How COVID-19 terraformed the startup funding landscape

All hope abandon ye who enter here. If 2020 had a tagline, that would be it. It's been a rotten year for the startup community. The Coronavirus pandemic has caused unprecedented economic damage, imperilled revenues, and poured cold water on investor confidence.

For legions of ambitious businesses, the last 9 months have been about survival. Of keeping bills paid and people employed until some version of the 'old normal' returns.

This challenge, unamiable at the best of times, has been made all the more difficult by a dramatic reshaping of the innovation funding landscape.

Equity investment in early-stage business has slumped, government aid has skyrocketed, and SME debt has spiralled to record-breaking levels.

With so much change, I wanted to take stock of what has happened, and how UK startups - the country's innovation engine room - have been affected.

Beware the Ides of March

Founders entered 2020 with a customary spring in their step and a pocketbook of ambitious targets. Ritam Gandhi, founder of digital solutions developer Studio Graphene, was hoping to "build on the strong foundation from the last 5 years and make a number of strategic investments into our business." While Stuart McDonald, founder of Velocity Smart, was gearing up for "market dominance” and “significant customer growth”.

Then, on 31 January, the first case of Coronavirus in the UK was confirmed. Just seven weeks later the country entered lockdown, decimating the travel, tourism, leisure and hospitality sectors, and grinding much of the country to an eerie halt.

The impact was devastating. Figures from the ONS showed the economy shrank by more than 20%, the largest contraction ever recorded. Small businesses were particularly hard-hit, with one survey finding that an astonishing 80% of British SMEs were suffering from falling revenues.

As hopes of a v-shaped recovery faded, and with COVID-19 continuing to spread, equity investors sought shelter. One study from analytics firm Beauhurst and co-working provider Plexal found that, since 23 March, investment in startups and high-growth businesses has fallen 21% compared to the same period last year.

More worryingly for startups, the COVID-19 impact tracker found that the amount of funding taken on by businesses in their first fundraise has collapsed, plummeting 52% relative to 2019.

These are not symptoms of an overall decrease in equity investment. In fact, Pitchbook's Q3 European Venture Report shows that 2020 will likely become the biggest year for allocations in the continent's history.

Despite galeforce headwinds, equity investment is actually increasing. But the prevailing uncertainty has inspired more safety-conscious attitudes. VCs are doubling down on their existing portfolios, shielding them against further turbulence, and participating in larger, later-stage rounds for more established businesses concentrated in thriving sectors.

The Government Intervenes

Faced with narrowing access to equity funding, many startups have turned to the range of government aid schemes launched in the wake of the first lockdown.

Bounce Back Loans have proven immensely popular, with founders like Anwar Almojarkesh, at Innovation Factory finding them “very useful”. Offering SMEs up to £50,000 in government-backed, low-interest debt, with no fees or interest due for the first 12 months, the BBL scheme has paid out more than £42 billion to nearly 1.4 million applications as of 15 November.

With the government extending the BBLS into the new year and softening its repayment terms through the 'Pay as You Grow' initiative, we can expect a wave of new applications through the festive season.

Schemes that predate the pandemic, like R&D Tax Relief, have also seen spikes in annual applications, thanks in part to accelerated processing speeds.

HMRC's latest annual report revealed a 20% surge in SME claims for the 17/18 financial year, and a 10% leap in first-time claimants, driven mostly by startups and scaleups. Claim volume also soared 17% to 62,095, with HMRC paying out £5.1 billion in relief, a 15% increase on the previous year and the greatest sum in the scheme's history.

The Future Fund

As popular as Bounce Back Loans have become, they are only designed to help businesses cover their immediate cash requirements.

Stuart at Velocity Smart, which took out loans from the BBLS and CBILS, put it succinctly: "They provided some short term cashflow support but did not address our growth requirements."

Stuart's observation mirrors a survey conducted by the British Chamber of Commerce and the TSB banking group, which found that the overwhelming majority of businesses were accessing loan schemes to support "critical day-to-day business operations". Of the companies surveyed, more than 70% said they were using Coronavirus relief to offset lost cash flow, while 40% were using it to subsidise wages.

Enter the Future Fund, a hybrid loan-investment vehicle delivering between £125,000 and £5 million in convertible loan note agreements (CLAs) which turn into equity at a recipient's next raise. Unlike other schemes, the Future Fund is based on match-funding, meaning the state's investment must be at least equalled by third-party equity investors.

While Bounce Back Loans and the CBILS are designed to help businesses keep the lights on, the Future Fund was established to lure growth capital back to genuinely innovative early-stage companies, as identified by seasoned Angels and VCs.

Has the Future Fund succeeded? The headline figures are promising: 745 companies approved for £771m of CLAs so far, delivering at least the same again in private investment.

But beyond this-top level data, there is scant information about which companies have received funding. There is also no guidance on how much interest recipients are signing up for, which weakens the negotiating position of future applicants while strengthening the hand of participating investors.

This lack of transparency has caused concern over the effectiveness of the scheme, which companies are benefiting, and whether investors are exploiting the Future Fund to sure-up holdings in businesses that would have no trouble raising additional growth capital.

A fascinating simulation conducted by Beauhurst has shone some extra light on Future Fund recipients. Assembling a proxy cohort of theoretically eligible SMEs, Beauhurst found that technology and IP-based businesses were likely to dominate the CLA receipts.

SaaS businesses comprised 19% of Beahurst's cohort, followed by companies in the Internet Platform (14%) and Mobile App (13%) sectors. This makes sense, given these three sectors also soaked up much of the private investment allocated over the eligibility window.

While I applaud the various schemes the exchequer has designed and implemented to support businesses, we shouldn't have to rely on private companies to simulate the workings of such a vital programme.

The government needs to be more transparent about where taxpayer money is being invested and must be willing to accept input from the broader business community on whether enterprises housing vulnerable innovation, across the full spectrum of sectors, are receiving the necessary aid.

With pressure being applied by the British Business Bank - which administers the Future Fund - and Darren Jones, chair of Commons' business, energy and industrial strategy committee, we may soon get a clearer understanding of the scheme's efficacy.

SME debt skyrockets

The prolificacy of the government's loan programmes, coupled with a steep increase in the demand for debt funding, have propelled the annual growth rate in SME debt to 22.8% - the highest rate since records began.

While large businesses have mostly paid off their emergency loans, startups and scaleups are shipping more and more debt. SME debt increased £1.6bn In August alone, while larger firms repaid £5.8 billion in aggregate in the same month.

True, the majority of SME loans are accompanied by the generous terms outlined above. But fears are growing that these debts will ultimately shackle startups moving forward, suffocating growth, and producing a generation of stagnant companies.

The Pay as You Grow scheme, which lightened the obligations of indebted startups, is a huge step in the right direction. With multiple vaccines on the horizon, and a healthy recovery hopefully close behind, the government must continue to show empathy and flexibility as startups recover from this extraordinary crisis. 

Optimism for 2021

The funding landscape may have changed, but one thing has remained hearteningly consistent: optimism amongst founders. Despite the shocks of the last year, there is an unwavering hope for a better 2021 in the startup community.

Studio Graphene told us, “we are very optimistic about 2021 and feel that whilst 2020 has been a challenging year, we do believe that the world will bounce back and everyone will be more resilient,"

The excitement is particularly palpable at companies which are well-positioned to capitalise on the mainstream embracing of digitisation and virtualisation.

As Anwar at Innovation Factories explained, "we are very optimistic as a company working on Artificial Intelligence. I think now it becomes an important part of our daily life."

This optimism must be encouraged by sensible policy, bravery from the equity investors once the economy rebounds, and most importantly of all, continued investment by the government.