Investors glued to the ups and downs of the local and global sharemarkets since the start of the year could be forgiven for thinking, or possibly hoping, there has to be something more.
More to invest in, that is, other than the group of shares listed on public market exchanges that oscillate between the extreme valuations caused by either fear or greed. Apart from investing in property, the sharemarket is where retirees or those saving for retirement have put most of their money, with the expectation of generating returns and income over the long term above the risk-free cash rate.
Take a peek into the composition of self-managed superannuation funds and it's clear the sharemarket is still where people are investing most of their savings – of the almost $600 billion invested by SMSFs, 34 per cent or $203.8 billion is invested in the sharemarket, 26 per cent is in cash accounts and term deposits, 16.5 per cent is in real property, with the remainder in trust structures and other unlisted assets.
But there are now more ways than ever to invest in private markets, and there are plenty of signs suggesting that these alternatives – in particular venture capital and the earlier stage "angel" investing – will make up greater proportions of individuals' overall portfolios in the future.
For one, the federal government, through its National Science and Innovation Agenda statement, which it announced at the end of last year, wants to reward investors both at the professional level and at the individual investor level for allocating more of their money into early stage private markets.
These proposals will be debated further in Parliament this year as legislation is drafted and the July 1 implementation date draws closer.
The biggest enticements in that plan include a 20 per cent non-refundable tax offset on early stage investments by individuals, capped at $200,000 per investor per year, with a 10-year exemption on capital gains tax, provided investments are held for three years.
Legislative debate
At the same time, early stage venture capital funds will receive a 10 per cent non‑refundable tax offset on capital invested during the year, with the maximum fund sizes increased and the ability to hold onto early stage investments enhanced.
More funds are expected to take advantage of the tax offset incentives. Similarly, more individuals will look to allocate money into early stage companies not quite ready for a public market listing.
To accommodate the demand for information and listings of early stage private companies, crowdfunding platforms have popped up to give investors access to this market.
OurCrowd and VentureCrowd are the two most prominent crowdfunding platforms accessible to Australian investors. Both evaluate companies worth investing in, co‑invest with institutions and established venture capital funds and link potential early stage investors with an ecosystem where entrepreneurs turn ideas into new businesses.
Currently, only investors registered as "sophisticated" are able to use OurCrowd and VentureCrowd, but draft legislation relating to which companies can be listed on these platforms and what types of investors can invest in them will be debated in coming months.
Traditional private equity, on the other hand, remains the domain of professional fund managers. Investors looking to get a slice of private equity investments do so via a pooled trust structure.
Most individuals will already have a small allocation through their superannuation funds, which tend to invest anywhere between 2 per cent and 4 per cent in private equity.
There are some equity firms that have made their funds available through stock exchange-listed structures, which enable shares in a holding company to be traded, but investors looking at buying shares in these companies should be wary of fees charged both at the underlying fund level and at the listed company level. While these listed companies have the appearance of liquidity, they often trade within a limited shareholder base.
Value of crowdfunding
While later-stage businesses with proven cash flows and profits can go to a bank to apply for debt funding or even to public sharemarkets to raise capital, early stage or start-up companies are left to rely on private equity funding to grow and develop their business models. Traditionally, these early rounds have tapped friends and family money, but the evolution of crowdfunding platforms means everyday investors can get involved in seed and early stage funding rounds.
In return for taking on the risk of investing in an unproven idea, early stage investors will get a stake in a new business at a relatively low valuation multiple. Then as the business develops and progresses through subsequent funding rounds, with new investors often providing further funding for equity, earlier investors may have their equity interest diluted or made smaller.
Funding rounds in early stage companies can occur as frequently as every 12 months. Investors who want to hold onto their stake from the very early "angel" or seed stage right through so-called A, B and C series levels and onto a "liquidity event", such as a trade sale or initial public offering, might be holding and continuing to invest for up between five and eight years, depending on the business.
During each funding round initial investors will be asked to invest again, but at higher valuation multiples, if the company's business concept has progressed. "Equity funding is the life-blood of early stage companies," says Steven Maarbani, PwC partner, Venture Capital & Private Equity.
Companies will use the early stage funding for product or brand development, renting larger premises, beginning production, hiring staff with specific expertise and, generally, to achieve key milestones set out in their information overview or memorandum for their next funding round, Maarbani explains.
As the company progresses through the stages of its business plan and funding rounds, it will ideally be increasing sales, number of customers and market share, and building its competitive position, he says.
"It is important at the outset that potential investors read the information provided and satisfy for themselves what the capital will be used for," he says.
Depending on the breadth and depth of your network, it's unlikely you'll come across the quality and quantity of potential new venture capital and private equity deals around the weekend barbecue. So, in order to be a serious investor, crowdfunding platforms and angel-investing clubs are a good place to get dealt into the game.
Broad reach
Individuals investing through a crowdfunding platform should be looking for a place where they can access deals and invest alongside – and on the same terms as – respected venture capital firms, says Dan Bennett, OurCrowd Australia and Asia managing director. Crowdfunding platforms should also be responsible for vetting businesses, based on quality factors such as experience and previous success of founders, he adds.
OurCrowd, which began in Jerusalem, Israel, in 2013 and has since started branches in California and New York in the United States and more recently in Australia, has so far raised $300 million among a base of 1200 individuals investing in 100 companies globally, according to Bennett.
OurCrowd investors can choose which deals they want to invest in based on information on the website. This can include a 20- to 30-page information memorandum, a page-long summary on the deal terms and a video on what the technology will do.
Investors put a minimum of $10,000 in each deal, Bennett says. Some OurCrowd users will allocate $200,000 to the platform, he says, spreading their risk over 20 deals, with the discretion to opt out of deals as they are presented to them.
Like OurCrowd, VentureCrowd, the platform that was spun out of private equity firm Artesian, which was owned by ANZ Bank until 2004, assesses potential deals according to their risk. It partners with established venture capitalists to source deals for registered wholesale/sophisticated investors.
Deals on VentureCrowd enable new investors to buy in on the same terms as the lead investor. VentureCrowd has also linked up with angel investing clubs, which have been popping up across Australia, to provide a way for investors who want to be more involved in selecting start-ups to meet like‑minded people.
Sydney Angels, for example, has about 80 members who can invest $50,000 or more a year. They meet once a month and are exposed to ideas in a forum like Shark Tank, the reality TV series based on the BBC's Dragon's Den concept.
In what appears to be a case of the free markets leading regulation, Bennett says the crowdfunding model is a good fit for retail investors even though regulations restrict the use of such platforms to designated "sophisticated investors" under the Corporations Act.
To achieve certification as sophisticated, an investor needs to have net assets of at least $2.5 million and an annual income in excess of $250,000.
"We've done deals with [early Facebook investor] Sequoia Capital, Accel Partners, with GE Ventures, with [Hong Kong-based] Horizon Ventures," says Bennett. "For $10,000 people are investing as if they're a multimillion-dollar corporate. Unless you write a $10 million check and beg Sequoia to take your money there's no other way to invest with investors like these."
Government incentives
However, while the intent of the federal government's National Innovation and Science Agenda statement seems to be to unlock private capital for investment in early and venture-stage companies at the individual‑investor level, the concept still has a way to go before it becomes a reality.
The draft legislation for regulating crowdfunding businesses requires companies that want to be on a platform accessed by non-sophisticated retail investors to meet similar reporting standards and revenue requirements as companies that are listed on public sharemarkets.
While this draft legislation is yet to be debated, PwC's Maarbani says crowdfunding platforms such as VentureCrowd are not likely to list companies on this basis and would instead continue to target only the sophisticated investor market.
As the regulations around crowdfunding evolve, more platforms are likely to enter the Australian market as investment firms target the space. Among the most recent entrants at this end of the market is the IQ Group, which is looking to develop a specialised life sciences' crowdfunding platform, according to George Syrmalis, IQ Group chief executive.
Not all ideas are winners
Seasoned venture capital and early stage investors are quick to sound warnings about the risks for those who might be encouraged by tax incentives to invest in start-up and early-stage private equity.
Venture capitalists are well aware that most ideas that find funding actually fail. Some estimate the figure to be as high as nine out of 10 businesses. Others have slightly more optimistic views.
The spokesperson for one venture-capital firm contacted by Financial Review Smart Investor says that the company expects to "blow up" 60 per cent of its capital on failed ideas, with 20 per cent returned dollar for dollar and the remaining 20 per cent hopefully finding fruitful concepts to pay for all the losses and – with luck – produce multiple returns.
VC firms will market their funds on the basis they can achieve north of 25 per cent returns but in the United States only the top quartile of funds actually achieve that level.
Investors who dip into investing in early stage companies on their own often burn through their capital quickly, says Daniel Petre, former Microsoft head and founder of AirTree Ventures.
"I call it the 'pissed dentist who goes to dinner parties and ends up investing in the latest thing, which is always something like Etsy meets Facebook meets Alibaba' syndrome," he says.
"The reality most people come to terms with is most ideas aren't going to make any money and that valuation really does matter," he says.
A common way for investors to burn through their capital is when it comes to a follow-on funding round and new investors look to buy in at valuations that reflect a different view of the company than the previous round, Petre explains.
Following the decline in share prices among some of the large US technology companies in the past year, including the likes of Twitter and LinkedIn, Petre says some earlier-stage companies are now revising down their valuations.
"Companies often find their cash only buys them a 12 months runway and they might think they are able raise again at eight or nine times [revenues] and they can't and suddenly go back to four times [forward revenue]," he says.
Unlike in the public markets, where companies are valued based on per share earnings or net tangible assets, early stage and venture companies base their valuations on a multiple of revenues and not profits.
High-profile hopes
"I worry about people who are bored in their retirement investing in this area," says Mark Carnegie, a venture-capital, private-equity investor and founder of M. H. Carnegie & Co. "I have seen examples of just how rapidly they can get out of their depth.
"Venture capital and early stage investing is the equivalent of a turmeric or a saffron in terms of how much you use in your portfolio. It's an exotic spice, it's not a tomato, carrot or a celery," Carnegie says.
"It's important investors understand investing in early stage and private equity should make up between 2 per cent and 5 per cent of an overall investment portfolio."
Because of the lack of what he calls "ridiculous follow-on money" in Australia, failures here have been less spectacular than in the US, where there are more investors chasing the next so-called "unicorn".
Founder of 99dresses Nikki Durkin has put herself out there as a public example of a start-up failure after raising $640,000 from a group of US investors on the back of being accepted into Silicon Valley accelerator program Y Combinator.
Globally, the biggest venture-backed start-up failures include Digg, the user-generated news aggregator that was valued at $US160 million at its peak after raising more than $US45 million from a group of prominent Silicon Valley investors. A couple of years later it sold for an estimated price of less than $US500,000.
Fab, the flash-sale retailer offers another cautionary tale for investors. By 2013, the start-up had raised more than $US300 million in venture-capital funding but last year was sold to Irish manufacturing company PCH in a deal speculated to be worth $US15 million in cash and stock.
The other side of the coin is that potential multiple returns for an early stage investor are limitless. Think how much a dollar in the hands of Mark Zuckerberg at the dorm-room stage of Facebook – or Steve Jobs at the garage stage of Apple – would have been worth today.
The poster child for success in the Australian start-up scene is enterprise software company Atlassian, which listed on the Nasdaq with a market capitalisation of $US8 billion – a long way from the $US60 million the company's founders secured from US VC firm Accel Partners in 2010, and even further from the $10,000 in credit-card debt Mike Cannon-Brookes and Scott Farguhar used to finance the business when they started out after meeting at university in 2002.
Early stage investors might be chasing telephone digit-style returns compared with the single-digit returns professional investors in the sharemarket are happy with, but they will accept one or two hits in a portfolio of one or two dozen misses.
