Risk vs Reward: What Will It Take to Find the Next Unicorn?

Finding the next unicorn

Venture capital deals for Australian startups have slowed. So what will it take to find the next unicorn?

It has been a turbulent three years for Australia’s venture capitalists. While the frenzied cheque-writing of 2021 gave way to doom and gloom in 2022, more recently a cautious, measured approach has emerged. So what lies ahead in 2024? Have higher interest rates and rising inflation permanently altered Australia’s VC landscape?

Samantha Wong, general partner at Blackbird Ventures, admits that the 0 per cent interest rate party is over and some startups are cutting staff or collapsing as funding gets tougher. But she – and others – are optimistic about the next 12 months, largely because of Australia’s now thriving tech startup ecosystem.

“I’m confident this is not a return to the dark ages and many more Australian stars are being born right now,” she says. “When I started in venture in 2015, startup jobs were scarce. Today, Australia has 40 unicorns [startups valued at US$1 billion-plus], which each employ hundreds or thousands of Australians. Every time a company is successful on that scale, some of its employees become founders themselves. Based on this fact alone, hundreds of startups will be born in the coming years that have a chance at becoming the new [online graphic design tool] Canva and a high-water mark will be set for the next generation.”

Finding the next unicorn

How Venture Capital works

At its heart, venture capital is a simple proposition. Typically, VC firms raise money for a fund from outside investors (called limited partners or LPs) then invest in a portfolio of mainly tech-focused startups in exchange for a minority ownership stake and a board seat. At a very early stage, sometimes before product launch, this is called angel or seed investing. Further down the track, the startup may raise more funds in a series A round then series B and so on.

It all boils down to risk versus reward. Investing early in a startup is risky but the returns can be enormous. For example, a 10 per cent stake bought on the basis of a company valuation of $10 million would eventually be worth $100 million if the startup becomes a unicorn. Later-stage investing is safer because the startup is established and likely to be expanding overseas – but that 10 per cent stake will cost more on the basis of a higher company valuation.

To deliver those massive returns, VCs want their portfolio companies to scale quickly and develop globally so they offer connections, mentoring, help with hiring talent, advice on further fundraising and other support at every step of the way. Jackie Vullinghs, a partner at AirTree Ventures, recently helped a startup hire its first head of product from another company in AirTree’s portfolio that had scaled to thousands of employees and sold to a listed competitor. And Square Peg Capital partner James Tynan jumped in to help one of its companies after a core function was shut down by a United States telco. “Within an hour we had them connected with another founder who had experienced a similar issue and within 24 hours they were connected with the CEOs of [US telcos] Verizon and T-Mobile.”

That speed highlights how Australia’s VC ecosystem has burgeoned over the past decade. Although VC emerged as an asset class in the early 1970s, exciting periods of growth were dampened by recessions, the 1987 sharemarket crash, the 2000 dot-com bubble burst and the 2008 global financial crisis.

The turning point came in about 2014. At that stage, “you could have counted the number of Australian VCs on two hands”, according to Vullinghs. Fledgling local VCs watched Australian stars such as Campaign Monitor and Atlassian turn to US investors for funding – and wanted a cut of the action. “Australia was producing world-class technology companies – good enough to receive investment from successful late-stage US firms – but local early-stage investment dollars were scarce,” says Wong. AirTree, Blackbird, Square Peg and other pioneer VCs raised funds here to back the next generation of unicorns, including employee engagement platform Culture Amp, driverless car developer Zoox, ecommerce tech platform Rokt and global payments fintech Airwallex.

What’s happening now

Figures from startup funding data platform Cut Through Venture highlight the VC roller-coaster of the past few years. In 2021, Australian startups banked more than $10 billion in VC investment across 731 deals, often on sky-high valuations. The frantic pace continued into early 2022 – then the music stopped. Rising interest rates, surging inflation and plummeting tech valuations slowed the VC frenzy, with $7.4 billion invested across 712 deals.

This year has been much slower, with only $2.3 billion invested across 249 deals for the nine months to 30 September. VCs – despite raising a record $2.7 billion from investors in 2022 – have spent cautiously, preferring to support their existing portfolio companies with bridge funding in order to grow into their high valuations. Cash-burning later-stage startups have struggled to attract investment or deferred raising capital, funding rounds have taken longer and VCs are exercising restraint and undertaking detailed due diligence, including meeting with entire management teams, not just the founder.

The most recent figures from Cut Through Venture, for 2023’s third quarter, showed no uptick in the number or value of deals but a significant shift in sentiment from the 161 investors surveyed, with more than half rating the investment climate as improved. Most VCs don’t expect to change their fundamental approach to investing – an idea that will disrupt the status quo is worth backing at any time. “For the best founders, there’s no correlation between interest rates and whether they start a company,” says Wong. “It’s usually more about a technology becoming available that suddenly makes a much better solution feasible – like cloud, mobile or AI – or their ideal co-founder is ready to take the plunge.”

Square Peg’s Tynan adds that the slowdown has a silver lining. “The benefit has been a greater ability to build a strong relationship before investing. The frenetic pace of 2021 could make that more difficult. We’re actively investing because we believe that times like these are when the best companies can be created.”

Nor do VCs expect to change the qualities they seek in founders. “What we look for in a founder is consistent because building an enduring business requires traits that persist across cycles,” says Vullinghs. Typically, VCs want passionate, inspirational, resilient founders with a unique idea that solves a problem in a big market. They must be able to articulate their vision succinctly, attract world-class talent and learn quickly.

They also need to be super-smart and very hard workers. “They are intense and operate quickly, constantly changing course to adapt to customer needs,” she says. “They don’t take no for an answer, knowing there is always a way around every problem. If they haven’t hit budget on the last day of the month, every employee is on the phone to get any outstanding customer contract signed to meet revenue goals.”

As brilliant as these founders sound, surely it must be tempting in tough times for VCs to step in and call more of the shots? Tynan says that’s not how it works. “Our model is always one of joining boards and building enough trust to be a founder’s first phone call when things go wrong. So when the markets shifted we took a personalised approach – working out what each company needed and working with the founders to help.”

When things go wrong

Despite motivated founders and 24/7 VC support, there are failures. Wong says an early warning that a startup is struggling is when revenue numbers are consistently missed. The VC will work with the team to diagnose why and look at strategies to accelerate growth. Often the company needs to buy itself time by conserving its cash – and that means layoffs. “This is always an emotional and stressful time for everyone involved so we try to support the founders and their teams with advice and for those whose jobs are affected, we try to find them roles in the rest of our portfolio.”

One high-profile collapse this year was rapid grocery delivery startup Milkrun, less than two years after it launched in late 2021. Early signs were highly promising – the seed round lead investor, AirTree, already knew founder Dany Milham through the Koala mattress business he co-founded in 2015 and it liked his speed and intensity, his ability to attract talent and the size of the potential market. Milkrun quickly became one of the fastest-growing companies that AirTree had ever backed.

But by June 2022, Milkrun had dropped its 10-minute delivery promise and in that same month, Woolworths launched its $5 rapid delivery Metro60 app. Milkrun had staff layoffs in early 2023 but rising interest rates, rent increases and other hurdles finally forced its closure in April (Woolies bought it in May and rebranded Metro60 as Milkrun).

AirTree’s Vullinghs says VC returns rely on a handful of successful investments generating outlier profits. “But it’s a double-edged sword. For every Canva, [online corporate training marketplace] Go1, [social media tool] Linktree and [human resources software developer] Employment Hero in our portfolio that becomes a billion-dollar household name, several startups don’t succeed. Company failure is painful, even if it’s part of an investment strategy that succeeds in aggregate. When a failure happens, we’re there to support the founder to close the business in an orderly fashion, help employees find their next role and manage the fund in the best interests of our LPs.”

The next 12 months

For an industry fixated on the future – finding and funding the next big thing as early as possible – VCs are surprisingly reticent about predicting where the next unicorns will come from. “If you tried to [do that],” says Wong, “you’d have missed Canva and Atlassian because there was no particular reason why those companies should have been born here in Australia.” The future, VCs argue, is up to the entrepreneurs and their big ideas.

But it’s also true that VCs get a valuable overview of which sectors are attracting the most entrepreneurial interest. Among the many contenders are healthtech, cybersecurity, enterprise software and fintech but there are two standouts: climate/cleantech and artificial intelligence (AI).

“I think we’re in the middle of at least two concurrent crises in which VC has a role to play,” says Tynan. “Climate has been a focus of ours for a while – we've invested in [lab meat producer] Vow, [renewable energy supplier] Amber and [reusable packaging maker] Zero Co – but as a theme, it's becoming more important… It’s now clear that we’re going to need to build some of the world’s biggest companies to solve climate problems.”

The second crisis, he says, is the explosion of AI capability and usage. “This shift has the potential to be as transformational as the shift online – but it’s happening much faster. We’ve been investing in AI-first companies for a decade and have more than 15 in the portfolio, such as Deci, which accelerates AI hardware, Tomorrow.io, which predicts weather, and Neara, which helps manage and transform energy grids.”

Wong also believes that AI is the next big technology shift. “It’s reaching a moment now where it’s ready for prime time. You can no longer be a software company without AI – it’ll be incorporated into every piece of software in every industry. We’re already seeing this transformation underway in companies like [AI search engine] Marqo, [AI image production platform] Leonardo.ai and [medical diagnosis tool] Harrison.ai.

She’s also keeping an eye on deep tech companies “innovating with atoms, not bits”. In other words, organisations developing physical rather than software-based solutions, using scientific breakthroughs. “There’s a new wave of companies being built off the promise of abundant, low-cost solar – like SunDrive Solar, which produces the most efficient commercial solar cell in the world – and Australia has a huge opportunity there.

“Then there are companies that are making sure we have resilient supply chains for the renewable world, like Syenta and Nomad Atomics. Australia’s hardware startup ecosystem is rapidly coming of age. It’s great to witness and I predict they are just the tip of the spear on this wave of companies.”

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