Malcolm and the unicorns – first published in The Sydney Morning Herald

Malcolm Turnbull is absolutely right to be throwing the switch to innovation – Australia is not going to mine or bank its way into an improvement in its long term growth prospects, at least not with existing models.

But there needs to be some circumspection around  innovation investment, because bad things can happen.

Case in point: some of the big names in global disruption have been jolted by a series of write-downs, disappointing listings and revenue misses over the past month as investors start to question the business models of the ‘unicorns’ – start-ups valued at over a billion dollars.

The nervousness is happening just as new figures emerged showing the big established VC’s are pulling back from the early-stage market.

US fund manager Fidelity, with assets of over US$2 trillion, took the knife to its holdings in both Snapchat and Dropbox, cutting its valuation in the disappearing messenger service by 25% just a few months after it made the investment. Snapchat has been valued at US$15b by investors.

Fidelity and others including Blackrock also marked down the value of Dropbox, which at one stage was thought to be worth US$10b. That value is now being questioned since rival company Box, with about half the sales, recently listed at less than one sixth of that.

The falling values take place against a backdrop of declining participation by the top tier of Silicon Valley vc’s, according to figures from Signalfire, a San Francisco venture firm, using publicly available financing data including RegD filings.

The pullback seems to flag some level of caution about the viability of unicorns – start-ups hitting a value of US$1b within a few years, especially since the visibility of ‘down’ rounds has risen, in part related to the listing of Square, which performed well for some but still left some investments under water.

(A ‘down’ round is an investment later but lower than the previous valuations. Down rounds make vc’s uncomfortable than ‘up’ rounds which serve to ‘confirm’ the model.)

In Fidelity’s case, we do not have the whole story, and it will almost certainly be one of a number of accounting entries the group made across a range of its investments (start-up or otherwise). Further, its reasons for the write-down could be as cynical as wanting to participate in a new round of capital raising in the written-down companies, but at a lower price. Asset managers have been known to play these games. That is their job.

But it is nevertheless worthwhile thinking more seriously about the business of investing in start-ups, since everybody, including Malcolm, has one, or knows someone who does and/or knows someone who may be putting money in.

Start-up investing is appealing. The thought of putting in small amount of money and a couple of years later taking out 50x that is exciting.

The reality, sadly, is that it just doesn’t work out like that.

It almost all cases, start-ups fail. It is the very nature of disruption that once everyone is doing, it really isn’t disruptive any more, meaning that the chance of picking the one investment that does make the cut dollar-wise is now one in a (not quite) million. You would be better off buying a lotto ticket.

This is not to say that the very some vc’s don’t do a great job of bringing companies through the labyrinth of executing a new business at the same time as satisfying investors through a number of rounds of capital raising.

But is this a product for the vast bulk of investors, whether self-managed or even institutional?

It’s not that hard to work out that it isn’t. Aside from the actual chances of success, the nature of start-ups is that they take more than a little time. This can be good since not all the capital is required on day one, but it’s bad in that the nature of the cashflows (to the investor) are lumpy – meaning that investor cashflow may only go positive a number of years after investee company cashflows start happening.

If you are the kind of investor who doesn’t need cashflow waiting isn’t a problem. But for those who need liquidity, start-ups do not provide this.

As we and others have noted, we are moving from the age of innovation to the age of deployment, following what is increasingly understood as a well-trodden path. For example, the age of electricity (which was the innovation) spawned massive deployment across industries as diverse as white goods and power stations. These businesses did not think of themselves as electric (although that was the technological breakthrough) just as Amazon does not view itself as a computing company, but a retailer.

So Malcolm spending a little time thinking about turning Australia into a more innovative nation is a good thing. He hasn’t got around to suggesting that the big super funds put a portion of their capital into start-ups. Let’s hope he doesn’t.

If you say it quickly enough, where is the harm in a manager with $20b of assets having a punt on a few start-ups? But the practical considerations, such as the lack of liquidity and therefore updated valuations (such as stock price) on a group of start-ups will ultimately leave investors in the dark as to how they are going (just like Fidelity and Blackrock).

There has been talk of the government providing a market for unlisted start-ups – a sort of buyer of last resort – to kick-start institutional interest in start-ups, but there are all kinds of problems with this, including lack of transparency, creating a system which is open to rorting etc.