Non-dilutive capital could keep the rewards of Australia’s flourishing tech sector at home

The recent news that Octopus Deploy raised a mega $223 million round from US venture capital firm Insight Partners signals the growing interest that home-grown tech companies are garnering from major overseas investors. This is undoubtedly an Australian success story and is testament to the levels of innovation emanating from the country right now, which more and more investors want a slice of.

Yet, it also raises another, more troubling narrative: founders of Australia’s future shining unicorns feel they can’t get access at home to the funding they need to fuel the next stage of their growth.

The numbers speak for themselves. Australian VC firms are writing bigger cheques, with 20% reportedly saying in 2019 their average investment size over the previous 12 months was between $5 million and $50 million. But that average is still considerably lower than the sum raised by Octopus Deploy.

The issue isn’t fundamentally that promising Australian startups are turning to international backers with far deeper pockets; rather, equity raises in general take money out of Australian businesses in the long term.

This problem requires the same innovative mindset that spurred the local startup boom to now be applied to find new, more attractive ways of providing growth funding. This will be key to ensuring that equity, revenues and jobs remain domiciled in Australia, and not lost abroad.

Downsides of equity funding for late-stage startups

Venture capital is the main catalyst for innovation and the foundation that tech hubs are built upon around the world. It’s not the favourable climate or surfing beaches that led to the eminent rise of Silicon Valley. Founders across the US and the world flock to ‘the valley’ with their pitch decks simply because VC firms there are more likely to dish out fast sums for their ideas. 

However, trading equity to fund growth is not always in a founder’s and their business’s best interest. The backing and strategic direction a VC firm can provide, especially at seed stage, is invaluable to getting a business off the ground. But often later-stage scale-ups — preparing to IPO or for another liquidity event — don’t want to give up more ownership just to extend their runway. 

The problem is alternative financing options are scarce.

Banks offer loans based on a business’s financial track record or assets they can use as collateral. However, young tech startups seldom have both of these crude yardsticks in spades — especially ones built on ‘intangible assets’, like software, which traditional lenders find difficult to quantify and fit within their narrow risk profiles.

This is a difficult dynamic that founders the world over have to traverse, and Australia is no exception. 

What is non-dilutive capital?

A trend that is really starting to take off is the emergence of non-dilutive capital, as more and more founders push for alternatives to raising growth funding. Put simply, this is any kind of fundraising that does not require founders to give up equity in their company. 

Non-dilutive capital can take different forms, and traditional bank lending is certainly one of them. But, with these institutions struggling to get their heads around the business models of tech startups, new and disruptive methods have arrived on the scene that are far more attuned to these ambitious companies’ growth trajectories and needs. 

One increasingly popular option is revenue-based financing, which offers loans to startups in exchange for a share of their monthly revenue until the principal is paid back. This pushes the evaluation of a business from the past to the present, but what about the future direction of these fast-moving and scaling businesses? 

New and more advanced forms of growth financing take this a step further. By leveraging machine learning trained on historical data sets of a startup’s financials, customer growth and prior equity raises, venture firms can model the future growth of the business. Looking at a much wider array of metrics allows venture firms to gather a better appraisal of a company’s future growth, enabling more calculated risk management while giving startups access to the best available capital for them.

Such alternatives remove the restrictive covenants and interest repayments that traditional lenders demand. This matches the model of SaaS businesses, like Octopus Deploy, which tend to be revenue-generating from day one and can experience exponential growth.

A win-win for the Australian tech ecosystem

While vast treasure troves of VC money have been building up in major financial and tech capitals globally for decades, non-dilutive capital is still a relatively new concept and few venture firms offer it.

At the same time, its true merits are not about how deep a firm’s pockets are but rather the flexibility of the financing it can provide. This is a new game with a more level playing field, providing a domain where Australia can carve out a niche and compete on a global scale.

By the same token, non-dilutive capital can be a powerful engine for growth for Australia’s most promising startups. This form of venture debt can help them speed through growth milestones between equity rounds, even fast-tracking them to IPO or another form of exit.

Furthermore, it can provide all-important working capital to ride out the pandemic or future economic shocks, which, as the 18 months has shown, can suddenly hit revenues and provide the death knell to otherwise healthy businesses.

While non-dilutive capital exists on the fringes at the moment, it will enter the fold of mainstream venture financing as more and more founders call for such solutions. There’s a window of opportunity for Australian finance to seize this gap in the market, catching up to the world-class levels of innovation the nation’s entrepreneurial spirit has created.

There’s everything to play for, and everything to lose.