Last week, I looked at Callaghan Innovation’s boldest goal: to boost private-sector investment in R&D by 75% by 2016. This week, I want to focus on a specific innovation that Callaghan plans to use in getting there: the Repayable Grants and Incubator Support Programme signed off as part of Callaghan's business case by Cabinet. It offers tech firms two-year grants of a maximum of $450K, and Callaghan aims to make 24 or fewer grants each year. Notably, you have to put up a third of the funding yourself (or source it elsewhere), which is a substantial constraint for a startup, even one that’s incubated.

It’s true that it’s hard for startups to cross New Zealand’s capital gulch: you can be small enough to subsist on the smell of an oily rag, or you can be stable enough to attract investment, but it’s very hard to grow from one category into the other. (Lance Wiggs graphs the dilemma nicely here, and you’ll see that Callaghan is rushing in where so far only angels are treading. There’s a real need here.) So how does Callaghan plan to let a thousand - OK, 24 - flowers bloom?

With help from two to four privately-led technology incubators. Last week Callaghan requested expressions of interest (rego required) from anyone interested in forming a technology-based incubator - that is, a privately-owned early-stage investment vehicle that channels seed capital to new ventures emerging primarily “from universities and CRIs”. You pitch to an incubator with your technology; it assembles the right team, if you don’t have one in place.

I see why this is attractive from a scientist’s point of view: you get management skills, which is the thing you most lack, and you get a footbridge over the funding gap, as the incubator channels the seed capital it somehow has access to towards you.

But I can’t see what’s in it for the investor. True, the government is giving you what’s essentially an interest-free loan, at least once you factor in the time it will take you to become profitable and discount the value of repayments (capped at 3% of revenues) back. But what do you get for that? You get a constrained ability to sell offshore (Callaghan’s EoI document requests input on how to structure clawbacks in the case of offshore sale). That’s a problem, because if your exit route is to become an acquisition target (which your private funders, who will have a 3 to 5 year exit horizon, are likely to want), you won’t find many buyers in NZ, and you won’t find many elsewhere who will want a company in which the NZ government retains, or will claw back - its initial stake (as Appendix B to the EoI seems to have it, though the Cabinet paper notes - optimistically - that funding will reduce to 25% to 35% over three to five years as the incubators earn income).

What’s more, your profit margin is likely to be small. If one or two in twenty startups hits it out of the ballpark (as VCs commonly assume), then you’re likely to hit it out of the ballpark once, perhaps, for each of the 24 startups you invest in annually. But the Cabinet paper foresees that you take 30%-50% of equity at the start (that’s before dilution: the remainder goes to the entrepreneurs) From the rest, you need to repay your investors - you’re a channel, not a source, of funding, and pay your staff - remember, your role is to build and staff a firm around someone else’s idea and apply to Callaghan on their behalf for funding. (You can invoice the entrepreneur for that, to a capped level, but you can’t pay your own salary out of the grant).

As the Cabinet paper notes, “Given time to build up a portfolio of successful exits and returns on equity, effective technology-focused incubators may [may! become self-sufficient.”

You can’t run a technology incubator if you’re a typical, founder-focused angel or VC, used to founding entrepreneurs and their teams who come to you with a concept. If you’re in that line of business, the Cabinet paper explicitly foresees that you found a new venture dedicated to the technology incubator model, where you build a business around someone else’s ideas. In practice, this will mean that the people who really do know most about rapidly building businesses - angels and VCs - will have to decide whether to either switch models, or found a subsidiary with less access to their pool of experience.

In fact, you’ll need to be pretty stellar to get to run one of these incubators at all: one of your crew has to have commercialised new technology before, you need access to private capital (for now) and to angels and VCs (for later), and you need to have the executive-search ability to source a top-notch team. Oh, yes, and you need to have a track record of past successes, plural, in this sort of investment.

From the investor’s point of view, the pitch is essentially this: sign up with us for a free stream of ideas, sourced fresh from a university or CRI. But New Zealand’s problem has never been that it doesn’t have enough ideas, and I can’t think of a venture capitalist I haven’t heard complain about the number of ideas - and teams - pounding the doorknocker. When there’s already a model out there that works, what Callaghan has to explain is this: why would you take on constraints to build businesses for others, when you could strap on your Nikes and just fund them yourself?

AuthorNicola Rowe