Wednesday, 5 January 2011

Government and Startups: Financing

How can the UK government help with startup financing?

London co-working space Techhub recently hosted an event featuring a Q&A with government minister David Willets on the topic of how the government can help the local tech startup community. Several interesting points were raised, but the two main issues seemed to revolve around finance and labour. In this post I’m going to focus on startup finance and I'll do another one later with thoughts on labour issues.

All businesses need capital in order to function - both seed capital to get going, and further capital to grow. Broadly, this capital can take three forms, and the government can assist with all three.

1. Debt Financing
There was some discussion during the event about how banks weren't lending to startups. It’s important to understand that banks aren't generally in the business of risky financing (relative to equity). Banks will only lend where there is reasonable expectation that the borrower will be able to meet the repayments schedule. This normally means either stable cashflows or reliable outstanding receivables. They will often want personal guarantees or collateral. 

The Silicon Valley Bank coming to London is good news - they’re a bank which knows how to deal with startups, and will no doubt make life a bit easier as well as encouraging other banks to up their game. But ultimately they are a bank with exactly the same fiduciary duties as any other bank - they're not going to be handing out credit like candy.

Debt financing may also come in the form of loans from friends and family. I'm not sure structuring this kind of financing as debt is a particularly great idea since most likely they’re taking on quite a lot of risk for limited upside, and so it's a better deal to offer them equity. However some might prefer the simplicity of a loan. 

How the goverment can help: In truth I think there’s not a lot the government can (or should) do to interfere with bank lending procedures. Schemes like the Enterprise Finance Guarantee are a useful short term measure for a tight economic climate, but will only help those on the margins of lending decisions. 

2. Equity financing
For the vast majority of startups, equity financing is the most important source of capital. Equity investors will usually specialize by sector and investment stage depending on the level of risk they are willing to take. Early stage investment will usually always be riskier than later stage.

Equity finance might come from individuals (business angels, friends etc) or from institutions such as VC funds.

How the goverment can help: As with debt finance, it's not the government's job to change investment criteria or decide which individual businesses should get investment. However there are at least two ways the government can increase the total quantity of equity capital available for early stage ventures -

a.) Capital Gains Tax. The presence of taxation skews the risk-reward curve, since it affects the ultimate cash return from the investment. By reducing capital gains tax investors get higher returns for the same level of risk.

b.) Increasing the supply of capital directly. The best way to do this is to invest alongside outside investors with an existing fund manager. This is exactly what ECFs are designed to do. It would be great to see some top tier VCs participating in this program. David Willets promised to come back for a second session with somebody involved with the ECFs in January, so keep an eye out for this. In particular it will be interesting to see what the minimum investment amounts are for these funds and how they can balance that with attracting the best fund managers.

3. Internal Financing
Finally, the best kind of financing is from customers (i.e. from revenues). Typically most startups will not be able to make enough from this source to fund high speed growth, but we shouldn't ignore this as an source of finance.

How the government can help: Buying from startups. This includes making startups aware of opportunities to bid for government work, and also the “competition prize” model for innovative solutions as with the Technology Strategy Board.

Should the government help with startup finance?
We've addressed some of the things the government could do to assist startups. Whether they should do these things or not is more difficult question. Some will carry a financial cost (like reducing CGT), which may not lead to an immediately measurable return. Every pound spent in this way is a pound that could be spent on more established industries, the NHS, education etc and is ultimately a policy decision for the government. 

In addition to the usual government capital allocation problem, any situation in which a the government is directly injecting cash into startups risks crowding out private investment and ultimately weakening the ecosystem. This kind of intervention only makes sense where there is market failure, and it's not immediately clear that this is the case. 

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