstances. 216 small companies have reported raising 19m. in the period since inception in January 1994 to July 1995, at an average of about 90,000 per company.(b) Institutions - Indirect Investment
Australian institutions considering inherently risky venture capital investment operate under significant constraints:
(i) The high cost of capital. Australia's 10 year bond rate, currently at around 9%, compares with the United States' at less than 7% and Japan's at less than 3.5%. These are taken as the risk-free rate, multiples of which produce the discount rate used to value projects. Some say that the appropriate rate for R&D projects at the start of commercialisation is five times that bond rate. The resultant discount rates for such projects are: Australia - 42.5%; Japan - 17.5%. As very few projects' cash-flow can support that level of discounting; fund managers invest elsewhere.
(ii) Fund managers' aversion to volatile listed stocks and to those which do not pay fully franked dividends. A manager's performance is subject to intense and regular scrutiny which mitigates against venture capital investment.
(iii) Fund managers' aversion to unlisted companies because of the perception that illiquidity increases risk. Expert commentary on this point comes from Christopher Golis, Chairman of Nanyang Management Pty. Limited, who quotes David Lewis, the vice-chairman of Hambros Bank, London:
The lack of liquidity is often cited by institutional as well as other investors as being a major contributor to risk. In private equity investment funds, to my mind, this is a non-sequitur. If it is liquidity you want, you are by definition a short term investor and you should not be in a private equity funds; the listed markets are for you.
Experienced institutional fund managers in the U.S. and Europe invest not in a single fund but in a series of funds. It is, like everything else, unwise to invest all your funds in one basket. Distributions (and thereby returns of capital) typically start in years four and five of a ten year fund. It makes sense, therefore, to invest an annual allocation of resources over a five year period in different funds. At the end of the five year period, distributions will be giving profits and cash-flow to be recycled into new private equity funds. Most experienced US and UK institutional investors adopt this approach as they know only too well that some years are good/vintage ones and others are not so good.
A concise summary of the government's first efforts to foster a venture capital market was given by Donald Brunker, Assistant Secretary, Engineering, Advanced Manufacturing and Automation Branch, Department of Industry, Science and Tourism at his presentation at the ADCAL Conference on 22 February 1995. In essence, the MIC scheme, begun in 1984, met with only limited success. The programme was ended in 1991.
Shortly afterwards, legislation enabled the introduction of Pooled Development Funds. Improvements effective from 1 July 1994 are generally seen to be sufficient to make the scheme a success. However, the AIDC recommends further enhancements to the scheme as outlined on page 12.Recommendations(a) Direct Investment - Business Angels
As a key incentive to support the early development of unquoted companies, the AICD recommends the introduction of tax relief designed to encourage private individuals to take up equity in SME's. The measures proposed aim not only to address the shortage of capital, but also to enable these investors, frequently experienced industrialists or other professionals, to avail themselves of their expertise in giving advice to management. The scheme parallels the PDF scheme for indirect investment, and should have the following elements:
1. Exemption from CGT on any gain realised on the disposal of shares in qualifying companies.
2. Capital gains tax rollover relief. An investor should be able to realise existing investments without penalty providing investment is then made in companies which qualify under the scheme.
3. Relief against the investor's other capital gains if shares are disposed of at a loss or written off.
4. The ability for a qualifying company to raise up to $5m in any one tax year. Note that whilst this limit exceeds the figure of $2m referred to in paragraph (I) on page 8, it is considered a realistic cap.
5. Investment in real property and retailing operations to be excluded from the scheme.
6. An investor could become a paid director without vitiating the reliefs subject to not being connected with the company or its trade before the eligible shares were issued.
7. Withdrawal of tax relief if eligible shares not held for a minimum of 5 years.(b) Indirect Investment - Institutions
The AICD recommends enhancements to the PDF scheme, namely:
1. Full relief against the PDF's other capital gains such that all losses realised by the fund itself should be capable of being fully offset against realised gains of that fund rather than the limited offset as at present.
2. Capital gains tax rollover relief. An investor should be able to realise existing investments without penalty providing investment is then made in PDF's.Summary of Recommended Initiatives to Encourage Venture Capital Investment
(Modified PDF's) Direct Investment
Up Front Incentives Nil Nil
Tax on Income
(Internal) 15% SME's
25% Other N/A
Tax on Income
(to Investor) Exempt or
Full Imputation Option
Treatment of Gains
(Internal) 15% SME's
25% Other N/A
Treatment of Gains
Treatment of Losses
(Internal) Full Offset
Treatment of Losses
(to Investor) Non deductible Full offset
Deferral of CGT
Full Rollover Deferral
Full Rollover Deferral