No such thing as a free launch
The recent New Zealand Aerospace Summit left me feeling like the NZ aerospace sector has reached a watershed moment. It is clear that NZ is home to a group of genuinely world-class innovators ready to deliver ground-breaking solutions.
However, to fully deliver on this potential they need stakeholder buy-in and capital sooner rather than later.
New Government funding
Government announced at the Summit more than $15m in new funding for the sector, which is great to see, especially the $3.7m earmarked for CAA. If this enables CAA to improve turnaround time for novel certifications this will be a major bonus for those companies engaged in the process, especially those with a burn rate working towards commercialisation.
However, if this new funding does not translate into faster regulatory approvals, NZ risks losing some of the most exciting companies on its shores to other jurisdictions that can facilitate development on a faster timetable.
The balance of government funding will be well received by companies that can access it, but relatively speaking it is a drop in ocean. It will only ever be a small supplement to R&D costs. If NZ is going to deliver on its potential as an aerospace sector of global importance, then a strong supply of growth capital from the private sector is essential.
The “Access to Aerospace Capital” discussion at the Aerospace Summit
Some of the key themes from this session were:
1. Aerospace is not immune to macro-economic trends. Geopolitical risk, a rising interest rate environment, inflation and supply chain disruption all create tougher fundraising conditions.
2. Sector-specific challenges are also present. Overseas competitors may be comparatively well-funded, complex regulatory frameworks extend time to market, and there is a shortage of top talent globally
3. Some venture capital firms (VCs) are in “wait and see” mode, but there is still appetite for investment in the best companies. This starts with a great team and novel intellectual property that is defensible.
How will these themes impact private capital raising?
Many start-up companies in the aerospace sector may be pondering the best way to raise capital and make it work for them in the current economic climate.
Regardless of where you think interest rates will peak, the change from “free money” to cost of capital is almost certain to impact growth companies in the aerospace sector.
For most founders, this is likely to take the form of tougher negotiations on valuation, resulting in higher dilution through equity financing. Founders will rightly be concerned about raising in an environment where lower valuations would see their own equity diluted beyond what they have come to expect in recent years.
The first port of call to solve this problem is usually to kick the valuation conversation down the road. Make today’s problem tomorrow’s problem, and maybe by tomorrow it will have solved itself (or at least become a smaller problem).
This typically involves issuing a convertible note or SAFE note rather than shares. These instruments then convert at a discount on the next full round, so the investor still gets some upside for investing early and the difficult conversation about what the equity is worth today is delayed.
Convertible notes have debt and equity characteristics, so some investors prefer them as they offer downside protection with interest until the next round. There are plenty of examples of where this is happening in NZ and overseas right now (see UBCO’s move to a convertible note, for example).
Tools to bridge a valuation gap
In addition to the investment instruments being used, it will be interesting to see if VCs become more creative when bridging valuation gaps in other ways. This might take the form of preferred equity that offers the investor more reward on an exit event beyond the NZ standard x1 non-participating preference.
The market might also see a move towards more investor-friendly flavours of anti-dilution rights to protect against downside risk, or structuring investment in tranches payable against development milestones.
These tools can all help bridge a valuation gap, but in some cases risk misaligning investors and founders. However, if the alternative is no investment at all then it may be something that NZ founders are prepared to live with.
The fight to keep investment in New Zealand
A challenge for NZ based VCs will be convincing some of the best companies in the aerospace sector to seek investment on these shores. Many companies with global ambitions are already looking for overseas capital, and there is an increased appetite in the sector from overseas investors, particularly the United States.
Rightly or wrongly, the valuation and size of the cheque can often cover a multitude of sins when it comes to the investment terms, and overseas investors are generally willing to write larger cheques at higher valuations.
For those companies that do respond to the siren call of overseas capital, they will need to keep the Overseas Investment Act in mind. Many of the technologies being developed in the sector are classed as “dual-use” technology, making the companies themselves “strategically important businesses”. Investment by an overseas person in a strategically important business usually requires notification to the OIO under the National Security and Public Order regime.
This is usually a straightforward exercise that does not need to delay the capital raising timetable if it is well-managed. If the transaction is assessed to pose a significant national security risk, the process has the potential to become much more involved at that point.
Once the money is in the door, companies will be focussed on making it go as far as possible. For most start-ups, if they can find the talent in the first place, the wage bill will easily be the highest expense month to month. This is especially true in an inflationary environment where companies are under pressure to support employees with rising costs of living.
Across the board, companies in the aerospace sector are relying on employee share plans to incentivise their employees. In some cases, this is being used to supplement a lower than market salary, but not always. For most growth companies in the sector, share option plans are the preferred structure, often with nominal exercise prices.
Founders and existing investors are generally expected to bear the dilution that these plans create, so in the long term this does represent a cost of capital for founders. Well-designed plans will strike a good balance between founder dilution and generosity, to help ensure that founders, investors, and employees, all remain aligned until a successful exit.
Thank you to Senior Associate Gareth Clendinning for preparing this article. If you have any questions about capital raising or employee share option schemes, please contact a member of the Technology law team.
Disclaimer: the content of this article is general in nature and not intended as a substitute for specific professional advice on any matter and should not be relied upon for that purpose.