Venture capital investments - Australia

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    Venture Capital Investments Australia

    Industry Overview

    Despite Favourable Environment, Australian VC Market

    Remains Underdeveloped Compared to Peers

    Despite a favourable environment featuring a strong market-based economy,

    robust financial framework, and high-quality education system, the Australian

    venture capital (VC) industry has not been able to tap into its full potential. This

    can be attributed to several factors, including a lack of government support for

    the innovative sector; poor commercialisation of the R&D sector; cumbersome

    legislation surrounding innovative industries, for example regulations pertaining

    to ESOP schemes, and insufficient tax incentives; and conservatism among

    Australian investors leading to a paucity of capital, particularly in late-stage VC

    funding.

    As of 2015, high-growth technology companies contributed only 0.2% to

    Australias GDP. Past government efforts to boost the industry, such as the

    Innovation Investment Fund (IIF) established in 1997 to create domestic VC

    funds, saw limited success, leading to the scrapping of the program in 2014. In

    2014, the previous government under Tony Abbott introduced budget cuts for

    the CSIRO, the countrys leading research institute, further highlighting the

    governments poor commitment to innovative industries.

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    However, recent macroeconomic shifts such as the end of the countrys mining

    boom, weakness in key commodity export markets such as China, and fears of a

    possible housing bubble have prompted the newly elected Turnbull Government

    to shift focus toward innovative industries particularly in the ICT and health

    sectors, which accounted for 52% and 31% of VC investment respectively (based

    on number of companies) in 2015. In December 2015, the government published

    its National Innovation and Science Agenda (NISA), under which it has pledged to

    improve commercialisation of the countrys R&D sector; streamline regulations

    and improve taxation frameworks in the innovative sector; and introduced

    several schemes to encourage a higher amount of VC investment in the country

    from both foreign and domestic investors. In line with these recent

    developments, the Australian VC industry has also seen an increase in interest

    from previously conservative institutional investors such as superannuation

    (pension) funds. Super funds represent a huge pool of potential capital, with

    around AUD 2 trillion in assets as of 2015. The combined improvement in both

    government and investor attitudes bodes extremely well for future growth in

    the Australian VC sector.

    Shift in Focus toward Innovative Industries

    Driven by Looming End of Resources Boom,

    Fears of Property Bubble and Uncertain Future

    in Major Export Markets

    The Australian economy is vulnerable to a number of risks. Firstly, its status as a

    capital-importing country means that it is highly influenced by fluctuations in

    overseas markets. Second, Australias banking system is highly concentrated.

    Each of the four major banks (Australia and New Zealand Banking Group (ANZ;

    AUS), Commonwealth Bank of Australia (CBA; AUS), National Australia Bank

    (NAB; AUS), and Westpac Banking Corporation (WBC; AUS)) have large offshore

    funding exposures and are heavily exposed to developments in the housing

    market. Third, according to the Financial System Inquiry commissioned by the

    government in 2014, Australia faces lagging productivity growth, due to a

    combination of high wage growth from the resources boom coupled with an

    ageing population.

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    For many years, the Australian economy has been overly dependent on sectors

    such as resources (e.g. mining); export of commodities (e.g. the export of iron

    ore to China); and real estate investment. The lag in the mining sector has been

    well-documented (a 2015 report by BIS Shrapnel estimated mining investment in

    Australia to drop 58% over the next three years); in addition to weak demand in

    China affecting iron ore exports (on 8th December 2015, iron ore prices dropped

    to a 10-year low; recent figures recorded a 5.6% yoy drop in Chinese imports);

    and what many believe to be a property bubble soon to burst (in 2015

    investment bank Macquarie (AUS) forecasted a 7.5% quarter-on-quarter fall in

    house prices beginning from March 2016).

    Faced with these dangers, it has become more crucial than ever for the country

    to turn its focus toward new businesses and new technologies the so-called

    innovative sector in which venture capital funding plays a fundamental role.

    According to a 2013 study commissioned by Google Australia, high-growth

    technology companies could potentially contribute up to 4% of the countrys

    GDP (or AUD 109 billion) from the current 0.2% by 2033. However, urgent

    measures must be taken by the government in order to overcome the numerous

    challenges strangling the industry at present and capitalise on the sectors latent

    potential.

    Venture Capital Funds Take Form of VCLP,

    ESVCLP or AFOF

    In Australia, venture capital funds are registered with the regulatory body

    Innovation Australia. They may take the form of either a regulated venture

    capital limited partnership (VCLP); an early stage venture capital limited

    partnership (ESVCLP); or an Australian Venture Capital Fund of Funds (AFOF).

    There are currently 12 registered ESVCLPs and seven conditionally registered

    ESVCLPs, while there are 40 registered VCLPs and four conditionally registered

    VCLPs. There is only one currently registered AFOF.

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    Each type of fund must meet certain criteria, outlined below:

    VCLP: must seek to raise a minimum of AUD 10 million and not more than

    AUD 250 million for investing into unlisted Australian businesses

    ESVCLP: must not raise more than AUD 100 million for investing into early

    stage Australian businesses

    Both VCLPs and ESVCLPs: must only invest in new shares, units, options or

    convertible notes that have an equity characteristic in these Australian

    entities (companies or trusts) where at least 50% of the entities assets and

    staff are located in Australia. The relevant entity must not have property

    development, land ownership, finance or construction as its predominant

    activity.

    ESVCLP: must have a plan to invest in early stage venture capital

    investments, which includes investment in businesses at the pre-seed, seed,

    startup, and early expansion stage of development.

    Both VCLPs or ESVCLPs: restricted from investing in loans, pre-owned shares

    or in non-Australian entities.

    VCLP: investments must be in Australian entities with total assets not

    exceeding AUD 250 million.

    ESVCLP: investments must be in Australian entities with total assets not

    exceeding AUD 50 million.

    Both VCLPs and ESVCLPs: must not invest more than 30% of committed

    capital in any single entity.

    Structure of Australian VC & LSPE Industry

    Source: ABS Note: LSPE = Later Stage Private Equity

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    Australia Boasts Strong Research Culture and

    Significant Investment into R&D, However

    Commercialisation of New Technologies

    Remains Poor

    The healthcare and life sciences sector plays a significant role in the Australian

    VC industry. The sector was the biggest contributor in terms of amount divested

    at cost in 2015, with a 38% share. It also contributed 31% of total VC investment

    in 2015 based on the number of companies receiving funding. In addition,

    roughly 25% of healthcare companies currently listed on the Australian Stock

    Exchange (ASX) received venture capital backing in their startup stages. Some

    examples of prominent healthcare businesses that have grown from early VC

    backing include Cochlear (AUS), Spinifex (AUS), Hatchtech (AUS), and Nitro (AUS).

    In order to ensure the success of such businesses and thus a healthy rate of

    return for investors a good rate of commercialisation of new R&D

    technologies is crucial to VC firms investing in the healthcare and life sciences

    space.

    According to Bill Ferris, founder of Australias first venture capital company and

    recently appointed chairman of Innovation Australia, Australia ranks somewhere

    between third and fourth in the world in terms of health and medical research,

    and also ranks highly in other research fields such as astronomy, environment,

    agriculture, engineering, information and communications and renewable

    energy. Australias higher education expenditure on R&D as a proportion of GDP

    is above the OECD average, and the country ranks highly in terms of research

    quality and output.

    However, according to the Global Innovation Index 2014, Australia ranks lowest

    among OECD countries on the rate of collaboration between researchers and

    firms, indicating the poor commercialisation of its R&D sector. The collaboration

    rate between researchers and large companies was 3%, which was far below the

    OECD average of 37%; for small to medium enterprises (SMEs), it was 2%

    compared to the OECD average of 14%. The reason for this poor

    commercialisation is largely due to a lack of communication between

    researchers and industry, as well as differing motivations and expectations.

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    As announced in the 2015 NISA, the Turnbull Government has pledged to take

    the following initiatives to help improve the rate of R&D commercialisation in

    Australia:

    Launch a new AUD 200 million CSIRO Innovation Fund to co-invest in new

    spin-off companies and existing startups that will develop technology from

    CSIRO and other publicly funded research agencies and universities

    Establish a new Biomedical Translation Fund to co-invest AUD 250 million

    with the private sector to increase the capital available for commercialising

    medical research within Australia

    Provision of grants such as AUD 520 million for the Australian Synchrotron;

    AUD 294 million for the Square Kilometre Array; and AUD 1.5 billion for the

    National Collaborative Research Infrastructure Strategy (NCRIS)

    Streamlining and refocusing a greater proportion of research block grant

    funding toward collaboration with industry, as well as an additional AUD

    127 million to research block grant funding

    VC Fundraising vs Research and Innovation Metrics (2014)

    VC Fundraising as % of GDP (%)

    Compound Growth Rate of GDE on R&D, 2000-2010 (%)

    Publications in Top-Quartile Journals (per 10,000 inhabitants)

    Science & Tech Occupations as % of Total Employment (%)

    Australia 0.01 7.2 13 37

    UK 0.05 1.5 12 28

    Canada 0.06 1.6 12 30

    USA 0.17 2.1 9 35 Source: Austrade, WEF, AVCAL

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    Improvements to ESOP Legislation Expected to

    Help Startups Attract and Retain Top Talent

    There are several challenging factors for startups looking to establish themselves

    in the Australian market, including a lack of access to capital, lack of government

    support, and the high costs of running a business in the country due to the

    combined effect of strong wage growth, high energy costs, and high

    transportation costs.

    In addition to these, one of the biggest hurdles for startup growth in Australia is

    the paucity of skilled talent available. Due to factors such as the poor

    commercialisation of R&D in the country as well as the burdensome regulations

    surrounding ESOP schemes, many successful Australian startups struggle to

    recruit local talent. In the Startup Muster 2015 report, 42% of startups cited a

    lack of available technical talent as their biggest external challenge. The lack of

    strong relationships between higher education institutes and corporations

    results in many promising graduates working for overseas MNCs rather than

    home-grown domestic companies. For example, in 2014, more than half of the

    participants in telecommunication giant Telstras (AUD) Cyber Security Challenge

    a competition designed to locate the best cyber security talent in the country

    opted to work offshore for multi-national technology companies, rather than

    seek employment in Australia. As such, many domestic startups are driven

    overseas in search of talented employees.

    An Employee Stock Ownership Plan (ESOP) is one of the most common ways for

    startups to lure and retain talent as well as boost employee productivity, since

    the value of each employees stake is directly tied to the success of the company.

    However, as of 2015, 41% of Australian startups had no employees with equity

    or options. This is because ESOP schemes in Australia have traditionally been

    burdened by complexity, cost, and the unreasonable tax treatment of options,

    whereby options are taxed at the time they are provided to the employee rather

    than when they are exercised. Many Australian entrepreneurs have said that the

    tax treatment of ESS options has reduced their ability to find talent in Australia

    and eventually pushed them to move operations overseas.

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    Thus, in order to retain talented Australian entrepreneurs and generate a strong

    pipeline of startups, the Australian Government in 2014 announced a series of

    measures to improve the taxation scheme on ESOPs, including:

    Income tax will be exempted from the first AUD 1,000 of ESS interests given

    to employees who earn less than AUD 180,000 per year

    Employees who are issued with options under deferred tax schemes will be

    able to defer tax until they exercise the options

    The Government will extend the maximum time for tax deferral from seven

    years from acquisition of interests to 15 years

    Startups who earn less than AUD 50 million revenue, are unlisted and

    incorporated for less than 10 years will be allowed to issue options under

    certain conditions or shares at a small discount, and have taxation deferred

    until sale or the small discount exempt from tax. The shares or options

    would need to be held for at least three years.

    Additionally, as part of the December 2015 NISA, the government announced

    several further reforms to improve the accessibility of employee share scheme

    legislation. Under the new rules, companies will now be able to offer shares to

    their employees without having to reve...