Last week the government announced a £500m Future Fund rescue package for startups. Why? Maybe it was Brent Hoberman’s wailing in the Financial Times or maybe someone at BEIS finally realised it was time to start justifying the vast amounts of money the Treasury gives them out of our pockets each year?
Whatever the motivation and the numbers, it’s worth looking at before deciding if it’s good/bad/enough/too much/likely to work or just another government FUBAR?
In the sector I specialise in, edtech, trawl through the accounts of all the startups in the last 5 years in England (those who survive) and you’d be lucky to find more than £20m in uncommitted liquid/cash reserves. That’s probably 4-16 weeks burn rate if they can’t access funds from banks, funds, investors or the government. It’s probably not much better in lots of sectors but here’s the difference; last week the Office of Budget Responsibility (OBR) published its estimates of how much the different sectors in the economy have been hit. If you can’t be bothered downloading the spreadsheet and finding tab T1.2, Table 1.2 Output losses by sector for the second quarter of 2020 and Effect on output relative to baseline, then here it is as an image. The worst hit sector, down by 90%, is education!
It gets worse. Education is a huge sector and the pain won’t be felt evenly. A good example will be universities who have become addicted to the income from the 450,000 foreign students, over 120,000 of whom come from China. Turning off this tap will bankrupt some. Rather than offering the opportunity for the education revolution dreamed of by academics like Professor Steven Jones it’s likely the very institution where he teaches will soon have no new shiny buildings, fewer academics (tenured or casual) and they may even get paid less
My focus has been K12 and the business of education outside school, such as holiday programs, tutoring, prison education, etc. In this area we have seen a tsunami of free or freemium resources being offered to schools (Hegarty Maths last week delivered several million lessons internationally) plus whole new e-learning products like Oak National Academy and BESA’s LendED. Perhaps more important than the content/assessment and curricula tools is the boom in platforms and systems, ranging from those provided by corporate behemoths like Google (GSuite) and Microsoft (365, Teams), must-have ‘new’ video conferencing systems like Zoom (founded in 2011) down to small UK startups like BitPaper. Large, well- funded companies can afford to keep pretending to give away their wares for free (nothing free is actually free) but for small UK edtech startups it’s likely to be an easy spiral to bankruptcy. Why? Every edtech product has operational costs, from backend necessities like Amazon Web Services, Microsoft Azure or Alibaba Cloud to onboarding costs to support new users (schools, students and parents). UK edtech startups generally have no idea of what their post-crisis conversion rates from free to paid might be, but if this exceeds 5% I’d be surprised.
Of the UK edtech startups I have invested in, only three provide any regular financial or management accounts/reports and they represent the best (2) and worst (1) of my investments. Of these, two have strong investor support and are still cashflow positive (for now). The other has a much higher profile, has deservedly won many awards, but is yet to make a profit a decade on and will likely struggle to deliver their Series A in 2020.
Of the three, only one fits the Future Fund ‘rescue’ deal. Many, even more investible, UK edtech companies probably won’t fit. Why? Here is what I think is wrong with the government’s plans to help startups:
- ‘£500m Future Fund’ isn’t £500m; it’s a maximum of £250m (in chunks of £125k to £5m) if startups can raise a matching £250m from private investors.
- There’s another £750m of ‘targeted support for the most R&D-intensive small and medium size firms will be available through Innovate UK’s grants and loan scheme’. The first £200m of this is for Innovate UK’s 2,500 existing ‘customers’ who want to ‘opt-in’ to their grants and loans. There may be £210m available if you aren’t already getting Innovate UK funding, but even that looks like it will cover only 1200 firms for £175k each.
- If you want to torture yourself, the current details can be found here
- Companies wanting to apply to the Future Fund need ‘warm’ (i.e. a minimum of £125k committed) matched funding investors; it’s probably too late to start loan book building
- It isn’t attractive to EIS and SEIS investors who are the backbone of UK startup funding
- To have raised £250k in the last 5 years isn’t a high threshold, but if this included convertible notes then you won’t qualify
- Numbers – in 2018/19 when the UK was supposed to be afflicted by Brexit uncertainty there were there were 670,000 startups while 508k companies were dissolved. About 50% of startups fail within 3 years. Even allowing for the high attrition rate, Future Fund probably has the headroom to help only 1000 companies or about 0.14% of the UK 2018/19 startups.
- The deals are really four-year convertible loan notes with an 8% (or more) interest rate. That will deliver the government and taxpayers (via Future Fund) the most senior class of shares in companies where there’s no public market to trade them. Isn’t that a key failing that sank Neil Woodford’s Investment Management?
- Companies can pay out early but this is where the dead hand of funds in drafting the deal can be seen. If the company hasn’t done a funding round in three years then the government/taxpayers/Future Fund either gets its money back or some of the same illiquid senior shares. Investors (funds) on the other hand get a 2x repayment – that’s right, 100% more than Future Fund!
- There is currently little information on how companies will be chosen. Will it be like the EU’s Horizon 2020 program and use a panel of sector experts to do due diligence and monitoring? My guess is this may be done by the Future Fund’s partner, the British Business Bank, or via their third party proxies like Newable and AngleCoFund. Having seen them spin their edtech credentials at the launch of the DfE’s £4.6m Edtech Innovation Fund, I am not confident.
Since the Future Fund was announced I have spoken with a range of contacts in the tech startup scene (no incubators or funds). I didn’t find a single one who thought this relevant for their company. The best description came from a successful entrepreneur who said, “it’ll just end up funding a load of ‘AI-enabled’ dog-dating apps”.
So what can be improved?
- Have a tiered system starting with a low (£75-£150k), mid £150-£500k and high £500k-£2m (not £5m). Both the first two bands should/could be EIS/SEIS eligible but not the top level
- Set a fixed maximum rate for funds at 8% (same as Future Fund and taxpayers)
- Disallow funds from charging companies ongoing investment fees. These are a common way of clawing back large chunks of their investment (for doing pretty much nothing in most instances) and reducing risk
- Quickly set up a small group of expert advisors who are prepared to help at a fixed reasonable day rate, say no more than £750 or at least 75% off their standard published rate. The work should be very specific and limited with a review turnaround in 48-36 hours (depending on deal size and complexity)
- Only UK-domiciled companies and funds should eligible to participate, i.e. not if your company or fund is based in offshore tax jurisdiction
- No share buybacks for the duration of the loan
- Remove the early payout,100% penalty bonus to funds and make it the same as for Future Fund/taxpayers
- No startup where the senior management team earns more than £100k/year in the last 5 years is eligible and the same salary packages for the entire SMT applies for the duration of the loan
- All loans and terms must be publicly published by Future Fund, BEIS or the OBR for its duration. This will include amounts, terms, milestone dates and similar information
- Eligible companies must, as in EIS/SEIS have only one class of shares (ordinary shares). If not, the Future Fund and fund shares should rate no higher than those given to existing EIS/SEIS investors and not contain any liquidation and similar preferences
- Future Fund should set up a public share fund giving UK taxpayers the opportunity to buy any small amounts as an ISA (max £20k p.a.) of converted equity from the program
These are just a few thoughts, but will it work or make a difference? I doubt it, but it makes good political sense because it makes what looks like a substantive gesture but isn’t. Allowing funds to have such unbalanced terms shows the paucity of commercial acumen at BEIS and with everyone who rushed out this deal. On the upside the Chancellor seems astute and has already sidestepped the knuckle dragging of banks to get government-backed loans more quickly to small businesses. That’s smart, effective and good politics. Future Fund ‘s rescue package right now looks like a dog’s breakfast, and if they don’t seriously improve it then keep an eye out for a pack of ‘AI-enabled dog dating apps’.