Government funds will save jobs, preserve innovation and deliver returns
I have spent more than 25 years hell-bent on building and then backing globally ambitious startups from Europe, often with my brothers Charlie and William. Both of our parents came from Australia and we grew up helping out with their small services businesses. For much of my memory, they both operated out of their respective apartments. All the rage these days.
Over the past 15 years I have ridden out both the dot com crash and the financial crisis as a founder and leader in two software startups whose products are sold to this day by Oracle and BMC. Then as an investor this past ten years I have backed companies like Tray, Citymapper, Automic, Transferwise, Bitrise, Urban, Ocean, Polkadot and Pusher. Over these decades, the UK has built a leadership position within a burgeoning European tech ecosystem. Yet, given the EIB, France, Germany and Denmark have already made their moves, unless we immediately extend the Covid resilience funding to our startups that position is in peril.
I argue three key points:
1. Startups are the best place to drive a Keynesian ‘multiplier’ effect on government stimulus money
2. Startups will help us ‘spring forward’ and not simply fall back on old solutions to tomorrow’s problems
3. The UK must not cede its position as Europe’s startup capital — Europe has come into its own in the last decade and competition with France, Germany and others is healthy
Keynesian Interventions Are Our Least Worst Option
There are many threats from Covid19 to businesses both large and small; operations in healthcare or leisure; outfits addressing established markets or making new ones; firms yet at an early-stage or already growing fast. I believe that all of these should be supported. With 50% of the world’s GDP in lockdown, ‘far worse’¹ than either recession in living memory we should not make a choice between them. A balanced portfolio of measures is essential since so much of our economy is interdependent and because this is not merely a question of survival, it is a question of global competitiveness.
We are likely in the foothills of a “cascade of crises”²: health, unemployment, credit, developing countries, commercial real estate, oil, revolutionary politics, refugees… that no person alive has ever seen. It is imperative we act early and decisively, make both cuts and investments ahead of the economic downturn. Naturally, Roubini sees this as an “I-shaped’ recovery, straight-down…as real as if an asteroid and hit the planet Earth and economic activity shut down.” ³ The specific consequences to the tech industry include that global supply chains will be rethought; advertising revenues have and will continue to plummet; automation of industry will deepen; surveillance of human health will enter a new norm. The bounce-back, which ultimately will occur, is one where Asia in general and China more specifically may well be advantaged. Not least, as both Fareed Zakaria and Tom Friedman point out, due to the new vacuum of global leadership created by the United States this time around. This leadership is crucial to provide a portfolio of economic stimuli but also beyond that to ensure we develop skills, key technological infrastructure and move our approach to sustainability forward, not backwards. In other words, the bands of people working experiments in innovation that we know as ‘startups’ are more essential now than ever.
Time to Spring Forward Not Fall Back
Some makers and hackers in our community have been calling this the ‘great acceleration’. Trump describes himself as a ‘wartime president’ — and wartime is when some of the biggest technological advances are made. There is a belief that changes to work, to education, to healthcare, to transport and so on have the potential catapult society forward 30 years in 3 months ⁴ ⁵. It is Europe’s and the UK’s startups that exist to make this a reality for consumers, business and government. This is a “crucible”⁶ moment. This is the time that we shall see the Googles, Genentechs, and Amazons of the future being forged. Is it healthy for us to risk forcing them all to move to the US once again, Or, perhaps more likely, see many of them develop in China? Europe, including the UK, can contribute by incubating its share.
Deep tech startups can take years to get to market with a product, and will be heavily loss making in that period. Assembling, funding and retaining a team of rock star developers with experience in the relevant sector is part of the alchemy of a successful start up. Yes there is a low survival rate for startups from seed to Series A — which makes the period between seed and Series A particularly hazardous. Some commentators and investors make the point that startups at this stage have more options than later stage companies to cut costs — but for those in deep tech — the sort of company Europe and the UK should do a better job of creating — the costs are generally the development team — and there is normally not much fat to trim. Commercial teams will already be small, and cutting those means all-important traction in the market is lost — leading to what venture investors like Fred Destin have described as a death spiral.
Michael Lind and Robert Atkinson in their book, “Big Is Beautiful: Debunking the Myth of Small Business.” “The best way to boost productivity is to remove obstacles to the replacement of small-scale, labor-intensive, technologically stagnant mom-and-pop firms [Sorry Ma and Pa] with dynamic, capital-intensive, technology-based businesses, which [in time] tend to be fewer and bigger…if government is to help any small firms, it should focus on the start-ups that have the desire and potential to get big, not on nurturing Ashley and Justin’s efforts to open a local pizza shop.”⁷
Of course I am not arguing to extinguish mom-and-pop retail shops but rather to shift the balance towards creating more venture capital and angel-backed companies. “The entrepreneurship that matters,” Scott Shane, a professor at the Weatherhead School of Management at Case Western Reserve University, “is the high-potential start-ups that are backed by sophisticated investors.”
In the US, where use of renewable energy has risen from 18 to 21% in the last year, Trump was rightly lambasted for supporting the coal industry when renewable energy is clearly both the commercial and moral path forward. Are we not committing a similar mistake by funding today’s high street, gas-guzzling cruise ships and hairdressers at the expense of AI-driven drug discovery; continuous health monitoring that respects individual privacy to stop short of state surveillance or new more efficient and inclusive financial products and distribution? This is the opportunity to trigger a huge multiplier from the Keynesian stimulus we apply.
Can we rely on rapidly cherry picking the winners?
It is famously challenging to pick the huge winners at the early stages of the venture. As Y Combinator founder Paul Graham wrote in his 2012 essay ‘Black Swan Farming’ reflecting on the dominance of Dropbox and AirBnB in his portfolio: “the best ideas initially look [to investors] like bad ideas…[so] they seem like good founders…who cares what investors think?” So it is misleading to infer from the outcome of a 70 to 80% attrition rate from seed to Series A over time, that we should therefore allow a number of existing fund managers, with the inevitable bias for their portfolio and sectors to cherry pick on an accelerated basis one in five of the current crop of UK seed stage startups for survival. Every great fund manager has their ‘anti-portfolio’ of the passes they made on companies highly challenged in fundraising that, finally, went on to make it big.
Whatever they say publicly, these same VCs are actually pausing right now. As they should. In times of such uncertainty it is inevitable. As it is also inevitable for them as risk managers when the pendulum swings this fast, they become risk averse and are likely to under invest even when they do. At the same time, attrition at Series A investment rounds is being accelerated. Necessarily there will be brutal triage and sometimes terminal delay. Since more reserves are needed for their existing portfolios, and new funds must now allow for a longer path to exit from the outset, there is less capital to bridge today’s ‘black swan’ event.
Capitalising these companies to survive when VC markets are focusing only on the immediate needs of their portfolios — perhaps for a 6–9 month period — is vital to retain the innovation and intellectual capital these startups are developing. Relying on existing Angel investors to come to the rescue is unrealistic — given Angels rarely operate with capital in reserve and are most likely under significantly more financial pressure than the VCs due to a complete absence of management fees.
Many comments have been circulating concerning the high levels of ‘dry powder’ in the VC community. And indeed, Dealroom.co, Pitchbook and a master crowdsourced spreadsheet all suggest that there might be as much as GBP 6Bn in early-stage VC funding targeting the UK right now.⁸ But when you take into account reserves; temporal diversification; stage focus and so on, it actually leaves less than GBP 200m for 2020. If we distribute this private capital amongst all the 1500 seed-stage tech startups identified by Beauhurst that is merely 100k GBP per company. This will likely deliver only 20% of the runway these companies now require.⁹ In any case — VCs (including the brand-name, BBB-backed set) normally only fund a small proportion of seed-stage startups — the majority of the burden falling on Angel investors. Or no investors at all.
Private capital is key. However, there is a clear role for the Government.
We understand that LPs are asking their GPs for their portfolios to cut costs and extend runway but also some have looked to provide extra pools of capital with explicit approvals. It seems Index has cleverly drawn upon its relationships with its LPs to be poised to raise a large fund as the downturn was triggered. As it did a decade ago. Not many managers can do this.
A 1Bn or indeed 3Bn government led co-invest fund for ‘scale-ups’ would both propel the clutch of companies that have already been nurtured and simultaneously also protect the investments of the growing number of larger natively European venture growth fund managers. It is estimated this would protect around 6,000 jobs today (undermining 50,000+ new jobs within 5 years); spur innovation; and also generate returns for the Government. No hand-outs here.
There are also other immediate steps that are being taken and are welcome for example the immediate acceleration of R&D tax credits and clawback for any error. And the efforts of Innovate UK to support fundamental research projects with grants. The government could go further by extending EIS tax benefits to corporate entities rather than just individuals — creating a big incentive for VC dry-powder to be deployed at lower risk.
Big tech can also partner with startups to share the burden of delivering and indeed provide sponsorship of key initiatives in the ecosystem. Large corporations should also maintain their transformation programs and step-up to make purchases of early versions of products as sophisticated customers for young companies.
The logic to furlough staff in the context of a startup is likely to be limited. They must be UK based and often development teams are right-shored across Europe or the world. Perhaps only for employees delivering sales and services that scales with the growth rate targeted and achieved. But the core product and development talent are normally already deemed highly essential and are not the type to sit on the sidelines. Startups are shifting to 4 day weeks, founders will cut salaries by 30%, but there is always productive work to be done in a startup. So it is much better that the government pays the salaries via investment and the team continues to contribute to the business. This is a double victory: the team continues spending their salaries in the economy at large AND they propel this possible winner forward.
Does This Run the Risk of Socialising Losses and Privatising Profits?
For companies who are already big, Chamath Palihapitiya, of Social Capital argues vehemently for letting airlines go bankrupt since a ‘bailout’ is principally for the 90% of shareholders who are already wealthy. The workforce will be managed through the restructuring anyhow. Many of the restaurant or hotel chains we are now supporting are owned publicly or by private equity and hence predominately ultimately wealthy family offices. These shareholders don’t need support. The corollary of Chamath’s argument is that saving startups that involve many individuals private angel investors (possibly with some venture backing) and preventing talented individual ‘makers’ being laid off today is also a worthy activity.
The Runway Fund
Providing 6–12 months of runway to early stage startups not eligible for other government schemes is essential to protect this emergent furnace of innovation. Seed stage startups often come close to death before success as they seek product-market fit. Then the natural attrition can happen in the Series A process. We have more diverse startups than ever and we should not squander that advantage, and hand the baton to France, Germany, China and others who all have schemes in place for this segment already.
Yes — not all startups should be funded. There should be a filter. But not a triage at this stage.
Firstly, an open and transparent system of selection and sponsorship from a broad but pre-vetted pool of angels, angel syndicates, crowdfunding platforms, seed investors and early stage venture investors who must monitor and report on investments through their lifecycle bring reputational risk and the filter of ‘good time (if not in every case good new money) after bad’ to bear.
Secondly, a deterministic set of qualifying and eligibility criteria should be applied such as: business plan; stage; funding to-date; and funding in the past 3 months.
Thirdly an independent, perhaps rotating, investment committee can weed out those with evidently poor traction or prospects and as a backstop for any mistakes or deception.
Co-investment or matched funds from private sector capital should be encouraged and seen positively, but not made mandatory. Although private capital may move fast enough for the most obvious candidates, this runway fund is precisely intended to provide security in face of the current freeze and shortfall in seed bridge funding. If the figures of Kauffman Institute are to be taken as average, this cleaned-up index of seed stage startups should deliver a return on investment to the Treasury well beyond the cost of capital and without considering the value of the jobs retained and the repercussions avoided. This is far from a hand-out.
This program would naturally be marketed, overseen and administered by the British Business Bank or another not-for-profit such as Capital Enterprise. Or perhaps even better a not-for-profit collaboration or platform brought to us by UK Fintechs? There has been discussion of BBB-backed funds to distribute this investment however they will naturally prioritise their existing portfolio.
In the run up to the end of the next tax year, it might make sense to include further measures such as temporary enhancements to the EIS and SEIS programs.
So I have laid out why we at Fabric Ventures believe it is so critical for the UK Government to have a fund for Pre-Series A startups that can deploy GBP 300M in convertible instruments, the ‘Runway Fund’, under the guidance of non-profits such as Coadec and Capital Enterprise who have worked hard to make this happen. This scheme will catalyse greater bridge finance, faster, for the most obvious and likely ‘in portfolio’ candidates and deliver much needed finance to allow companies to fight another day. This is critical for those outside of portfolios and where the jury is still out. Let’s remember most, if not almost all, of the startup world’s most enduring successes have been in that category at some point.
Now is not the moment to worry if some companies saved will go on to fail — they will, nor the hazard to the brutal side of capitalism’s Darwinistic brilliance this precedent might create. In the same sense that the Health Authorities look to provide masks and gloves for each frontline worker, it would be short-sighted for our Government to focus on the high street or scale-ups at the expense of our innovators. We need to nurture our green shoots, who comprise the future, as well as propping up the veterans. Our economy will need this the sugar-rush and the long term sustenance once we’re through the worst of the crisis. Our entire tech ecosystem is the organism on the front line here, vital for the future of our economy, and we should therefore look for a balanced solution to battle both the current crisis and deliver upon our competitiveness in the coming decades.
- The Economist, 9th April 2020
- Fareed Zakaria, CNN. https://edition.cnn.com/videos/world/2020/04/05/fareeds-take-coronavirus-global-crisis-gps-vpx.cnn
- What Dr. Doom Told Me About the Coming Recession, Azeem Azhar, The Exponential View.
- “How Covid-19 is accelerating the shift from transport to teleport” — FT, March 30 2020 https://www.ft.com/content/050ea832-7268-11ea-95fe-fcd274e920ca
- “How to come out stronger from the Covid-19 Crisis: Accelerate Simple and Digital” — Bain & Company, April 1st 2020 https://www.bain.com/insights/how-to-come-out-stronger-from-covid19-crisis/
- Covid-19 crisis will “create the next Googles and Amazons” [https://sifted.eu/articles/covid-19-new-google-amazon/
- New York Times opinion piece The Coronavirus Is Showing Us Which Entrepreneurs Matter:
- This sum is destined to be split between new investments and supporting existing portfolio companies meaning many existing companies will be falling through the cracks. Beauhurst estimated a mere 25 of the 1500 companies were backed by ‘brand name’ venture investors. It will also l be weighted towards Series A and not a Seed Prime round (so we can divide by 3). It should be invested over four years (so we can divide by 4); it includes biotech and medtech (so let’s cut it in half) Inevitably the current dislocation will lead to some LP defaults, some GP failures and the recurrent departure of ‘VC tourists’, including CVC’s pressured by their corporate balance sheet position. So we end up with less than GBP 200m of this dry powder for 2020.