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Federal Budget 09 brings hope for emerging companies, but time is still critical

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Following on from his first report plotting the impact of the closure of Commercial Ready Grants on Australian innovation,  Nick McNaughton provides his assessment of the 2009 Budget and looks specifically at the impact of the announcements relating to the improved R&D Tax Concession and the introduction of the Commonwealth Commercialisation Institute (CCI).

The 2009 budget was eagerly anticipated by a large segment of the Australian business community. The need for extensive government support during the on-going Global Financial Crisis (GFC) was well understood. To the government’s credit, it has attempted to use this time of hardship to re-energise innovation in Australia.

One document that stood out was “Powering Ideas – An Innovation Agenda for the 21st Century“.

Produced by the Department for Innovation, Industry, Science and Research, the report clearly and eloquently looks at the history of innovation in our country and identifies Australia’s failure over the last decade to keep up an appropriate level of investment in innovation compared to our peers. The 2009 Budget is stage one in the long path towards rectifying the country’s under-investment in innovation over the last decade.

So what are the highlights? Certainly the Commonwealth Commercialisation Institute (allocated $196m over its first four years, and $82m per annum thereafter) goes a long way to addressing the gap in commercialisation of great ideas being incubated in CSIRO, NICTA, Universities and by entrepreneurs.

Commercialisation is an art, not a science. It requires input and commitment from seasoned business executives who have decades of experience taking promising ideas, products and services and creating profitable enterprises from them. Over the last two years in my role as a VC, I have looked at over 340 entities in Australia (we have backed two!). The one common theme is the genuine lack of commercial expertise in these entities to make them globally successful. Investment absolutely has to be made in this area and the CCI is the right body to achieve it.

There is little detail currently around the CCI. It is in all of our interests to have this organisation up and running and productive as soon as possible.

The problem with ‘resetting’ the innovation agenda is the same as re-booting your computer. If you don’t remember to save your current documents, that work is lost. The Government could have done a better job of transitioning from Innovation Policy 1.0 to v2.0.

Commercial Ready did not rise like a phoenix from the ashes in this budget. We had little expectation it would. The amendment to the R&D Tax concession is welcomed. The problem is that a significant number of companies who are early innovators in Australia will not be around to take advantage of these additional tax credits. Many have been struggling with the cash drain of the R&D burden since CR was cut in May 2008. Many are on life support. At least with CR, cash payments were made on a quarterly basis in advance of the expenditure. Now the cash does not arrive until after the tax year has finished.

To address this issue, on 18 March 2009 the Government announced the Innovation Investment Follow-on Fund (IIFF). The IIFF programme still lacks detail over two months after its announcement. These delays are hurting companies.

The lack of clarity on the terms of IIFF have left company Boards in a holding pattern as they review their funding options. If IIFF is an equity-based programme, there is a whole range of issues that will arise as a result.

Firstly, many of the companies eligible for IIFF were BITS backed entities. The BITS funding started to wind down in FY05/06 and subsequently the fund managers would have had their equity positions in these companies diluted (as additional funding rounds took place). Now the BITS fund managers have access to additional capital and a relatively short horizon to complete the investment. The problem arises when you consider the BITS fund manager will be a minority shareholder (in the range of 10-40 percent) and with all equity investments the pre-emptive rights of all shareholders will be activated. The key discussion area will be around valuation. I foresee a lot of horse trading as equity holders try to balance the need for a capital injection with a desire to preserve equity positions. Inevitably, these discussions will cause more delays. This is precisely the opposite of the original intent of IIFF – to get early-stage companies the cash they need to get through ‘death valley’.

Of course, there is a simple answer to this. Make the investment a convertible note and defer the valuation issue. The dollars can be invested in the company and the note will convert at a future valuation (usually the valuation at the next formal round). Most Boards would be comfortable with a discount rate being applied to the note, allowing upside for the BITS manager. This gets money into cash-starved companies quickly and will allow the $83m IIFF budget to be fully committed.

The medium and long-term future for Innovation in Australia looks promising. I am most concerned about the short term. As CR winds down (only $55m will be spent on CR commitments in FY09/10 compared to $133m in FY08/09), more companies will have to cover the cash burden of R&D on their books. The reality is they can’t and many will go under (despite the improvement in the R&D Tax Concession – a measure too late to save them). Equally, we are now seeing the short-term consequences of no innovation transition plan. Patent applications are down between 10-15 percent Year-over-Year – a clear sign of fewer entrepreneurs being willing or able to start down the entrepreneurial path.

The Government can redeem itself with swift implementation of IIFF and rapid progress on the CCI. The entrepreneur and investment community are watching with interest.

Nick McNaughton is CEO of Blue Cove Ventures, an investor in early-stage Australian companies.

Photo: tinken (flickr)

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