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With the business failure rate for early-stage technology startups reaching new highs during 2020 as a result of the pandemic, the investor community is seeking to shake up the UK’s funding infrastructure to make it easier for new tech businesses to access the capital they need to accelerate their growth.
Early-stage firms have struggled during the Covid-19 pandemic, with 1,067 startups filing for administration, liquidation or dissolution between the start of lockdown on 23 March 2020 and September.
Of these, 273 fast-growth companies made filings in September alone – a 181% month-on-month increase from August – marking the highest number of startup collapses in one month for a decade.
This followed months of startups struggling to secure government support (83% were ineligible for the Future Fund loan scheme introduced in April) as well as venture capital (VC) investment, which was highly concentrated in a few hands with just 5% of the £1bn raised between start of lockdown and end of May 2020 going to firms that had raised investment for the first time – a trend that has persisted.
The Venture Capital Trust Association (VCTA) is an organisation set up to represent the UK’s venture capital trusts (VCTs) – listed companies set up in the late 1990s to pool money from investors and provide equity capital to high-growth small businesses. It operates in diverse sectors, ranging from digital technology and software to medicine development and specialist manufacturing.
VCTs currently manage about £5bn – 80% of which is spoken for by the VCTA – and operate under specific legislation that sets out how they can allocate funding.
Because the VCTA invests primarily in businesses that are in the process of scaling up, it has a vested interest in the overall funding landscape and ensuring that the UK has a good supply of startups. The challenges that startups faced in 2020 are a top-of-mind concern for the VCTA, which has been actively lobbying the government to address shortcomings in the Future Fund loan scheme, for example.
New opportunities for VCTs
Speaking to Computer Weekly, VCTA chair David Hall says the UK’s exit from the EU opens up new opportunities for the way tech startups can access capital, because it provides scope for the rules on state aid to be rewritten.
State aid in the European Union (EU) is the name given to a subsidy, or any other kind of aid, provided by a public authority that has the potential to distort competition. This includes VCTs themselves, which are designed to direct a greater flow of capital towards smaller companies with high-growth potential by offering tax-relief incentives to investors.
“The deal is, you get tax relief on the way in – so you invest your money into the firm, get 30% [income] tax relief…and a second thing is that any returns that are given are generally paid out by way of a dividend, and the dividend itself is tax-free,” says Hall, adding that the “quid pro quo” at work here between government and investors is that this relief is only available to those who invest along certain criteria set for VCTs.
As the rules currently stand, a VCT can invest up to 15% of its money in a single company, and each company can receive up to £5m in any 12-month period, with a cap of £12m over its lifetime. Also, the only companies eligible are those that are less than seven years old from the date of their first sale, have gross assets of £15m or less at the time of investment, and have fewer than 250 full-time employees.
David Hall, VCTA
Things are different for “knowledge-intensive” companies which, in order to support the UK government’s policy objectives, are allowed 12 years, rather than seven, to receive initial VCT funding, have a more generous cap of £20m and can have up to 500 employees.
However, now the UK has left the EU, Hall says VCTs and the domestic legislation they operate under are no longer bound by European state aid rules, and are therefore one funding avenue that can be re-thought.
The scope for change comes because, under the current UK government’s revised state aid regulations, EU state aid legislation is prevented from being imported into UK law after the Brexit transition period. “The main amendments made by these regulations are revoking direct EU legislation and treaty provisions that will become retained EU law,” says an explanatory note accompanying the regulations.
Hall says: “European state aid says you can't invest in businesses that are older than 10 years, you can’t put more than £20m into a [knowledge-intensive] business. Now, what we don’t know yet, and what would be interesting to see, is if the UK government could allow us to do more. Rather than put £20m in, put £40m into a business, for example, or you could invest in a business that is slightly older.”
In over 25 years of VCT activity in the UK, there have been a number of relaxations of the original rules by the government, says Hall, causing the pool of funding managed by the country’s VCTs to swell from £100m in the 1990s to about £5bn now. However, European state aid rules have prevented further relaxation.
“The more you relax that, the bigger it gets, the more businesses it backs, the more money that goes into UK ventures,” he says.
Other funding mechanisms ripe for expansion
To further help the UK’s struggling startups, Hall says the government should also look at changing how the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) operate.
These two initiatives have been designed to encourage innovation by granting private investors a significant tax break when investing in early-stage, “high-risk” companies.
“SEIS’s top limits to what it could do, for example, were again bounded by state said, so it could put £250,000 into a business,” says Hall. “It could widen that funding for the small startup business, and I think that would appeal.”
Hall adds that crowdfunding (“the crowd”) has emerged as a “really good distribution channel” over the last few years as it helps to “disintermediate between relatively small sums of money”, which is otherwise very high cost if many intermediaries are used for lots of small deals.
For clarification, crowdfunding in this context refers to equity crowdfunding, not the donation-based fundraising that has been dominated by US giants Kickstarter and Indiegogo.
“The crowd is probably something where you can, if you can give that more impetus, have a very effective distribution mechanism,” says Hall. “Clearly, you’ve got to have ‘health warnings’ because it’s early-stage equity, but if you can put the right regulation around it, that’s a really effective way of going forward.”
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If a SEIS-style tax break was worked into the arrangement, though, a much wider set of people might be motivated to invest in smaller tech firms that have clearly fallen outside the scope of more traditional funding paths, says Hall.
“That will maybe increase the volume of both people who are prepared to invest in the marketplace, and also the volume of capital that gets mobilised.”
In January 2021, new research found that London-based tech startups received $10.5bn of VC investment in 2020, accounting for a quarter of all European tech funding that year.
Asked how the distribution of capital in the UK can be made less London-centric and spread more equitably around the rest of the country, Hall says the answer lies in creating new tech “clusters”.
“You’ve got pockets of knowledge and experience, so what you’ve got is a skillset of people out of a particular area,” he says. “If you look at something like the Southwest, a lot of it has been in the defence supply chain.” Hall points out that clusters also allow for a better exchange of ideas, labour and capital, which in turn will attract more funding because that cluster is identified with a particular expertise.
“What we’re waiting for now is the extent to which the government will change the [state aid] framework,” says Hall, adding that the above measures could work together to bolster the UK’s startup ecosystem by providing broader access to funding, especially for smaller firms, from a range of sources.
“Just because startups don’t get to that end state [of a big funding round or becoming a unicorn] doesn’t mean they don’t have a viable business, because some of the business are quite viable in providing an income and lifestyle, or whatever it is an individual needs,” he says. “You don’t have to go all the way up the ladder to be successful.”