Think at London Business School
How research into entrepreneurial finance is shaping the world
By Luisa Alemany
Taxpayers could be the ultimate winners from government support for ‘made-in-crisis’ startups through the right investment structures
The domino of lockdowns in Europe in response to COVID-19 sparked a range of financial measures from governments to support their SMEs in an effort to save businesses and jobs. These included direct cash checks, paying salaries of employees that were not working, preferential loans and emergency tax measures.
Shortly after, a few countries with a tradition of fostering innovation realised that startups were unable to access the relief packages on offer. The loan schemes were designed to safeguard traditional companies with tangible assets and profits – ‘safe’ investments that are likely to be able to repay their borrowing.
Startups, by their nature, are typically not ‘safe’ investments. The failure rate in seed stage for tech startups – that is when the business is simply a prototype without a revenue stream - is as high as 80%. It means that eight out of 10 companies will not succeed, with or without crisis.
This presents a big challenge for policymakers when designing an effective relief package for innovative startups: how to identify which startups deserve the money.
Government officials and banks are ill-equipped to analyse the viability of innovative startups and identify which ones will make it. To be fair, it is not in their job description.
The other challenge in creating a startup bailout fund is which financial instrument - debt, equity or a combination - is the most efficient, given the risk and the nature of innovative ventures.
A functioning entrepreneurial eco-system is the lifeblood of an economy and the key to future growth.
“The answer is to use business angels and venture capital to screen the best startups and use a financial instrument, such as a convertible loan, to get the upside of those few startups that will make it big”
The pandemic has not been kind to these sapling companies which have barely taken a breath. The crisis prompted some venture capital investors to shut the doors to new investment to focus on supporting their existing portfolio. This, in turn, has hit hard those startups in the process of fundraising.
There is still venture capital money available, but its focus has shifted into some specific sectors that are now growing rapidly such as healthcare. If we look at the venture capital investments from the USA, Europe and Asia from 1 March to 5 June, healthcare has increased 8% of the total pie. In that period in 2019 it accounted for 18%. In 2020 (COVID-19 period) it represents 25%.
The big loser is the B2B sector, from 13% share of total investments in the March to early June period of 2019 to 7% in 2020. (Pitchbook data as of 7 June 2020).
Around the world many startup founders that we have worked with and spoken to say that they have adapted their cash needs as fast as possible because they are not counting on fundraising in the next 12 to 18 months. You can hear their views in our #LBSResilientFounders video series.
But funding companies that are likely to fail is not a good use of taxpayer money. So, what is the solution to supporting startups through the pandemic – and in other crises? The answer is to use private investors (business angels and venture capital) to screen and select the best startups and use a financial instrument, such as a convertible loan, that can become equity to get all the upside of those few startups that will make it big.
France was the first country to introduce specific relief funds to protect its startup ecosystem. At the end of March, the government unveiled a €4 billion (£3.55 billion) support plan. Germany and the UK followed suit. These three countries lead the rankings in terms of startups, unicorns and venture capital financing, so it was not a huge surprise that they were the first to react.
To date, startup relief packages have so far been introduced by nine countries in Europe: France, Germany, Norway, Netherlands, Denmark, UK, Portugal, Switzerland and Austria, as well as Israel and Canada (see Table 1).
Table 1: Summary of key information on Startup Relief Packages around the world (as of 1 June)
Source: Own research based on public information provided in government websites
In each case, the demand has exceeded supply. Just one day after the application process opened for UK’s Future Fund on 20 May, applications worth £500 million had been made, double the initial £250 million of financing aid available. Similarly, the Netherlands’ COL and TOPSS bridging loans experienced massive oversubscription. This demonstrates the scale of the challenge and the extent it was underestimated by policymakers.
Surprisingly, as this article gets published, the USA is not in the list of countries that have offered a hand-up to their startups. The home of innovation, life-changing technologies and most successful unicorns has not shown any sign of making funds available for their struggling founders and entrepreneurs.
Startups in the USA can only apply for general aid aimed at SMEs under the Paycheck Protection Program, but there is a question mark over its success. Southern European countries, including Italy, Spain and Greece, are also not supporting their startup ecosystem. Only Portugal has announced specific measures.
The stimulus programmes currently available are all financed by governments and distributed through development banks, state-owned investment companies and growth funds. The application process is either investor or company-led, with the first being most frequent due to the characteristics of the investment structures.
“There is some positive news for startups around the world, but it is a drop in the ocean”
Each country has specific criteria for company and investor eligibility for the aid available. For companies, it’s usually a requirement that its incorporation is domestic. It must demonstrate success of securing previous funding rounds and be specifically affected by the COVID-19 situation. Investors must have a relevant track record and be able to provide additional funds to support the company in subsequent fundraising rounds.
The amount of funding and types of instruments available vary by country. France’s €4 billion package - the largest to date - offers four instruments: convertible loans, state-guaranteed treasury loans, accelerated tax refunds and payments of innovation grants. Switzerland, with its €140 , provides loan guarantees up to a maximum amount of CHF1 million per company. Startups in the Nordics can apply for loans at different stages of development (pre-seed, seed, expansion) and innovation grants.
But there is a commonality between the structures of relief funds that cannot be denied: the convertible loan. A convertible loan is debt that can be converted into equity under certain conditions. So, if the company that is funded through such a scheme becomes the next Skype or Amazon – or launches the first vaccine to protect humanity against COVID-19 - then the government can convert the loan into equity and get a percentage of the total value of the company. This allows the taxpayers to share in the potential reward of a high-risk investment – and not just the risk.
For example, let’s imagine a startup that needs $1 million of funding to continue its operations through the crisis. The government invests 50% of that and a group of business angels invests the other 50%. Now, let’s say there are 10 investments like this. The government has allocated $5 million, using convertible loans, in 10 companies.
Out of the 10 companies, seven fail completely; two will return the loan (plus interest) and one is successful. This means that it continues to raise funds and grow, and, at some point, the company is either bought by a big corporation, another investor, or list in the stock exchange market through and IPO. In this case, the government converts the loan into equity. The stake of the government, after several rounds of financing is diluted and could be reduced to as little as 5%.
“This allows the taxpayers to share in the potential reward of a high-risk investment – and not just the risk”
Now, let’s imagine that the successful company is Skype, or Whatsapp. If we do the numbers, 5% of Skype, when it was bought by eBay for $2.6 billion, would have been worth $130 million - 26 times the original investment. Skype was only two years old at the time. If the startup that the government supported happened to be Whatsapp then the upside would have been even bigger. Facebook paid $19 billion for a five-year-old company. And a 5% stake was worth $950 million – almost 200 times the original stake.
Even if you support 10 startups and nine of them do not return a cent, if you get a Skype or Whatsapp in your support package, with the convertible loans, you will still get all the money back and a very profitable return. For this reason, having the option to convert into equity is key.
Out of the 11 countries that, at the moment, have a startup relief package, six of them (France, Germany, Netherlands, Canada, UK and Portugal) are using convertible loans (see table 2). Terms of such contracts typically require that the private investor has to apply for the funding on behalf of the startup when choosing a convertible loan. Typically, the government is able to provide a specific amount of aid per company which then has to be matched by at least 50% contribution from a private investor. This makes sense as VCs and business angels screen startups for a living, and is putting their money where their mouth is – so to speak.
The loan term seems to be between 24 and 36 months with the discretion of exit/conversion method reserved for the government.
Table 2: Startup’s Relief Packages around the world: instrument used and conditions
Source: Own research based on public information provided in government websites
Start-ups in France are able to choose convertible notes with between six and 24-month terms and a single-digit interest rate. For this type of funding, the government has created an €80 million package to support bridge financing between rounds. This amount must be matched by private investors by 50%. Ultimately a relief could be in the range of €100,000 to €5 million per startup.
These measures are exclusively reserved for companies whose fundraising was initiated but could not materialise because of the current health crisis. In two months since the announcement, the 4 billion euro relief package has already been committed, so more money might be assigned to continue supporting the startup ecosystem.
Germany, which announced its €2 billion relief plan for startups just a few days after France, also offers convertibles through its Corona Matching Facility (Pillar 1), which came into effect at the end of April. The funds are distributed by the government through the German state-owned KfW and the European Investment Fund, which together form a general partner (GP in venture capital terms) and must be matched by private investors. The GP then determines the exit either through conversion or repayment of the loan.
“Many countries consider general packages for SMEs satisfactory. This mindset will see vital innovation lost”
The much-anticipated Future Fund features an unsecured convertible loan with a 36-month term and interest rate of minimum 8%. UK-based startups can receive between £125,000 and £5 million, provided by the government through the British Business Bank. This amount must be at least matched by co-investments from investors. The amount of the loan will convert on the company’s next qualifying funding round into the most senior share class issued in such round at a minimum discount of 20% of that round price.
While, there is some positive news for startups around the world, it is still a drop in the ocean. Only 11 countries in the world, as per our research, are right now supporting their most innovative companies - the big tech companies of the future. Many countries consider general packages for SMEs satisfactory. This mindset will see vital innovation lost.
Companies that are now an intrinsic part of our daily lives, such as Airbnb, Groupon, Whatsapp, Uber, Slack and Instagram , were ‘made-in-crisis’ – during the financial crisis of 2008. Meanwhile, well established companies, such as Disney (1929), HP (1939) and Microsoft (1997) started in deep crisis. They would have not been candidates to receive SME financial aid.
“If the startup that the government supported happened to be Whatsapp then the upside would have been even bigger”
Groups of startups are coming together to speak with one voice and urge the authorities to survive the crisis. Most recently, associations representing more than 3,000 startups from around Europe, formed United Tech of Europe. They are preparing a combined effort to persuade policymakers to create a pan-European Covid-19 recovery plan directed at startups. It is important for the future of the nations, but it is also a good investment of taxpayer money.
In India, according to Techcrunch (10 April 2020), venture capitalists and startups sent a joint letter to the Prime Minister to ask for help. They requested the government provide interest-free loans, take care of 50% of the employees’ salaries for six months and some tax benefits. It is interesting to note, that venture capitalists in India seems to prefer plain loans to convertible loans, thus not really allowing for the potential upside to get back to the taxpayers.
The best returns in venture capital are always made in those funds launched in the worst years. As we can see in Figure 1, with data from UK based venture capital funds, the internal rate of return (equivalent to the compound interest rate) of the funds that started their investment period in time of crisis is the highest.
Figure 1: Return of venture capital funds in UK by vintage year (1990-2010)
Governments around the world need to understand this. They can’t miss this moment. Right now, there are hugely exciting innovations and advances in new technologies in healthcare, cleantech, education and the work environment that need funds to survive this crisis so that they can help improve our lives and the world we live in. By co-investing with private investors through convertible loans, they could yield some exceptional returns for the countries that choose to look after their innovative founders.
Pawel Stach (MFA2020) is completing a Masters in Financial Analysis (MFA) at London Business School
The #LBSResilientFounders series draws on the experiences of founders who have seen and survived sudden shocks that threatened to sink their ventures. We learn how they adapted – and what they wish they had done – to save their business, preserve their wellbeing and take advantage of post-crisis opportunities.READ MORE