Innovation involves the creation of new and improved products, processes and services. It is about doing things in new and clever ways that increase efficiency and add value. Although Australia is a clever country that has world-class universities, respected research agencies and pioneering scientific institutes, its entrepreneurs have often struggled to commercialise their innovations. This has been attributed to a number of factors, including a lack of venture capital funding being available to start-ups. Venture capital is a scarce resource because it is an extremely risky investment that can take many years to provide returns for investors. The venture capital market is highly sensitive to economic conditions and is often disproportionately affected during downturns. Angels and venture capitalists are the two main sources of venture capital funding for start-ups. While it is the founders of start-ups that come up with the revolutionary ideas for new products and services, it is angels and venture capitalists who provide the finance necessary to develop and commercialise these ideas. Angels and venture capitalists are therefore key actors in a country’s innovation system, even though they are not necessarily innovators themselves. By providing much needed capital to start-ups, these investors share in the risks associated with these companies. This chapter discusses the importance of innovation and the critical role that start-ups play in a country’s innovation system. It also examines the nature of venture capital investment and the special roles that angels and venture capitalists play in financing start-ups.
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OECD, OSLO Manual: Guidelines for Collecting and Interpreting Innovation Data (OECD, 3rd ed, 2005) 46. This definition has been adopted in various Australian Government reports, see e.g., Australian Government, Department of Industry, Innovation and Science, Office of the Chief Economist, Australian Innovation System Report 2017 (Report, 2017) 7, 114 (‘Australian Innovation System Report 2017’). It has also been relied on in designing the ‘principles-based test’ in the ESI program (see 22.214.171.124).
Chandrajit Banerjee, ‘The Human Factor: The Fundamental Driver of Innovation’ in Soumitra Dutta, Bruno Lanvin and Sacha Wunsch-Vincent (eds), Global Innovation Index 2014 – The Human Factor in Innovation (Cornell University, INSEAD and WIPO, 2014) vii; HM Treasury and the Department for Business Innovation & Skills, ‘Our Plan for Growth: Science and Innovation’ (December 2014) 53; Richard R Nelson, The Sources of Economic Growth (Harvard University Press, 2000); Daniele Archibugi, Jeremy Howells and Jonathan Michie (eds), Innovation Policy in a Global Economy (Cambridge University Press, 2003); Christine Greenhalgh and Mark Rogers, Innovation, Intellectual Property, and Economic Growth (Princeton University Press, 2010); Bronwyn H Hall and Nathan Rosenberg (eds), Handbook of the Economics of Innovation: Volumes 1 and 2 (Elsevier, 2010).
See Jean-Philippe Deschamps, ‘Innovation and Leadership’ in Larisa V Shavinina (ed), The International Handbook on Innovation (Elsevier Science, 2003) 824; Jan Fagerberg, David C Mowery and Richard R Nelson, The Oxford Handbook of Innovation (Oxford University Press, 2005) v; David L Rainey, Product Innovation: Leading Change through Integrated Product Development (Cambridge University Press, 2005) x.
For instance, the innovation process can include activities from ‘identifying problems and generating new ideas and solutions, to implementing new solutions and diffusing new technologies’: Itzhak Goldberg, John Gabriel Goddard, Smita Kuriakose and Jean-Louis Racine, Igniting Innovation – Rethinking the Role of Government in Emerging Europe and Central Asia (Report, World Bank, 2011) 20.
Stephen Barkoczy, Tamara Wilkinson, Ann Monotti and Mark Davison, Innovation and Venture Capital Law and Policy (Federation Press, 2016) 20. It is worth noting that although most innovations result in only small incremental changes, others can completely revolutionise industries.
Ground-breaking new devices such as Apple’s iPad and iPhone have completely revolutionised the computing and telecommunications industries and have given birth to new industries such as the software ‘apps’ industry: see further, Pai-Ling Yin, Jason P Davis and Yulia Muzyrya, ‘Entrepreneurial Innovation: Killer Apps in the iPhone Ecosystem’ (2014) 104 (5) American Economic Review 255. Over the last decade, the apps industry has witnessed explosive growth. There are now millions of different apps available to both iOS and android users and hundreds of millions of downloads taking place each year: Artyom Dogtiev, App Download and Usage Statistics (8 October 2018) Business of Apps <http://www.businessofapps.com/data/app-statistics/>; Sam Costello, How Many Apps Are in the App Store? (7 April 2018) Lifewire <https://www.lifewire.com/how-many-apps-in-app-store-2000252>.
Australia has ‘an enviable reputation as a destination of choice for international students seeking a high quality university education’, with international education being the country’s third largest export: Universities Australia, ‘Keep it Clever’ (Policy Statement 2016, 7 October 2015) 3. In a recent report, Australia’s higher education system was ranked 10th out of 50 nations: Ross Williams, Anne Leahy, Gaétan de Rassenfosse and Paul Jensen, U21 Ranking of National Higher Education Systems 2015 (Report, Melbourne Institute of Applied Economic and Social Research, May 2015) 8. The Australian university sector is led by the ‘Go8’ universities, which are a group of eight research intensive universities. Six of these universities (the University of Melbourne, Australian National University, the University of Sydney, the University of Queensland, Monash University and the University of New South Wales) were ranked in the top 100 universities in the world in 2018: Times Higher Education, World University Rankings 2018 (2018) <https://www.timeshighereducation.com/world-university-rankings/2018/world-ranking#!/page/0/length/100/sort_by/scores_overall/sort_order/asc/cols/scores>.
Australia’s leading research agencies include Commonwealth Scientific and Industrial Research Organisation (CSIRO), the Australian Research Council and the National Health and Medical Research Council.
These institutes include the Florey Institute of Neuroscience and Mental Health, the Garvan Institute of Medical Research, the Peter MacCallum Cancer Centre, the Victor Chang Cardiac Research Institute and the Walter and Eliza Hall Institute of Medical Research.
The Productivity Commission has recognised that ‘[t]he rationale for government support of start-ups is that they create knowledge and network spillovers that benefit other businesses and the wider community, resulting in a “virtuous” cycle of entrepreneurship, innovation, investment, income and employment growth’: Productivity Commission, Business Set-up, Transfer and Closure (Report No 75, Productivity Commission, 30 September 2015) 253.
It has been observed that start-ups ‘start small but have the capacity to experience massive and sustained growth, often enabling them to become significant players in global industries within a small number of years’: StartupAUS, Crossroads 2015 – An Action Plan to Develop a Vibrant Tech Startup Ecosystem in Australia (Report, 2015) 10.
Ibid. In contrast to start-ups which have emerging high-growth businesses, traditional small businesses tend to have ‘less differentiated products or services’, are ‘often trading in a confined geographical area’, and will remain small even if they experience growth: StartupAUS, Crossroads – An Action Plan to Develop a Vibrant Tech Startup Ecosystem in Australia (Report, 2016) 22.
See Treasury and Department of Industry, Innovation, Science, Research and Tertiary Education (n 19) 13. While the precise definitions of the various stages vary widely, the Australian Bureau of Statistics has set out some features that identify them. It notes that a company in the pre-seed stage is generally in the process of setting up, and its products are at the testing or pilot production stage. A company will generally be in the seed stage if it is in the process of setting up and its products are in the R&D stage. A company in the start-up stage will generally not yet be fully operational, even though it may or may not be generating revenue. Finally, a company will be in the early expansion stage if it is operational and has a product in the market place. It will generally show significant revenue growth, and may or may not be profitable: Australian Bureau of Statistics, ‘5678.0 – Venture Capital and Later Stage Private Equity, Australia, 2016–17’ (28 February 2018) <http://www.abs.gov.au/AUSSTATS/abs@.nsf/Latestproducts/5678.0Main%20Features12016-17?opendocument&tabname=Summary&prodno=5678.0&issue=2016-17&num=&view=>.
The OECD has noted that venture capital, along with expenditure on R&D, is ‘among the first expenditures to be cut during recessions in OECD countries’: OECD, Science, Technology and Industry Scoreboard 2009 (OECD, 2009) 7.
Christopher C Golis, Patrick D Mooney and Thomas F Richardson, Enterprise and Venture Capital: A Business Builders’ and Investors’ Handbook (Allen and Unwin, 5th ed, 2009) xxi; Douglas Cumming, ‘Introduction’ in Douglas Cumming (ed), The Oxford Handbook of Venture Capital (Oxford University Press, 2012) 2.
The adverse impact that the global financial crisis had on access to finance for Australian businesses has been widely recognised in various reports: see e.g., Productivity Commission (n 25) 124. In particular, it has been noted that the global financial crisis led to a slowdown in lending to small businesses and a widening of interest rate margins in Australia: Senate Economics References Committee, Access of Small Business to Finance (Report, 30 June 2010) 1.
It is worth noting that there are also two other less-commonly discussed sources of venture capital funding for start-ups, namely ‘corporate venture capital’ and ‘university venture capital’: see generally Barkoczy et al. (n 11) 45–8. Corporate venture capital involves large companies investing in start-ups through their in-house venture capital funds. Engaging in corporate venture capital allows companies to stay abreast of new developments and facilitate the early acquisition of new technologies from potential future competitors. Some of the world’s most active corporate venture capital investors include Intel Capital, Google Ventures, Cisco Investments, GE Ventures and Microsoft Ventures: Australian Private Equity and Venture Capital Association Limited, The Venture Capital Effect: A Report on the Industry’s Impact on the Australian Economy (Report, 13 June 2017) 59. University venture capital, on the other hand, involves universities funding start-ups that have been created by their researchers and spun out of their institutions. While investment of this type may provide financial returns for the university, it also allows research developed within the university to be disseminated, which can provide significant reputational benefits. Universities such as Stanford, Harvard and MIT are famous for their spin out technology companies that contributed to the establishment of famous venture capital hubs in the United States such as Silicon Valley and Route 128. In the Australian context, it is interesting to note that Monash University and the University of Melbourne, with the support of the Victorian Government, have recently established BioCurate, a new $80 million fund to support early-stage biomedical research: see BioCurate <http://www.biocurate.com>.
These rights are designed to give investors greater control over their investee companies. They often include ‘board rights’ (which enable the investor to sit on the company’s board), ‘veto rights’ (which limit major strategic, operational or financial decisions being made without the investor’s consent) ‘drag-along rights’ (which enable the investor to compel the other investors in a company to sell their shares along with the investor’s shares to a third party purchaser), ‘demand rights’ (which allow the investor to force a company to become listed on a stock exchange), and ‘pre-emptive rights’ (which give the investor a first right of refusal to buy new shares issued by the company): see Barkoczy et al. (n 11) 57–8.
An IPO involves listing a company on a stock exchange. IPOs have traditionally been seen as the best outcome for exiting a venture capital investment
. Listing on a stock exchange is a lengthy and expensive process that can be achieved by only the most successful start-ups. Once the company has listed, its shares are publicly traded and are therefore more liquid. This makes it easier for investors to subsequently sell the shares: see further ibid 68–9.
It has been noted that venture capital investors ‘accept greater risk’ than other investors, and consequently also ‘hope for a higher return’: John H Spillman, ‘United States of America’ in Beat A Brechbühl and Bob Wooder (eds), Global Venture Capital Transactions: A Practical Approach (Kluwer Law International, 2004) 313–4.
See OECD, Financing High-Growth Firms – The Role of Angel Investors (OECD, 2011) 33 (‘Financing High Growth Firms’); Joseph W Bartlett, Fundamentals of Venture Capital (Madison Books, 1999) 12; Dylan Democrat Damon, ‘The Legal Aspects of Venture Capital Agreements: Part I’ (2007) 25 Companies and Securities Law Journal 43, 44.
While venture capitalists primarily invest other peoples’ money, they sometimes also invest their own money in the funds they manage. This signals to investors that they have ‘skin in the game’, which can sometimes help them raise capital.
It has been suggested that one of the most important ways that angel investors can help their investees is by leveraging their professional networks to help connect investees with venture capitalists who can support their continued development: Wong et al. (n 55) 228. It should, however, be noted that not all financing for earlier stage companies is ‘linear’, in the sense that angel investment is always necessarily followed by venture capitalist investment. There is evidence that many angel investors are supporting start-ups all the way through to exits, without venture capitalists being involved: Financing High Growth Firms (n 52) 19.
Follow-on investments are subsequent rounds of funding to finance a company’s continued growth. The fact that venture capitalists tend to have a greater ability to make follow-on investments means that they often dilute an angel’s initial investment in a start-up. It has been noted that this adds to an angel’s element of risk: Damon (n 52) 45.
Carried interest payments are often set at around 20% of the profits made on investments. The way in which profits are calculated can differ depending on the arrangement made between venture capitalists and their investors. In some cases, carried interest payments are only paid after capital has been returned to investors together with an additional ‘threshold hurdle return’, which takes account of the time that the investors’ money has been held in the fund.
The valley of death is a widely used idiomatic expression that can have different meanings in different contexts. For example, one meaning that has been given to the expression is as follows: ‘The valley of death describes the point where a business, often a technology based business, has a working prototype for a product or service that has not yet been developed enough to earn money through commercial sales. The company needs to find sufficient money to develop the prototype until it can generate sufficient cash, through sales to customers, that would allow it to be self sufficient and grow’: Science and Technology Committee, Bridging the Valley of Death: Improving the Commercialisation of Research (Eighth Report of Session 2012–13, House of Commons Science and Technology Committee, 12 March 2013) 8.