The SaaS Fundraising Death Zone

TL;DR: the ecosystem of early-stage investors (angels, seed and VC) has a structure and set of incentives that creates ideal (or even necessary) points in a SaaS startups life for raising capital. Unfortunately, changes in the ecosystem have created what I call a “Death Zone” between Seed and VC tiers of investors which can seriously affect the ability of a SaaS startup to raise the capital they need to grow, and in some cases, survive. For most SaaS startups, the death zone occurs where they are doing between $50K and $200K in MRR: the startup is too big to raise from Seed funds, but too small to raise from VCs, and because it is counter-intuitive, it is a major risk to SaaS entrepreneurs running successful, growing startups.

saas-fundraising-death-zone

Building a SaaS company is hard but rewarding. After bootstrapping AffinityLive for its first few years (very very difficult), I decided that the time was right for us to engage with investors and raise capital to accelerate our growth further. Fundraising is always hard work, but I didn’t realize until I was well into the process that I’d made the mistake of trying to fundraise at a time in the business’ life that I’ve since come to call the SaaS Fundraising Death Zone.

This post is an attempt to help other SaaS founders out there not repeat my mistakes, because while our outcome has actually been really awesome, the probabilities of success were much lower and the effort required to get a great outcome was a lot higher than it would have been if I’d known this information a couple of years ago. I hope this post is helpful, and feel free to share it with other founders you think could benefit from it (Twitter, Facebook, mailing lists, etc).

Early Stage Investor Types

Before explaining the Death Zone, it makes sense to summarize the different types of early stage investor active in the ecosystem. This is just my experience and perception, but since these observations underpin my lessons learned, it makes sense to spell them out here.

Angels
Angel investors are those early stage folks who mostly write $25K-$150K checks out of their personal funds to back a company early. They’re usually people who’ve had a good exit from the industry or have risen in it enough to qualify as an Accredited Investor – they’ve got their own nose for picking winners and often their main payoff is the emotional satisfaction from investing (paying it forward, giving back, being able to share the excitement of the early stage journey from a front row seat) – early stage companies are so risky most Angels would get better financial returns from playing table games in Vegas. As a very small time angel investor myself (through Startmate) I treat every check I write as a donation in the balance-sheet of my mind.

Seed Funds
Seed Funds are those early stage investors who mostly write $750K-$1MM checks for companies that have shown some promise and have achieved more traction or have a more compelling team/vision/opportunity that allows them to bypass (or combine) angel investors. They tend to raise smaller funds (anywhere from $10MM around $100MM, but they’re raising more too) to invest in startups, and most of the time they’re backing companies based on their belief of their ability to get to a Series A.

Most of the time these Seed Funds are newer and as they prove out their track record they raise larger and larger funds which let them write bigger checks and graduate into “VC Funds” land – you could argue that some of the names below are already there.

Prominent examples of these types of funds are SoftTech VC (2015 fund was $85MM), XSeed (2012 fund was $60MM), 500 Startups ($100MM in 2013), Illuminate Ventures and Costanoa Ventures ($135MM in 2015).

VC Funds
VC Funds are the folks with the big firepower – they raise many hundreds of millions, sometimes into the billions from their investors to then put to work investing in startups. Names like Kleiner Perkins ($525MM fund in 2015), Sequoia ($700MM in 2010), Andreessen Horowitz ($1.5B in 2014), Accel ($475M just for early stage in 2014), Greylock ($1B in 2014) and Benchmark ($425MM in 2013) are prominent in this category.

These funds invest in companies they think can be IPOs and billion dollar exits, and while some of them do seed investing (often writing $500K checks alongside others) they really get into the game and place their bets at the Series A stage (all the partners I’ve spoken to at these firms who do seed investing just to get the inside run on the Series A) and then follow on (or join in someone else’s party) in Series B and later stages.

OK, now we’ve gotten that out of the way, let’s look more closely at SaaS companies, and more specifically, the rule of thumb around how they’re valued.

SaaS Valuations

Valuations are a funny thing – the true answer is that a company is worth what someone will pay for it. In early stage SaaS, however, when there’s a lot of uncertainty but there’s some proof points, a good rule of thumb is to consider the valuation of the business as being 10x annual recurring revenue (ARR). Applying this rule of thumb, if you’re doing $50K in monthly recurring revenues, your current rule of thumb valuation $6MM.

Now, if your SaaS business is growing fast (more than tripling or doing 200% a year in revenue growth), you can expect to see this multiple move up to 15x-20x. If you’ve tapped into something super lucrative and frictionless (Zenefits, Slack) you’ll see these multiples go a lot higher because investors are happy to overpay now if they’re very confident you’ll be worth that higher price very soon. While we all like to obsess about outliers (and aspire to be one), it makes sense to look at the more general case of a successful SaaS business that has solved a real problem and is doubling revenues year on year.

The reason for bringing up valuations is that the process of raising equity funding involves “selling” some of the company to new investors (although mostly by issuing new stock, so the company gets the money, not existing shareholders). You might think that raising $2MM for a company that is valued at $6MM is much the same as raising $2MM for a company valued at $40MM – you’re just selling a smaller percentage of equity – but you’d be wrong because investors have different needs.

Incentives for Early Stage Investors

For everyone in the early stage except the Angels (and sometimes also them), there’s a very strong incentive for an investor to buy 15%-20% of startup when they invest in a funding round. In fact, from talking to dozens of investors and many more entrepreneurs about it, the percentage is actually the fixed aspect in the investing formula – increasing the check size just increases the valuation, but the percentage is the piece that is fixed in place.

The reason for this is that investors know many of their investments are going to be duds and return nothing at all, some will return nicely, and occasionally they’ll get a massive home run which makes almost of the money in the fund. It is known as a power-law, and Peter Thiel and Marc Andreessen do a great job explaining it. The consequence of this arrangement is that investors want to make sure they have a meaningful piece of each company they invest in (they believe each one will be the home run when they invest, otherwise they’d pass) so the returns are great if they’re right. They’re also conscious of their own time in selecting and then working with/helping a startup they invest in – if they only have 5% of a company, they’ll be a lot less excited to work alongside those founders than they would be for a company they own 25% of.

So, if the percentage is the thing that investors doggedly stick to and the valuation rises and falls with the check size (amount they invest in that round), why is there a death zone? Well, it turns out that check size is in many ways defined by the size of the fund and funds aren’t nearly as flexible as we’d like.

Fund Size and Check Size

The early stage business model for a fund (Seed or VC) is pretty similar – the fund raises money from Limited Partners (LPs) who are looking for a return on their investment – usually they’re wealthy family offices, college endowments, pension funds, etc. When the LP invests in a fund, they’re handing over their money for a period of 10 years (roughly). The fund then invests that money in startups, front-loaded often into the first 3 years, and then “follows on” with the successful businesses to keep their percentage as high as possible through future rounds of investment.

Seed Fund Check Sizes

To use a specific example, let’s look at a Seed Fund which has raised $60MM (to keep the math easy). With a $60MM fund, the investor is basically saying they’re going to invest $20MM a year for the first 3 years (leaving the back 7 for the companies to “exit” and return the cash through an IPO or sale). In reality, though, they’re not spending $20MM each year – when they invest they keep funds in reserve for each investment so they can “follow on” in future rounds and maintain their stake. While the ratio of first money to follow on reserve for each fund varies a bit, from the early stage funds I’ve spoken with the ratio tends to be around 1:2, or one third up front, two thirds for follow on.

This means of the $20MM per year they’re trying to commit for the first three years of the fund, they’re actually writing $7MM in new money checks, and keeping $13MM to follow-on with the future rounds of funding for the successful companies.

Dividing this $7MM through, if they’re doing 8 deals a year (two a quarter is a good rule of thumb), they’re writing an average $875K check, meaning they’re probably tapped out writing checks much past $1MM for their first money in.

VC Fund Check Sizes

Now let’s look at a VC fund like Greylock Partners. They have the same fund lifespan (10 years), but they’re working with $1B (which is up from the $500MM fund they raised in 2005). This comes out to $333MM a year in the first three years of the fund’s life. These bigger funds aren’t putting all of their fire-power in at the early stage, but given the big multiple returns happen there it is probably fair to assume they’re putting half of their fund into early stage investments ($166MM a year), and using the 1:2 ratio between first round and follow on reserve, this means they’re needing to put to work $55.5MM a year in early stage deals. Assuming the fund is doing 8 of these Series A deals a year, they’re having to write a check of $6.93MM for each of those deals for the numbers to fall out. Looking at actual data, the average Series A round was $6.9MM in 2014, so this isn’t a bad general guess (and anecdotally prestigious firms like Greylock don’t fit into the average so the thought of them writing $7MM+ checks as part of above-average Series A deals makes a lot of sense).

You might be thinking, “well, these guys have a lot more money to play with – so why wouldn’t they do a deal where they buy 20% of my awesome startup for $3MM, spending half the money they do on average? That makes us a bargain!” In practice, this doesn’t happen much because the VCs know they have limited bandwidth and they really need to shovel this money from their LPs into startups to make it all work. If they were to invest an average of $3MM in a deal, they’d have to work twice as hard for their management fees – and they didn’t buy that place in Jackson Hole to leave it empty for months at a time.

They could of course write the same big check with your startup at a lower valuation, but then they’d be taking 40% of the company – crowding out the other shareholders, especially the ones who need to work their butts off for the next 5-7 years to get the company to an exit, which is why only predatory investors do this in the early stage.

Now, while it isn’t necessary for a Seed or a VC firm to be a slave to these averages (they might keep less in reserve to follow on because they’re on a tear and know they’ll be able to follow on with the next fund they’re out spruiking now), and there are certainly many exceptions that prove the rule, the size of the fund certainly does define the parameters of the partners when they’re writing checks – Jeff at SoftTech isn’t likely to write a $10MM check to a startup he really likes because that means sinking almost 12% of the current fund in one bet.

Looking at the fund size, check size, incentives and SaaS valuations together exposes the SaaS Fundraising Death Zone.

The Death Zone

When a SaaS startup is very early (little product, no revenue, showing promise), Angels will often invest on a convertible note, essentially an IOU which the company converts into investor shares at a future financing round. Commonly these rounds are in the neighborhood of $500K from 10-20 individual investors on a note often capped at $4MM (which gives an implied valuation of $4MM for the startup and means the angels collectively will have 12.5% of the company when they do a priced round).

Once the company has some traction and proof points, they’ll want to go beyond the prototype engineering team and invest money into acquiring customers. To do this, they’ll often raise a round from a Seed fund with more firepower than Angels can provide. Given Seed funds will want to write around a $1MM check, and because they want to target the 15%-20% ownership stake, the pre-money valuation at the Seed stage will likely be not much more than $6MM – which using the 10x ARR principle means the startup will be doing $50K in MRR if they’re doing well, or a lower amount of recurring revenue is their growth rate is awesome.

The company then puts the funds from their Seed round to work and builds the revenues up to $200K in MRR. Using our 10x rule of thumb, this gives them a pre-money valuation of $24MM, and a check of $6MM will give the investor at the Series-A a 20% stake of the business (post money). They then keep on building, raising money on the way as they need, and then either get acquired, go public, or completely screw it up and die.

The problem is the gap between $50K in MRR (where Seed funds top out) and $200K in MRR (where the VCs start to do their Series-A deals) – and it is a gap I’m calling the Fundraising Death Zone.

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Entrepreneurs who try and raise between these two points are at a significant disadvantage – they’ve basically got four difficult options.

  1. You can accept the rules of the game and raise $1MM from a Seed fund at a lower valuation than they’re worth (the $6MM cap which still gives the Seed fund the % ownership they want). A lower value means more dilution (you can only sell equity once), but the Seed fund really can’t write a bigger check and if you need capital, you might have to take what you can get.
  2. You can convince the Seed fund investor to lower their percentage requirements. This isn’t easy at all and involves great salesmanship by the entrepreneur to convince the Seed fund investor that having a smaller percentage of a massive winner for a check size they can write is better than having 0% and missing out on the winner entirely because of their fixation on maintaining a certain percentage.
  3. You can convince the VC investor to give you a valuation your business don’t deserve (now) and raise a big round, which is the more common scenario if you’ve got something great going for you (reputation, team, media buzz, VCs or their portfolio companies use the product themselves, etc). This can however be a poison pill in the medium term because you need to earn the valuation you’ve been prematurely given, and then earn a future higher valuation to ensure you don’t end up with a down-round.
  4. You can convince the VC to write a smaller check, increasing their relative workload. This also requires a lot of salesmanship and the only way to really make this happen is to make it clear you’re coming back for a bigger check in the near future at terms that will be favorable to them (the balance of a check size they want at a not-crazy valuation).

Now, this doesn’t mean fundraising in the Death Zone is impossible – it just gets a lot harder. Professional investors are spoiled for choice in the early stage with lots of companies crossing their path, and when something doesn’t fit their pattern of valuation, stage and check size, it is a lot easier for them to pass and harder for you to build competition in the deal.

The real problem with the Death Zone is that it seems counter-intuitive – surely a company that is doing $120K in MRR can raise money a lot more easily than a company doing $50K in MRR? It is more than twice as successful revenue-wise, has been de-risked more and it is a lot harder to fake $120K in MRR than it is to get to $50K with some clever but unsustainable growth hacking. Investors must be a lot more into a company doing $120K than one doing $50K!?!? While it doesn’t make sense for entrepreneurs, the needs of early stage investors and the limits on the check sizes they will write means often this isn’t the case at all.

This counter-intuitive nature is the big risk for SaaS entrepreneurs. It makes logical sense to think “hey, we’ll hold off from fundraising now until our numbers are better, we’ll get a better valuation from better investors”. But the reality is, if you blow past $50K in MRR, you’re going to want to make sure you’ve got the internal resources to more than 4x the size of the company or else you’re going to face a shitty or much more difficult path to successful fundraising – especially if you need to raise capital in the Death Zone.

I hope this has been helpful – if you’ve had different experiences or have a different perspective, please share them in the comments below!

UOW Occasional Address – It's what you do with it that counts

Introduction

Today is one of the days you’ll remember for the rest of your life.

It might be because you feel proud – it is the culmination of thousands of hours work and study.

It might be because you feel relieved – no more cramming for exams and assignments at the last minute.

It might be because you feel dominant – after countless hours of swearing and rage you’ve managed to beat the compiler and debugger enough to graduate!

It might be because you feel appreciative – for the amount of support you’ve received from teachers, parents and friends over many years, efforts that you might not have appreciated at the time when you were stressed about an exam or an assignment.

It is probably all of these reasons, and more – this is a special day for you all (and sometimes more so for the parents and friends up the back).

Given this is such a special day, when you get a call from the VC and you’re asked to give the Occasional Address, you naturally want to make it to be good.

You think back to the great addresses given at occasions like this by people like Steve Jobs, Theodore Roosevelt and Nelson Mandela.

You naturally think, “Hey, I should try and impart some wisdom and amazing advice,” and then you realize there’s a little problem.

I’m less than 10 years older than the average age of the graduands here. I don’t have enough grey hair yet to have any wisdom to impart.

It gets worse though. I’m an Informatics drop out. I’m never got to sit in your seat as an Informatics graduate.

What legitimacy do I have to fill you full of advice about what to do now you’ve graduated?

Damn, so we’ve got a bit of a problem.

So, rather than vainly try and fill you with wisdom I don’t have, coming from a drop-out without legitimacy, I thought instead it might be more valuable for you to share a few stories and lessons learned, and then I want to do something a little unorthodox – I want to throw thrown down a challenge to each and every one of you.

That’s right. A challenge.

If you only take away one thing from my talk today, I want you to remember this: it isn’t where you’ve been, what you’d done or what you’ve got: it’s what you do with it that counts.

What I want to do today is challenge you in what you do with what you’ve got. I’ve got three stories to share with you today – one that might help see how to work with what you’ve got, one about the perspective you should have, and one that is about why you should do it, rather than talk about it.

Find something you want to work hard, be passionate and get better at

As I mentioned before, I’m a drop out. It was early 2000, and the whole world was crazy. The internet was changing everything, or so they said. I’d been dabbling as a freelance web developer to make some extra money to spend on beer, back in the days when that meant writing code first, and making things pretty and usable second. The minority of Australian households with internet connections all used modems, and frankly, the quality of web design sucked.

So, in early 2000, I dropped out of uni, quit my job at the Novotel, and moved out of home, all in the course of a couple of months. I registered my company, Internetrix on the 10th of April 2000, and within a week, the Nasdaq crashed.

The dot com bubble burst, and I’d just staked my ability to survive on an industry that was just taken around the back of the shed and shot.

As you can imagine, this situation presented a few challenges. So how was I able to grow from Internetrix from a one-man-band into an award winning company, recognised as a partner by companies like Google, with clients in the US, Japan, China and of course here in Australia?

In short, there were three things – work hard, be passionate and never stand still.

Selling thousands of dollars of IT services to businesses when you’re a 20 year old with no track record is bloody hard. When they’re small businesses, it is harder. When they’re small businesses in Wollongong, it is almost impossible.

If keeping a fledgling business going wasn’t hard enough, the government introduced the GST when I was only 3 months in; I had to learn accounting and tax, and quickly, since I couldn’t afford an accountant.

And being young meant I was easy prey for bad actors – between being ripped off and having people threaten to sue me I had to learn quickly how to survive in the jungle.

It was frigging hard work, but thankfully I didn’t have the temptation of a cushy graduate position as an alternative of making it work.

This could have been because I wasn’t a graduate – I’d dropped out. But it wasn’t.

This could have been because the whole industry had just exploded and no one was hiring IT people, especially drop-outs with very little experience.

But it wasn’t.

I pushed through without the temptation to do anything else because I’d been bitten by the startup bug – the freedom and excitement of creating something out of nothing was just too intoxicating for any mere job to ever be enough after that.

I didn’t start Internetrix to get rich. I started Internetrix because I had a believed that the internet was indeed transformative.

I also believed that your average business they had been doing it wrong – they spent money on a website without knowing why, and how the investment was going to pay off.

From the beginning, had a passion for building a startup that helped clients get a positive return on their online investment – this passion put my business on a good footing, and I was able to develop long term relationships with clients that allowed my business to grow.

But this energy for hard work and passion to throw yourself at something isn’t enough – in our industry, you have to have a hunger to keep learning. Things change so incredibly fast. You need to be constantly reading, experimenting, learning, hacking and tinkering.

It is only by being at the top of your game that you can combine your willingness to work hard, with your passion for the field, and know when you stand in front of a client, a colleague and a new hire that you have what it takes. IT is a meritocracy, without the baggage of other professions, so you’ve always got to be willing and able to bring the best to any occasion. Cramming won’t do it. You need to be continually training, and if you’re working in a field that you don’t care about, that you’re not passionate enough to read about in your spare time, do something else.

So, what’s the lessons here? Since what matters from here is what you do with what you’ve got, make sure you’re prepared to work hard, be passionate and stop improving at what you’re doing. If you’re not, you should do something else.

Play on a World Stage

In mid January 2006 I found myself in the Hard Rock Casino in Las Vegas  as a guest of the owners of MySpace, which at the time being was the world’s 4th most trafficked web property. Later that week I was pitching to the world’s most respected venture capital firms, the people who’d make the initial investments in Google, Yahoo, EA, Facebook and many other household names.

I spent three months living at the home of Mike Arrington, the founder and editor of Techcrunch.

This all happened because I co-founded a company, Omnidrive, with a fellow uni dropout, Nik Cubrilovic in mid 2005. If you’ve used Dropbox, you’ve got a good idea of what we were building – cloud based storage with clever sync technology between multiple devices. And while our business failed (and Dropbox just raised a round of capital on a $1B valuation), the crazy roller-coaster experience was one of the most valuable things I’ve ever done.

Thrust into the limelight of Silicon Valley and playing the startup game at the time Facebook was just getting going was an amazing experience, not for what I learned about business, fundraising or the industry, but because of what I learned about myself.

Driving down Highway 101 through the heart of Silicon Valley, you see the headquarters of companies like Oracle, Yahoo and Google. Seeing these buildings, and realizing they were real places, with real people working there, people just like you and I, was paradigm shifting.

When it comes to technology, Silicon Valley is unquestionably the top level the world stage. It is where the best in the world compete and define technology worldwide. One night I was lucky enough to have dinner with Marc Andreessen, the founder of Netscape, because a friend of a friend made an introduction and he was free and keen to find out about what we were doing. It is just that kind of place.

While initially feeling very inadequate and out of my depth, it didn’t take too many meetings with VCs, too many conversations with entrepreneurs at dinners and beers with senior engineers from places like Yahoo and Google at parties to start to realize that I had what it took to go toe to toe at this top tier game.

And it wasn’t anything special about me. I was an average student. To this day, my staff would ban me from all hacking and meddling if they could. And yet, as time went by, I got the sense I wasn’t out of my depth.

I thought about the dozens, if not hundreds of tech people I’d work closely with in Australia over the years, and realized that they could also hold themselves in this, the beating heart of technology globally, and could honestly regard themselves as being world class. The distance between Wollongong and San Francisco might be great, but the difference in calibre of technologist wasn’t nearly as great as I’d imagined.

The University of Wollongong has one of the best IT programs in Australia, and so what I’m saying is that you have what it takes to go toe to toe with the best in the world too.

Two UOW alumni who aren’t that far ahead of you – and one of whom was sitting unemployed on North Wollongong beach in January – have built a startup in the last 6  months. After going to Silicon Valley a couple of months ago, they are now in acquisition discussions with some of the biggest names in technology fighting over them.

These guys are just like you, and if they can do it, so can you. Why shouldn’t you be the next Steve Jobs, Bill Gates or Mark Zuckerberg? Seriously.

So, what’s the lesson here? When it comes to thinking about what you’re doing to do with what you’ve got, make sure you’re mindset is to be world class and play on the world stage.

Be the man in the arena

This last story is not my own, so it is probably the most important of three stories I’m going to tell today.

Theodore Roosevelt was the 26th President of the United States, and when he became President in 1901 at age 42, he was the youngest man ever to do so. Widely regarded as one of the best Presidents in US history, Teddy was invited to give a speech at an occasion like this at Sorbone University in Paris, one of the world’s oldest Universities, established in the 12th Century.

In his speech, he reflected on the temptation among the learned and privileged scholars and academics before him to become commentators, critics and cynics. He cautioned against this, and delivered some of the most stirring words I’ve ever read:

It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.

There is little use for the being whose tepid soul knows nothing of great and generous emotion, of the high pride, the stern belief, the lofty enthusiasm, of the men who quell the storm and ride the thunder. Well for these men if they succeed; well also, though not so well, if they fail, given only that they have nobly ventured, and have put forth all their heart and strength.

When it comes to rising to the challenge of what we’re all going to do with our education, our skills, our lives, I believe this message is the most important. As President Roosevelt says elsewhere in this same speech, “To you and your kind much has been given, and from you much should be expected”.

As Informatics graduates, you have more power, more opportunity to change the world, than any other group in the history of mankind. I mean that. Think through history, and think about the forces that are going to drive, enable and facilitate the future of our world more than any others. Technology is common to all of them, for good or for evil.

Just take a moment and reflect – today, there are now more than a billion people online, and if you throw in mobile phones there are billions more.

We’ve seen how technology has changed the world in Egypt, Tunisia and other parts of the middle east in the last few months.

Closer to home, the opportunities to change healthcare, education, how we live, how we work, and more are vast. We’re only three or four decades into the information revolution – even if we accept the pace of change now is much faster, compared to previous revolutions – industrial, bronze, etc – we’re surely now in little more than the first early rays of a new dawn.

I believe we all have the power, the opportunity and the responsibility. But, to make a change, to make a difference, you have to be in the arena.

So, how can you get into the arena?

Of course, I have a natural bias towards seeing the arena as being a part of a startup. You put it all on the line, and even if you fail you still learn so much more than you would working for a bank or the government in a graduate role. There has never been a better time to do a technology startup – thanks to cloud services the costs of getting going are lower than they’ve ever been, and with a mature web audience of over a billion people, and app stores and the like making distribution and payments easier than ever before, I’d encourage all of you to keep the idea of doing a startup in the back of your mind.

But, being the man in the arena doesn’t just mean doing a startup. It can mean passionately advocating for change and improvement in a workplace. Or using your technology skills to help a cause you’re passionate about. Whatever you choose, the key is to both avoid the temptation to just throw rocks or criticism and cynicism from the stands, and show the courage to get down into the arena.

So, when answering the challenge of what are you going to do with what you’ve got, make sure whatever your doing, you’re doing it in the arena, for that’s the only place that matters.

Conclusion

From here, you’ll follow many different paths, across careers, across the world.

You should take this time to reflect and look back with pride on what you’ve achieved – enjoy this moment and the sense of achievement that rightly comes with it.

But also realize that from here, it isn’t what you’ve done to get here that matters – it is what you do with it that counts.

When it comes to choosing your challenge, work hard, be passionate and always keep getting better.

When it comes to framing your challenge, be world class and don’t be afraid to play on a world stage.

When it comes to how you tackle your challenge, remember to always be in the arena, fighting to succeed but not afraid to fail.

Good luck and I wish you all the best in rising to the challenge of doing something amazing with what you’ve got.

Wollongong is on a burning platform

Over the last couple of years, I’ve been getting increasingly concerned about the future of our city. Leaving aside the rot exposed through the ICAC investigation, I’ve been mostly worried the future of the city from an economic perspective.

Are we going to be a place where our young people can build careers & families with confidence and a sense of optimistic opportunity?

Or are we going to increasingly be a hollowed out city, with a population that in large part commutes to Sydney for work, or lives off Centrelink, or comes here to to retire?

Are we going to be proud and strong, or are we going to be like Tasmania – a small backwater that everyone looks down upon and only survives because they suck in taxes paid by the rest of Australia living in large part off handouts?

My worries about the future of our city have grown even more acute over the last few months.

Our city has operated with a bit of a handicap in all 31 years I’ve lived here – the downsizing at the steelworks and in the broader manufacturing sector has been playing out since the 1970’s. But while we’ve stoically pushed forward over the years, I’m concerned that rather than just the disappointment of unfulfilled potential that we’ve learned to live with, we’re actually facing some very serious challenges that could threaten the viability of our city.

Our Two Fires – Carbon Pricing & Dutch Disease

In the short to medium term, there are two external forces, more than any others, that are affecting Australia’s entire economy.

The first is the transition to a carbon constrained economy, and while there might be debate around the details and timing of a carbon price, I think most people accept that reducing global dependence on carbon (ie, coal) as an energy source is inevitable.

The second, and much more important and threatening issue in my view, is Dutch Disease, the situation where a high currency value because of exports in one part of the economy – in our case, the mining/resources boom centred around WA – makes it almost impossible for exporters in other parts of the economy to compete.

While Carbon Pricing and Dutch Disease are having a negative economic impact in lots of communities around Australia, there are few, if any, that are threatened as much as our city and region.

In a message to all his staff earlier this year, new Nokia CEO Stephen Elop told a story that I think has strong parallels to the situation our city is currently facing:

There is a pertinent story about a man who was working on an oil platform in the North Sea. He woke up one night from a loud explosion, which suddenly set his entire oil platform on fire. In mere moments, he was surrounded by flames. Through the smoke and heat, he barely made his way out of the chaos to the platform’s edge. When he looked down over the edge, all he could see were the dark, cold, foreboding Atlantic waters.

As the fire approached him, the man had mere seconds to react. He could stand on the platform, and inevitably be consumed by the burning flames. Or, he could plunge 30 meters in to the freezing waters. The man was standing upon a “burning platform,” and he needed to make a choice.

He decided to jump. It was unexpected. In ordinary circumstances, the man would never consider plunging into icy waters. But these were not ordinary times – his platform was on fire. The man survived the fall and the waters. After he was rescued, he noted that a “burning platform” caused a radical change in his behaviour.

We too, are standing on a “burning platform,” and we must decide how we are going to change our behaviour.

I believe our city too is standing on a burning platform.

Examples of our industrial decline

Lets have a look at an example, in the form of Bluescope, the region’s largest employer and also responsible for tens of thousands of related and multiplied jobs.

Bluescipe recorded revenue of $4.75B in their Coated & Industrial Products Division (which is pretty much all of Port Kembla), down over 20% from over $6B in sales two years earlier (2008). And this is just sales – during this period, raw material costs went up, and the Australian dollar increased in value by more than 70% since late 2008. This exchange rate movement – the Dutch Disease in action – has made every person on payroll, every megawatt of electricity and other AUD expenses 72% higher now than their international competitors, assuming no increases in wages, power costs and the like.

Little wonder then that Bluescope experienced a drop in profit of 85% between 2008 and 2010 (and in the GFC and the 2nd half of 2009 they actually made sizable losses). While today’s announcement of an additional $300M in industry assistance for the steel sector (read Bluescope and OneSteel) will make some people in the city feel comfortable (and it isn’t tied to the carbon tax legislation, so the Greens would have to support it – good luck with that), $300M isn’t a lot of money compared to the $1.25B per year in revenue that Port Kembla is down compared to 2008. Even a government, with all the resources of treasury, can’t compete with global market fundamentals – just ask George Soros, the man who broke the Bank of England in September 1992.

BSL.AX - no wonder the share price is down 90%

 

There have been lots of other examples where trade exposed employers in our region have become extinct. We’ll all remember the closing of the Bonds factories in the area last year, the latest in a long line of shutdowns and mass layoffs which in previous years have included brands like Midford, and even more recently, locally owned Poppets. Unfortunately, the ledger is stacked with much more bad news than good on this score.

When it comes to our traditional economic base, our city has been lurching from one crisis to the next, while the rest of the world passes us by. It doesn’t have to be this way.

Recognition, leadership & vision

Facing up to these challenges requires an honest debate, strong leaders and the willingness for our community to come together, face facts, make some tough decisions and put in place a plan to change our economic base.

So, is there a frank debate about these issues at the moment? Are our leaders – both incumbents as well as aspirants – speaking out, being honest, and putting forward a plan? Let’s have a closer look.

Local Government

Our city is going to the polls in just 7 weeks time. I’ve been following the news as more people throw their hat into the ring, and I’ve been really hoping to hear someone out there talk about the elephant in the room.

But, alas, all I’m seeing is an empty and meaningless debate about which group of candidates is going to have better consultation and more inclusive government than the next.

What of debating the big issues, like the future of our city?

On the whole, the candidates have been silent about this, and those that are making noises about anything of substance are currently running on platforms made of platitudes that few would argue with, but which on their own are utterly meaningless.

Sure, you could argue local government is roads, rates and rubbish. I disagree – a strong Mayor and City Hall can act as a very effective leadership and lobbying force with the levels of government that actually have power, not chains – but that raises the question – where are our State and Federal representatives on this?

State & Federal Government

I’m heartened that the State and Federal members I’ve talked to about our burning platform situation are very aware of the issues. My sense from talking to them is that they see the same bleak future if we keep doing what we’re doing. The problem is, changing the nature of an economy isn’t easy, cheap or quick.

Unfortunately, they’re not out in front on the debate, and while I’m disappointed, I can also understand why.

If I was Sharon Bird, Stephen Jones or Ryan Park, I wouldn’t want to come out and scare the horses unless I had a plan to turn fear into hope. To bring up this issue without knowing you can get the support of your caucus and the treasury to make the investments to do something about it would be what Sir Humphrey would call “courageous”.

Sharon, Stephen and Ryan are worldly and smart; while some of the crazier voices in our public life might suggest fixing the exchange rate, putting up tariffs and other failed policies to provide the perception of short-term relief, our members know that going back to the “good old days” isn’t possible without a flux capacitor and a Delorian.

When it comes to bold initiatives and investing in action to transition our regional economy, our members are also hamstrung, even if they have a plan. Our safe seat status at state and federal levels of government means that our members will always struggle to get attention from the party and concessions from Treasury, and the safe seat status owes a lot of the current economic makeup of the city, which doesn’t help create the motivation for change either.

Starting a debate

Our city has been making a gradual transition over the last few decades, but the size and speed of the threats – the intensity of the fire burning under our platform – is stronger than ever before. The Finance and Insurance sector – thanks to the likes of the IMB, Community Alliance Credit Union (formerly Illawarra Credit Union), Oasis Asset Management (now known as a division of ANZ and known as OnePath) – is now the largest employer in the region, and Greg Binskin and the team at Tourism Wollongong have consistently gotten in front and espoused a vision for a strong tourism sector in the region which they’re making a reality with dogged determination.

But, to be honest, what we’ve really got here is a number of disparate actors working to improve the fortunes of the city through their own actions – what we don’t have is any real leadership, debate of vision for the future of the city, which our community can participate in and get behind.

This is a real shame, and while we continue to be mute and complacent, we ensure that by doing what we’ve always been doing, we’re going to keep getting what we’ve always been getting.

Learning from others – a tale of three cities

We’re not the first community in the world to face serious challenges like this – I’ve researched three examples which we can look at as proxies for our situation, so we can learn from their mistakes and successes. There’s a lot we can take away from the way others have faced and overcome the same adversity and threats we’re facing now. Here’s a little information about these three cities below.

  • Sheffield in England suffered for decades as the pain of the loss of their manufacturing and industrial economy in the 1970’s led to widespread unemployment and a contraction in their city and population, and have only just started turning things around.
  • Detroit, a cautionary tale, is still suffering and shows no real sign of improvement on the horizon.
  • Waterloo in Canada, saw the writing on the wall and transitioned their industry very very successfully before they declined, creating a really smooth transition and a great success story.

Sheffield – an industrial twin

The first proxy city to our own is Sheffield. The home of British Steelmaking, Sheffield saw a 10 fold increase in its population in the 1800’s through the industrial revolution, however when international competition on its inefficient sector took its toll from the 1970’s, Sheffield saw its population decline markedly (down over 7% in the 10 years to 1981, and negative each other post-war decade until the last few years).  Anyone who’s seen The Full Monty, set in Sheffield (1997), will have a feel for the bad times that city has seen.

Sheffield has since invested in developing its higher value business services sector, and while accepting the lower job contribution made by the manufacturing sector compared to days gone by, a focus on technology and real innovation has helped to bring prosperity back to manufacturing in this natural cross-roads in the middle of Britain.

None of it would have been possible without a strong, coordinated plan and commitment of various stakeholders – for more information, have a look at this excellent case study on how Sheffield is becoming a knowledge region. For specifics on how their regional governments are working together with detailed plans, check out the “Moving Forward: the Northern Way” website and plans.

Detroit – a cautionary tale

Detroit. Motown. The City of Detroit, which used to be the 5th largest city in the United States, has now shrunk to be 18th, with a population of around three quarters of a million. Only New Orleans has gone backwards further, and Detroit can’t blame a hurricane for its woes – Detroit’s failings are all man made.

The home of the American automotive industry, Detroit has been in decline since the 1980’s. As the Economist details:

Employment has fallen every year since 2000. Even as the carmakers recover, they will not resume their role as guarantors of middle-class prosperity. State leaders have struggled to respond to structural shifts. Unfortunately, rather than reform a collapsing revenue system, they have passed short-term fixes. Attempts to reinvent Michigan have moved fitfully. Grants for college students did little to encourage them to stay after graduation. Tax credits for green manufacturing industries may create too few jobs at too great a cost, according to Don Grimes, an economist at the University of Michigan.

Detroit is what happens when a city faces a series of structural challenges and threats that are as certain as gravity, and then put their head in the sand. The city levies an additional 2.5% income tax on its citizens – this was probably a good idea when the city was prosperous, but now it is a massive disincentive for anyone to live there, especially given its high levels of crime and general decay. Some statistics show their unemployment rates falling, but the reality is, people are leaving the city and its surrounding counties by the hundreds of thousands. Perhaps there is a future for a smaller Detroit, but $50B in Federal bailouts for the 3 big US auto-makers in the GFC seems like it might not have been the best investment that could have been made.

Another American city that I have done a bit of research on is Pittsburgh, the former home of the American steel industry. Pittsburgh has seen a dramatic downturn in its own steel industry, and while their ability to cultivate a high tech and startup sector looks really promising, it is still in many ways early days – the City is still losing around 10% of its population each decade, and has been since the 1960’s. Hopefully, Pittsburgh can achieve the same sort of success as Waterloo, below.

Waterloo – our Canadian doppelgänger

The town of Waterloo, Ontario, has got to be the closest thing Wollongong has to an international twin.

  • Waterloo is around 100KM from the largest city in Canada, Toronto, their equivalent of Sydney. Wollongong is 83KM from Sydney.
  • The population of the City of Waterloo is around 100,000 people and the population of the region Waterloo is centred in is around 492,000 people. Wollongong, Shellharbour and Kiama LGAs combined have around 300,000 people, with another 150,000 if you include Wollondilly and the Shoalhaven LGA’s, giving an Illawarra total of 450,000.
  • Waterloo has a strong and internationally renowned university, the University of Waterloo, which is actively engaged in their city. In addition to being a significant employer in the city, the University of Wollongong is increasingly taking a leadership role in helping to shape the future of our city (such as through the Innovation Campus).
  • Waterloo has historically been an industrial town, with strength in tanning and rubber. In the 1980’s the industry suffered a downturn, related to headwinds in their main downstream market, Detroit, and thousands of jobs were lost. From the 1970’s, the Illawarra region has suffered similar frequent retrenchments and large rounds of layoffs in from industrial sectors.

What sets our two cities apart, however, is what Waterloo did the face of its own structural change. Instead of grinning and bearing its fate, a number of civic leaders got together and decided to try and build a new, emerging industry to take up the slack.

The outcome of this effort, which recognised the opportunities an innovative and engaged University could provide when combined with relatively close proximity to the financial capital of the country, has been nothing short of amazing. The City started focusing on technology, and they managed to grow their industry from a total revenue of C$300M in 1997 to over C$19B (yes, B as in billion!) in 2007. The best known product of Waterloo’s success is undoubtedly Research In Motion, the company behind the successful Blackberry mobile phone.

After spending a week with Tim Ellis, Chief Operating Officer of the Accelerator Centre in Waterloo earlier this year, I’ve gotten a much deeper appreciation of what they’ve been able to do, and I’m firmly of the opinion that we can do something similar here in the Illawarra. The University of Wollongong has signed an MoU with the University of Waterloo – I expect many more beneficial things to come out of these two institutions cooperating.

One part of a vision for our future – creative, high tech & very liveable

I believe our city needs to take strong action to deliberately re-shape our economy if we want to be more than God’s waiting room, a bogan backwater and a place for exhausted commuters to sleep each day.

However, the isn’t a single silver bullet, and there isn’t one industry or sector alone that is going to change everything for us and make for a better, sustainable future.

I do believe, however, that the creative sector, particularly backed by technology, can play a very important part in helping to change the fabric of our city and its economy for the better.

In my recent post on the 5 Pillars of Tech, I reflected on the nature of the IT industry in our city, and put forward a case where a Startup led technology sector could have a massive and positive difference in the future of our city:

A technology Startup is product focused. They’re often developing software, and although hardware is still possibly, it is at least an order of magnitude harder to do, and it requires a lot more capital than you can usually find in Australia. Being software product focused makes you very capital efficient – no need for plant, equipment; just people and ideas and the odd laptop or two.

A technology Startup is globally oriented – they might not be selling internationally, and their first 4 clients might be companies who share the same building as them, but generally speaking, a startup is trying to solve a niche problem in a new way for a global market.

By being product focused, often software-based with a zero marginal cost of production, a technology Startup is also highly scalable. With more than a billion people online now, and the growth in smartphones and their associate app marketplaces, distribution has never been easier or less tied to your geographic location. In this sense, being a city of a quarter of a million, in country with only 22 million (which makes us a flea on the back of a Chihuahua riding on an Frigate – I’ve done the maths, and these are honestly the right ratios) doesn’t have to be a critical disadvantage.

As a foundation investor and mentor in StartMate, and the founder of two technology companies that now employ 16 staff, I’ve seen first hand how powerful and catalytic the Startup sector can be for the wider economy. Also from my 5 Pillars post:

When it comes to the role that Startups can play in contributing to the economy of the region, the best thing about them is that they’re easy to start, they harness the things we have – smart people, lowish costs of living – and their development and cultivation is within our control.

They’re also great job creators – 20 companies with 10 staff creates the same opportunities of one large company imported into the region – and even if these startups fail, the experiences, lessons and skills developed by getting out there and doing it are incredibly valuable, whether the founders choose to do another startup, or join the ranks of the other technology sectors.

I’ve recently come back from spending a month in San Francisco, which for those who don’t know is the “captial” of Silicon Valley. Part of the time I spent there involved talking to investors, and many of them were asking about where we’re based, and whether we’d move the team to Silicon Valley if they invested in us. I told them, no, are you crazy? Why would I do that? They asked for details about what made Wollongong a great place to grow a startup, so I told them the following things:

  • Talent – the University of Wollongong produces 1 in 7 technology graduates in Australia. In Silicon Valley right now you can’t hire an engineer for love nor money – I’ve never seen a war for talent like it. Just telling prospective investors the graduate statistic was enough to get them asking how they might be able to look at helping the companies they’ve already invested in – who can’t hire good technology engineers – to come to Wollongong.
  • Stability – Wollongong is an absolutely beautiful place to live. Knowledge workers can base themselves anywhere now the world is flat – having a team based in Wollongong is great for the team, and great for the business too. I heard from large multi-national employer in the region that they experience staff turnover of 5%, whereas their Sydney office, which in every other way is identical, faces 50% turnover a year. Even without factoring in soft-costs like the cost to the business of losing all that knowledge each year, the hard recruiting and training costs for this kind of turnover they’re seeing in their Sydney office are crippling, and makes Wollongong a much better place to be.
  • Diversity – if the world is flat, it is also now increasingly online. There are billions of internet users, and we’re not far from having more mobile phones than people on the planet. What isn’t changing any time soon though are the needs to speak the language and be connected and comfortable with the culture of your markets, which are increasingly Asian based. Our time zone, our strong cultural diversity and the language skills that that brings us are not insignificant, and I think they’re almost always underrated. My team today includes three people from China, one Canadian, an American, a Kiwi by birth, and doesn’t include the English, Vietnamese, Irish and other cultural heritage we all bring to the table.
  • Proximity – we’re an hour from the commercial capital and largest city in Australia. We’re even closer to our main international airport, and then an easy flight to almost anywhere in the world. We’re on the a growth time zone – Asia – for the first time in our country’s history. But we’re still small enough so that more than half of my staff walk to work each day. Less time commuting to work, markets, investors and clients means more time to spend either building a world-class company, or enjoying life with our family and friends.

For these and a litany of other reasons, I think Wollongong stands a great chance of becoming a technology and startup powerhouse, in much the same way that Waterlook in Canada has become a powerhouse on a global stage and reinvented their economy at the same time.

So, how do we make it happen?

Next Steps

The most important next step for all of us is to start to raise the alarm. Unless our city wakes from its slumber to realise the platform it is dozing on is on fire, we’re going to end up like Detroit – so hollowed out, broken and depressed that things will get better only because they really can’t get any worse. If we waken the community now, and start an honest debate about our future, we might be able to pull off a Waterloo; even if we fail, we won’t be any further behind than we are now.

To facilitate this, I’d love to see something similar to Melbourne’s Wheeler Centre here in Wollongong. Imagine something led by the Mercury, which makes use of our newly refurbished Town Hall, to facilitate the debate.

Let’s give our elected representatives some ammunition to take to Canberra and Macquaire St.

Let’s learn from the successes of others. Action, cooperation and agility is much more important than a big overarching plan.

Let’s encourage the University to keep building its relationship with Waterloo so we can benefit from their experience.

Let’s look at ways to supercharge our new and emerging industries. Tourism, financial services, technology, education. We need to focus on the industries that grow the economic base and bring jobs, income and prosperity into the region. Health and Community services, which have grown a lot of the years deserve our appreciation, but they don’t grow the economic base – they exist only if the economic base can be taxed enough to pay for them. When it comes to technology, the closing comments in my 5 Pillars of Tech article provide a bit of a blueprint; I’m sure Greg Binskin can probably provide his own specific advice for the tourism industry.

Whatever we do though, we need to remember, if we want to keep getting what we’ve been getting, we should keep doing what we’ve been doing. We need to do more. We need to do better.

We’ve got so much potential – to rob our children of the opportunity they deserve to have, and consign ourselves to the fate of a slowly decaying industrial town mired in depression, disadvantage and disappointment for merely a lack of action is just not good enough.

Going to America – online business from down under

<Update> Dec 2012:

So, it looks like Christmas has come early. As mentioned in my April update below, the SSN barrier has been impossible to overcome. Until now. Thankfully, the legends at Stripe (Disclosure – AffinityLive pays them a lot of money, they don’t know we exist) have changed things – as long as you have a US bank account, you can enter 0000 as your last 4 digits of your SSN and get an operating account! I strongly recommend my friends at Silicon Valley Bank to set up your account with them – NOTE that you don’t need to have an LLC or a C-Corp to open an account with SVB.

</Update>

<Update> April 2012:

It is impossible to get a merchant account and accept payments in US Dollars without a Social Security Number (SSN). I’m not 100% sure if this is because of issues around the Patriot Act (no sending money to Iran or Korea, or remaining axes of evil), general money laundering, or because the back-end providers (I’m told there’s really only a couple of them who handle everything in the US) require it and every bank and gateway as to play by their rules.

I know this sounds silly, since a company doesn’t have a social security number (only people with the right to work in the US can get one), but it is just the way it is.

At this point, you’ve basically got four choices:

  1. Use PayPal (where the customer leaves your site) and accept their credit card in US dollars. You’ll get a horrible exchange rate and a pretty poor user experience.
  2. Go with a “reseller” and pay a high commission fee. I looked into FastSpring at the time.
  3. Find someone who trusts you and use their SSN to open an account with someone like Stripe, or
  4. Move to the US on an E-3 Visa and get a Social Security Number yourself.
Sorry I don’t have better news.
</Update>

Running an Australian business with Australian customers is great – you can get trading with an ABN in minutes, and while the GST caused us all a lot of grief a decade ago, it now enforces a fairly simple discipline that keeps your business in check. Hell, if they’d just get rid of payroll tax that creates an incentive to move jobs offshore, and insist that corrupt union reps have a ‘fiduciary’ duty to look after their best interests of their members rather than their own political careers, we’d be set.

Unfortunately, though, running an Australian business in a global market sucks. A lot.

This post tries to outline an approach to setting up your Australian internet business so that you can trade on close to a global market scale, competitively. And that means being able to price your product in US Dollars, and get paid in US Dollars, without getting completely screwed by transaction, currency exchange and lots of other fees.

This post is a work in progress, and will be updated as better advice and the pain of real world experience corrects assumptions/guesses. If you’ve got something to ask or contribute, please do so in the comments.

Getting Paid in USD

When it comes to the global marketplace – particularly online – the only game in town is US Dollars. A big chunk of the market is in the United States, people who aren’t are largely aware of how to convert from USD into their own currency, and most importantly of all, when prospective customers are comparing offerings and prices, they’ll be benchmarking your offering against your competitors, who’ll be pricing in USD.

If prospective have to think and convert your currency of choice into USD for comparisons and then their own currency for the cost to them, they’re probably going to have to reject you.

So, you need to get paid in USD if you’re selling online to a global market.

There are roughly four ways I’ve found to get paid online in USD as an Australian.

  1. Use a US Gateway and set up a US entity
    This method means getting a business, a bank account and a tax identification number set up in the US. It involves cost, paperwork and dealing with the IRS. However, it also means you can access very competitive pricing from gateways – the people who link your website to the credit card payment networks and thus get money into your account. A couple I’ve found – Cocard and Authorize.net in combination – are going to cost me US$18/month and their fee is only 0.15% above the credit card company interchange rate. Pretty compelling, but now your business has two bank accounts, two legal entities and two currencies to do accounting for, not to mention the risk of double taxation and other inter-government scams.
  2. Use a European Gateway and set up an EU entity
    The next option I’ve come across still involves creating an entity, but in this case it is more of a piece of paper entity. No bank account, no legal structure, no double accounting. As far as I can tell, you pay a small fee to someone like simpleformations.com, and then you find a company who’ll give you a merchant account such as www.nochex.com who can take credit cards, and they’ll deposit the funds as a wire transfer into your Australian account.
    Unfortunately, all the options I have prices for at the moment have a minimum monthly transaction of A$3000 or so.
  3. Use an Australian Gateway who supports multiple currencies
    As far as I’m aware, the only option open to Australian businesses who want a merchant account that supports multiple currencies is the National Australia Bank. I’ve made an enquiry to find out what the current state of affairs is on this, everyone I’ve talked to who’s tried this has had a terrible experience. A search for “nab merchant account rant” on Google turns up gems like this and this. I’ll update this post if this option surprises me and becomes even remotely competitive, but I’m not holding out much hope.
  4. Use a US ‘Reseller’ style company to collect credit card payments on your behalf
    This option is lowest setup effort, but it also provides less control, is least professional for users and costs the most in transaction fees. Companies like Plimus or Fastspring are effectively becoming our retail or reseller front end, reselling our product, and so all client interactions and payments go through these companies. They also charge up to 10% for their effort (and risk taking) getting between you and your customer, which while compared to traditional retailing and channel’s isn’t crazy, but they’re not actually finding you customers and handling client support the way a regular retailer or reseller would; 10% for payment processing is very high. If you’re only doing small amounts of revenue, this might work, but if you’re trying to build a business that is more than a hobby, this is a stretch.

Having reviewed a bunch of the crappy options, the direction I’m leaning towards is setting up a US entity, opening a bank account, and getting a tax identification number.

Having a US entity, bank account and tax identification number

The idea of this post is to save future Aussie entrepreneurs some of the hassle/drama/uncertainty associated with doing business globally. If you’ve got any knowledge of any of this stuff and could affirm or correct any of these assessments, I’d really love to hear from you in the comments or by emailing geoff.mcqueen – at – hiivesystems DOT com!

The following is what I’ve worked out through a bunch of research, a couple of hours on the phone talking to staff in the IRS, and reading ATO Tax Rulings.

While I recognise that spending hours on this while we’re trying to get AffinityLive ready for launch is a bit stupid – this is what you pay accounts for, right? – I’ve found in business that understanding the fundamentals of these sorts of things yourself is priceless – after all, as a Director, it is me, not an adviser, who’s on the hook. Additionally, whether it is in IP law or other areas, understanding the basics means I’m in a better position to assess whether one adviser or another is more expert, and thus make the best decision about who to go with.

US Entity

Business registration in the US is handled on a state by state basis. One of the most appealing states for registering your business is Delaware – their fees are low, they have no sales tax (whereas in California it is close to 20% and the state is still almost bankrupt), they don’t take to kindly to people suing company officers and they are “friendly” like the Swiss when it comes to confidentiality. Handy.

There are a bunch of different entity types you can register in Delaware. The most common types as far as I can tell are a C-Corp and an LLC.

C-Corp

A C-Corp is like an Australian Limited company. Note that it isn’t equivalent to a Proprietary Limited (Pty Ltd) company, as a C-Corp has to have officers, needs to file returns to the state, and a bunch of other stuff. Nothing too scary, but more formal than you’d be used to if you’re running your own Pty Ltd company.

The company can file its own tax returns with the IRS (Federal, not state).

A C-Corp can keep hold of its own money from a tax perspective, paying dividends only when it wants to. It also doesn’t have limits on the number of shareholders like some of the other structures, so it is a good type to use if you’re looking to raise a round of capital by selling equity to investors. This entity is pretty much what you’re used to with running an Australian company, but having a C-Corp makes the repatriation of funds to Australia a bit more interesting, and makes transfer pricing a potential issue, as the C-Corp is a full company, and your Australian parent operation may well be a shareholder – or the only shareholder – but the IRS will treat the C-Corp as its own entity.

A Limited Liability Company (LLC)

An LLC is a particularly curious beast. It is like a company in that the business shields the owners and officers from personal liability should the business fail and have debts. It can have a bank account and trade just like a regular business. However, it can’t submit its own tax return like a company and pay tax – instead, the profit that the business makes flows through to its “members” (like shareholders), and they pay tax on it just like it was any other form of income.

In this sense, an LLC is much like an Australian Trust structure. And the way the Australian Taxation Office treats these LLCs – also known as “hybrid vehicles” because they tend to be more like a partnership where the “members” or shareholders can be natural persons and companies – is pretty good from what I’ve read so far. More on that later.

Registration

Regardless of the structure you follow, registering the company in Delaware is fairly inexpensive; there are a ton of agents out there who’s job it is to do just this sort of thing.

Just one example is IncNow.com, and the cost of registering an LLC and being up and running within a week is under US$300.

Annual fees are in the range of US$120 – also fairly reasonable at $10/month.

You also get the forms you need to submit an application for an Tax Identification Number (TIN), which your merchant account people will need you to have  to set up your account with them.

Franchise & State Taxes

In Delaware, they make their money by charging a small “Franchise tax”. From my reading, this would be around $90/annum. Bugger all really.

IRS and Federal Taxes

While business setup in the US is a matter for the state jurisdictions, it is the Federal Government you really need to worry about. Like in Australia with the ATO, the IRS are very bureaucratic and hungry for your money.

Every year, they require all taxpayers in the US to pay income tax and file a tax return – this includes not just individuals, but also companies, members of LLCs, etc.

If you’ve got an entity and a bank account, odds are that means you too. I’ll outline a bit more of what I understand the alternatives and situation to be in the Tax Returns section below.

Australian Taxes, Dividends and Double Taxation

Of course, if you’re running your company/business from Australia, you’ll have your regular dealings with the ATO to worry about too. This in and of itself isn’t a problem, but bringing together multiple tax jurisdictions around your taxable profits is asking for trouble – if someone’s going to get f*cked, it is going to be you.

Tax returns and not getting double-screwed

While there are undoubtedly a bunch of issues to address with running an international business and dealing with governments, the one that I’m trying to get to the bottom of with this post is tax.

Basically, I don’t want to be paying tax on the same income twice, and where possible, I want to be paying the lowest rate of tax I can on hard-earned profits.

Situation

Everything from here on in is assuming we’re running the US operation through a Delaware LLC, with a bank account in the US, and credit card based income coming into this US bank account.

There will be a few thousand dollars a month – initially – of expenses in US Dollars, mostly things like hosting fees with our US hosting provider, and a few odds and ends like local US phone numbers and such. All other expenses – our rent, our staff costs for product development and client support – will all be in Australia and paid in Australian dollars.

All income for our AffinityLive.com product sold to clients outside Australia will come through this LLC, with clients paying recurring monthly, quarterly or annual subscriptions in the hundreds of dollars via credit cards per client.

As a result, it is expected that the US entity will be quite profitable compared to the Aussie HQ given its lower fixed costs.

Complying with the IRS

As far as I can tell, running an LLC means that you’ve got two choices – the LLC can submit its own tax return acting as a corporation – a 1120 form – or its “members” can submit tax returns for their own share of the income that is distributed from the LLC.

To simplify things, we’re currently planning on completing our US tax return using a an 1120-F form, which is what a foreign company completes to declare income earned through their business activities in the US.

The IRS agent I spoke to today told me that we’re effectively declaring the income as Australian company income, earned through US business activities, and the LLC in this case is a financially transparent entity that doesn’t complete its own tax return.

If you submit a corporate tax return as the LLC, you’ll be taxed on your profits the normal way; I think it is around 33% or so. Then, you can repatriate your after-tax income to Australia, and the IRS is pretty much done with you.

The standard tax year in the US is a calendar year; again, to simplify things, we’re going to complete an 1128 form to move our tax year to be July to June and thus in-sync with our Australian financial year.

Witholdings

In some situations – and I don’t quite understand thesem but they seem mostly related to property transactions? – the IRS will also withhold a percentage of your dividend on top of the tax they’ve already collected.

One of the reasons to go with an LLC over a C-Corp and to use the 1120-F form, completed as the Australian parent, is to avoid dealing with dividends and transfer pricing issues at all, so hopefully withholding won’t be an issue for us.

Foreign Tax Credit

Australia has a tax treaty with the United States, which means income earned in the US is taxed by the US, and once it is repatriated to Australia, you get a credit from the ATO for the tax you’ve paid.

In a way it isn’t quite this easy, as the ATO will actually “gross up” your dividend to put the amount the IRS took away from you back on, at which point the ATO will calculate the amount of tax payable as if it was all Australian money, and then it will credit you for the amount you paid to the IRS on the US income, and you’ll then owe the ATO whatever extra tax they say you owe them. I think this is there so that ATO gets to charge you Australia’s tax rate and get more money out of you for income earned in places with lower company tax. What I don’t know is whether the reverse applies, and the ATO will allow us to “deduct” all of US tax from our total tax payable (since the US rate is a bit higher), or whether the ATO will have it both ways – charging you more tax when the other country has a lower rate, and saying bad luck and quarantining foreign income and tax when there is a higher international rate.

No Franking Credits on US post-tax earnings

When a company declares a dividend and pays its shareholders, the shareholders need to account for that income as part of their normal tax return process, and pay tax on that income at their marginal tax rate. In Australia, a concept known as Franking Credits means that Australian taxpayers don’t have to pay tax on the whole amount of the dividend, since the dividend has already had company tax come out of it. It is a fair and great system, but unfortunately, the dividends that come as a result of internationally taxed income don’t get franking credits.

The following example, courtesy of a great newsletter from the team at Johnston Rorke, shows how you could lose almost two thirds of your hard earned profits to taxes due to this lack of franking credits. In the example, a foreign company makes a $1000 profit, the company tax rate in the foreign market is 35%, and the personal tax rate for shareholders in the Australian parent company is assume to be 40%. They’ve also included a dividend withholding tax rate.

As you can see, even allowing for the Foreign Tax Credit (note the “Nil” as the tax payable in the Australian company), the fact the shareholders have to pay tax at their full marginal tax rate (no dividend franking) means the effective tax rate on the end shareholders is a horrible 64.9%.

Things Still to Work Out

There’s still a lot of questions in the above.

I currently don’t have a good handle on exactly how the ATO will treat the income that comes via the LLC, as it is what the ATO calls a Hybrid Vehicle. While it would appear that the ATO will recognise the tax credit, I want to know for sure that this is the case, and unfortunately for me, researching this information on the web is pretty tricky, as the ATO has been making changes in the last couple of months – see http://law.ato.gov.au/atolaw/view.htm?docid=”AID/AID201077/00001″ for information that at the time of writing this post, was less than 3 months old.

I also want to understand the C-Corp scenario a bit better – particularly the dividend withholding issues – in case we find for legal or investor reasons we need to step up from an LLC to a C-Corp.

Another thing to look into is the option of setting up a structure in a tax friendly third country. Capital Gains tax in Australia is particularly horrible for entrepreneurs; not only do we have profits and incomes taxed, but if we manage to sell a company we’ve spent tens of thousands of hours and much personal risk building over many years, the tax man then wants to tax the money you get from selling the company at the top marginal tax rate in the year you sell it, in effect taking half of your pay off for success as tax. Other countries like Hong Kong and Singapore don’t have similar capital gains tax situations, however, since all the IP is currently owned by an Australian based company, and changes would need to be very well thought through as moving the holding company to another country would be expensive because it would trigger a capital gains tax event at the time of moving (since a company you set up in, say, Singapore, would be buying the Australian company, and the ATO would tax the shareholders – you – on that transaction even though no real money changed hands).

If you have any knowledge of how this is treated through first hand experience, or can point to an online article that explains it a bit more clearly than the ATO website tax rulings, I’d really appreciate you leaving a note in the comments.

Market Planning & Industry Categories – ANZSIC gets updated

I’ve spent a lot of time over the last few months doing marketing planning for Hiive Systems. Unfortunately, our product is targeted at the professional services sector – think consultants, creatives, advisors, and that sort of thing.

I’ve been really conscious in this marketing process NOT to just keep on doing what we’ve always been doing, so thinking about existing clients and then defining our target market based around them just isn’t good enough. I’ve been thinking through industries based on my experience and memory – almost brain-storming – but it is a pretty crap way to do things, and certainly isn’t an extensive data set.

One of the best ways to work would be to start with a big long list of industries, and then tick those sectors that look appealing for closer examination. Unfortunately, Google has completely failed me – asking for a “list of professional service industries” came up with a bunch of very poor listing websites.

Going to more official sources, the primary list I’m aware of, ANZIC, has always seemed to me to be pretty poor. There’s a special category for fur trappers, but anyone who does anything related to marketing – from consulting through to web development through and beyond to display advertising – is bundled into the same generic blob.

Today, however, I realised that the ANZSIC list was updated in 2006, to reflect the way that industries have changed and evolved since the list was last compiled in 1993. Now with a lot more detail in the service sector – the one that keeps growing in an advanced economy like Australia’s – this list is actually useful.

If you’re interested in seeing it for yourself, the ABS have a copy (publication number 1292.0) at their website. Hopefully if you’re trying to write a marketing plan, this will help you out too…

#publicsphere in Wollongong

The third #publicsphere event was held in Wollongong yesterday (with nodes in Melbourne and Brisbane joining in). With all things that involve an open forum and public consultation, there will be some good bits, and some bits that don’t quite do it for you.

In terms of contributions to the debate in the form of a paper or submission, you really can’t go past the Silicon Beach Lifeguard paper, assembled by Elias Bizannes along with a small army of contributors and editors from the SiliconBeach community. Here’s a video of Elias introducing the paper:

In addition to the paper/submission approach of SBA’s Lifeguard paper, there were also a lot of other good presentations.

Silvia Pfeiffer from Vquence gave a fairly sobering analysis of the challenges and opportunities facing the Australia startup sector. While much of it wasn’t new information for those of us who do this stuff every day, Silvia’s presentation did a brilliant job of assembling a plethora of issues into cohesive lists and constructs, and while I knew about the pieces already, the way she put them together certainly had me coming away with a much clearer picture of our situation. Hopefully her slides will be up on her Slideshare account soon.

Another stand-out presentation in my mind came from @nambor (Rob Manson). After getting the undivided attention from everyone in the room in Wollongong thanks to the coolest set of chops in the room, he proceeded to share how the challenge of succeeding has less to do with “supply side” factors than the (neglected) “demand side” factors. He wasn’t talking about economics (specifically): he was talking about success in technology. The basic thesis is that tech types want to keep pushing supply side – concepts like ‘building a better mouse trap’, ‘build it and they will come’, ‘lets keep innovating’ – while the demand side – taking the time to show tech users how their productivity and lives can be improved by new stuff is really poorly done and needs more focus. This principle, which played then into his main thesis of Diffusion is the Innovation, was then expanded upon. Rather than me butchering it, I’ll just embed his presentation here.

The day itself wasn’t all geek, however. Towards the end, we had a great presentation from Tim Parsons present from a creative perspective. As you’d expect from a futurist in the creative space, the presentation was exquisite. The content itself was great for stimulating some ideas and discussion, and I really thought the sentiment that “Online Culture is the Mainstream”, and not something reserved for geeks anymore, was a great observation, and something I really agree with (since now I’ve got mum on Facebook, and my girlfriend blogging). Anyway, the slide deck is at embedded below (it still looks great, but Tim’s passion in delivering it made it 10x better)

There were many other excellent presentations through the course of yesterday that I haven’t got the time or enough good quotes to include here in this post, but the good news is that the Senator’s team will be uploading the video (which was already streamed, but probably needs to be cleaned up a little and spliced into talks) next week. I’ll update this post then with a few links (including a link to me own impromptu talk on Skills, Talent and Education).

Ethics & the end of (media) days

I was lucky enough this week to be a guest of the team from Kells at a lecture they ran in Wollongong, featuring the acclaimed Simon Longstaff from the St James Ethics Centre. The morning lecture, which went for about an hour, with more than half an hour of questions and answers was an excellent and by far the most intellectually challenging way I’ve spent a Wednesday morning.

While the concepts of the values and principles framework surrounding ethics – defined, as attributed to Socrates, as “what ought one to do” – is something I’ve read about and studied before, it isn’t until you have someone present the crystalised examples and contexts, from Plato through to Madoff, covering issues from the Trojan Horse through to the Global Financial Crisis, that it really has the penny drop.

Given the event was hosted by a law firm, it was interesting that ABC’s Fora program had recently broadcast a speech from Geoffrey Cousins on moral courage, which started with the challenge that what is legal isn’t necessarily moral (or ethical). For the various people at the event I spoke to, I’ve made things a bit easier and embedded Geoffrey Cousin’s speech below.

But getting back to Simon’s speech from this week, which I had the pleasure of seeing in person and interacting with. Simon raised the issue of what’s “right”, and the challenged the audience to be a little more bold about standing up for what’s right.

Simon related a story of how an Australian organisation committed to tackling child abuse thought they would get a better response from politicians, the media and broader society by commissioning a study into the economic effects of child sexual abuse, measured in lost productivity and the costs of treatment. Simon challenged us to be bold enough to declare that stopping child sexual abuse doesn’t need any further justification than that it isn’t right.

So how do we know what’s right? Simon covered three different tests: two old, one relatively new.

  • The first old test is the golden rule: do unto others as you’d have them do unto you. A pretty simple test, but with a subtle change of “do unto others before they do unto you”, things change pretty significantly.
  • The other older rule comes from St Augustine(?) and basically says to just ask your conscience. Of course, this depends on your upbringing to an extent, and puts into relief the importance of bring great parents.
  • The third rule is known in some places – particularly the US – as the sunshine test, where you only do something if you’d be happy for it to be on the front page of the newspaper or if your mum was to know about it in full.

Most people are aware that traditional media is facing some pretty tough choices. The day before the Ethics lecture, one of Australia’s key media companies, Fairfax, reported a massive loss of A$380M for the 2008-09 financial year. With the transition of the high-margin classified business to online environments, and the GFC and digital advertising blowing away a lot of display advertising, there are serious threats to the media and its important role in public interest and discourse.

I’m generally a fan of the concepts behind more participative, citizen journalism and the ability of the online environment to give people a voice. However, thinking about the three guidelines that help people facing ethical and moral dilemmas to decide on what is the right thing to do, it is that third aspect that would appear to have the strongest effect on behaviour, particularly since we can’t rely on the Law to guide ethical decision making.

If in 20 years the media has been scattered and decentalised, will we loose an important decision making tool and ethical compass?