A deer contemplates R&D reform at while drinking a nice cup of tea. Photo: Getty

Why half-baked R&D changes are a finger in the eye to startups and software

The government is proposing to reshape research and development incentives, with MBIE proposing to phase out the Callaghan Growth Grants and replace them with R&D tax credits. Nathan Torkington has some concerns.

As the FAQ says, there are differences in the definition of eligible expenditure between the Growth Grant and the proposed R&D tax incentive (for instance, overseas expenditure on R&D). The proposed R&D tax incentive has no R&D intensity threshold, a much higher cap and lower minimum R&D expenditure threshold than the Growth Grant. Some firms may get less money, but others might get more.

This policy is very clearly aimed at large and profitable companies. If you’re a Fonterra, or a Mainfreight, or a TradeMe, you can receive a discount on the tax you pay on your profits. That’s good: we want these companies to increase their spending on R&D. Another 1% spend from them represents tens of millions spent on R&D. Good, we need it, New Zealand lags horribly.

However, there are plenty of other companies in New Zealand. In particular, I work with software companies and startups at that. It’s time for a side-track on startups…

A side-track on startups

A startup is a small company that wants to get big fast, generally to beat would-be competitors to the opportunity they’ve identified. To grow artificially fast, startups don’t make profits and reinvest some of those profits in building more product and opening new offices. Instead, they take investment money and spend it on sales people, marketing, but (most importantly) programmers to build the product and get more users.

Those startups on full burn are growing really fast. You may have heard of some: PushPay, Vend, Soul Machines. Until recently, Xero was on that list but they’ve finally reached the point where they’re shooting for profitability and not simply pure growth.

The growth here is in users and not profit. Indeed, startups run at a loss while they burn like this: they’re spending more to obtain the next set of users than they are making from their existing users.

The way to make sense of this behaviour is to recognise that the company is the product. The startup wants to be bought: either by a lot of people through an IPO on the stock market, or by another company as an acquisition. Why would someone want to buy an unprofitable company? The best reasons are (a) the startup can just stop growing and then it’ll be profitable; and (b) the users are desirable to the acquirer (because you can sell them other things / they’re already users of the acquirer’s product / etc). There are other reasons companies are bought, including delusion and speculation, but these are the more defensible ones.

Often the buyers are not Kiwis: if you’re a Kiwi firm and you are going to sell, you’ll sell to the people with the most money. If that’s a Kiwi company, great. If it’s Fairfax or Apple or Adobe (all of whom have acquired NZ tech startups) then that’s great too. Realistically, in the software space it’s generally international buyers.

Because the company is the real product, the ostensible business of the startup (building and selling some software products) is not profitable while the startup is growing. The profit comes when the company is sold.

Think about that for a second, it’s important: a startup generally won’t make a profit while it’s building and selling its accounting/AI/payments/… software.

Most importantly, you won’t know whether the company can be sold until the company is sold. The larger and older the startup, the more chance there is that it’ll be acquired, but there have been 8 year old startups that grew large and then blew up because they weren’t profitable and nobody bought them.

While they’re growing, though, they’re hiring people. If the startup is in NZ, it’s hiring Kiwis. if it’s in England, it’s hiring Brits. If a startup in England gets a better R&D incentive than its competitor in NZ, then the British startup has an advantage: the money the Brits get from their government can be used to hire more people to move faster and pull ahead of the Kiwi startup. A shitty R&D incentive policy in NZ makes Kiwi startups go under while their foreign competitors thrive.

Back to R&D …

How do our startups fit into the R&D tax credit scheme? Short answer is: they don’t. Tax is a concern if you’re profitable. If you’re not profitable, tax is the least of your worries.

So the R&D tax credit does nothing for startups and high-growth firms.

Nothing.

Even worse, the proposal is half-baked. It’s clearly aimed at the kind of old-school physical product companies that dominated the 20th century in NZ: Gallagher, Fonterra, etc. It talks about R&D as following the scientific method, and there are lots of examples with dies and machine blanks.

Even weirder, the definition of R&D specifically excludes market research, design, and social sciences work. The iPhone is a UX innovation, and indeed Apple’s whole market distinguishing feature is R&D around Design. Facebook are doing R&D right now via social sciences, trying to understand the networks of conspiring bots and political actors (I know this as I went to Social Science Foo Camp at Facebook in January). Lean and agile software develop starts with iterating with a customer, trying to design the feature or product that they want and will use. This is literally called The Design Process and it’s critical to building a new product. Not covered in MBIE’s doc.

Now back to startups …

In a high-growth software startup, every dollar spent on that startup is R&D … because the company is the product. You don’t know until you actually sell it whether it’s saleable.

That’s the Silicon Valley model of startups … five years of loss-making while you burn investment money to get big, then you start to worry about breaking even, and then once you’ve proved that you CAN make money (even if you’re not making very much) you’re sold.

Maybe it’s five years, maybe it’s eight years, maybe it’s three years. The pressure is on software startups to be profitable (or at least break even) ASAP to prove their viability. Investors got burned funding companies that were never able to be desirable to an acquirer or profitable enough for an IPO. Now they’re saying “prove you have a long-term future by being breakeven”.

Whenever it comes, whether at year eight for Silicon Valley or year three for NZ, there’s still a huge risky early-stage part of a startup’s life that this policy does nothing to address. Early-stage startups are not profitable, are almost exclusively doing R&D, and are utterly unsupported by this policy.

To be sure, there’s a way to cash-out R&D tax credits. The consultation document says “The Government is committed to providing a better policy option to support these businesses. However, the policy issues are complex and will not be resolved in time for the introduction of the Tax Incentive in April 2019. […] The existing R&D tax loss cash out scheme may be reviewed as part of any further policy work but no changes will be made to it for the 2019-2020 income year.”

The consultation about the tax credit policy admits that they don’t know how to apply R&D criteria to software and that this isn’t aimed at startups. Yet they’ll still phase out the Callaghan grants. This is irresponsible.

Instead of developing both the big company and the startup policies together, consulting, and then retiring the Callaghan grant, MBIE has opted to develop a BigCo policy and let startups pray that the Startup policy is (a) developed and (b) any good.

Perhaps I’m wrong. Perhaps I’m misreading this. But if I’m accurate, then this is a big MBIE finger in the eye to software and startups.

I used to question why we need NZTech and NZRise. This is why! We need people paid to box the ears of MBIE and remind them that they will never get another TradeMe, Xero, or PushPay if they don’t start taking the job of nurturing these companies seriously.

So what next?

Have a look at the UK if you want to see some startup-friendly R&D policy. R&D is 100% claimable as expenses, and small-to-medium businesses can even get cash back. The calculations are astonishing.

The MBIE consultation is interested in “what are the effects on your business of this proposed tax policy”. Your company should complete that consultation, if you’re a startup doing R&D.

In particular, visit MBIE’s R&D Incentive Online Submission App and answer Q2-5 (what is R&D, scientific method), Q7-8 (design, UX, etc.), Q12 (growth startups can sell product for less than the cost of producing it, to build customer-base), Q13 (software). If you don’t want to do this through their app, the MBIE site says how to do it via email and the end of the consultation doc has a short list of the questions. If you are very short of time, Q7-78 and Q13 are most important but you’ll want to read the relevant bits of the consultation doc (don’t worry, it’s a quick read).

MBIE should put the tax credit system on hold until they have a proposed solution that works. Creating uncertainty for startups while they figure out what the 21st century looks like is not good policy development.

I’d personally like to see MBIE do some open learning with the software industry about what R&D looks like here, and how they might define and measure it. The MBIE doc has a feel of “gosh, this software world is odd! We know we don’t know!” but it’s bloody weird that you’d admit you didn’t know but not seek out people who could help.


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