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So another one of our high-flying Kiwi tech firms is about to be gobbled up by off-shore investors.

News broke this morning that Endace, the successful security and networking company founded by businessman Selwyn Pellet and listed on the London Stock Exchange’s Alternative Investment Market, has been approached by “California networking solutions firm Emulex with a cash takeover offer worth US$130 million ($156.76 million)”.

I’m happy for Selwyn Pellett, who stepped down from the company in 2010 and the Endace team. They started over a decade ago working on cutting edge technology at Waikato University and became global leaders with major banks and blue chip companies among their clients.

But it is also disappointing to see yet another innovative company that was nurtured with millions of dollars worth of government grants, leave New Zealand ownership and control completely. Selwyn Pellet acknowledges that today in the Herald:

“People who shouldn’t be happy if they understand the implications are the New Zealand taxpayers. They should be saying, ‘That was one of the highest-tech companies in New Zealand, it could have with appropriate encouragement spawned another four or five companies’ … the company itself has so much IP [intellectual property].”

His comments sparked a testy exchange with Science and Innovation Minister Steven Joyce – via Twitter. It went something like this:

The flurry of tweets is revealing. It shows the guilt discomfort Selwyn Pellett feels about the company he founded, which received over $10 million in government grants, going lock, stock and barrel to a US company. While Endace’s shares are openly traded on the AIM, it still has a significant New Zealand shareholder base and most of its staff are based in New Zealand. But what we have discovered when our tech companies sell is that, despite best intentions, the R&D operation is unlikely to remain in New Zealand long term.

The Herald piece and tweets show that Pellett is sensitive to the issue and has been reflecting on the big picture funding of New Zealand tech companies. After all the Endace story is a familiar one. This TIN100 survey published in September reveals that in the last 20 years, 42 TIN100 companies have been acquired by overseas buyers. Many of them were recipients of millions in TechNZ and other government grants.

So we as taxpayers put millions into companies that become successful and grow, get on the radar of big overseas players and are bought out. We’ve seen this time and again with the likes of Humanware, Navman, The Hyperfactory, Sonar6, Next Window, 4RF and Fisher & Paykel Appliances.

The question is whether this is a problem. Is it worth it for the country to fund this type of thing given the predictable outcome?

It really comes down to the value the companies deliver to New Zealand before they are sold. Some of them generate significant revenues, so will be paying tax. They employ hundreds of skilled New Zealanders. There is much-needed experience gained in developing start-ups to the stage that they become acquisition targets. There is also a fair amount of technology transfer between these companies – so their development has spin-offs for the tech industry at large.

How do you quantify the impact of the government grants? It’s difficult – but this 2009 Infometrics study looked at the impact of TechNZ funding. It concluded:

The total value of TechNZ investment received by surveyed firms (excluding for research that is yet to generate a return) is $39.5m. Therefore, based on the estimated value-added a very crude benefit-cost  ratio is about four. We calculate that the discounted value of the  increment to sales would be $509m and the discounted benefit cost ratio  would be 12.9 based on plausible assumptions, outlined under Return on
investment.

A more robust calculation of the net effect on GDP requires an econometric comparison of companies that received TechNZ funding with those that did not, allowing for possible self selection bias. Strictly speaking one would also have to allow for the deadweight loss associated with the imposition of taxation required to generate TechNZ funds.

Other than higher sales and export earnings, other benefits received from TechNZ funding were brand positioning, skill retention and recruitment,
addition of R&D capacity, and credibility in the market.

The Study suggests that government funding has significant financial spin-offs – and many other benefits. No one is arguing that this type of support should be withdrawn. But is there a way of retaining the value of the direct government investment if the company is sold?

Convertible notes

Here’s where Pellett suggests the idea of replacing grants with convertible notes. I haven’t heard his plan in detail, but I imagine it is a sort of loan that converts into equity if the company is sold – in full or partially –  within an agreed time frame.

So lets say the government issues a tech start-up $2 million to help it with its R&D efforts. This is issued as cash to the start-up which can spend it on the agreed activities. But if the company is bought, the convertible notes the Government holds convert to an equity stake in the company, so the Goverment gets its $2 million back when the company is sold – or when the foreign shareholding in the company reaches a certain stage – say 60%.

Convertible notes are used a lot in the private funding of start-ups with mixed results. In effect though, this vehicle could protect the Government’s direct investment in these types of companies or encourage them to stay New Zealand owned and controlled for longer. For the latter to happen they need better access to capital – but that’s another story.

For the entrepreneurs running the start-ups convertible notes would be less attractive than straight grants because there are added strings attached and they effectively require an interest-free loan to be repaid if they sell out. But its an idea worth considering and increasingly, people like Pellett, Rod Drury and other serial entrepreneurs do seem to care about the bigger picture – value for money for the taxpayer.

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