Venture Capital for the People
Instead of giving loans or bailouts to startups, governments should respond to the coronavirus crisis by becoming investors – and using their stakes to shape the future of the economy in the public interest.
According to the publication Business Insider, Britain’s biggest unicorn startups are ‘begging the government’ to help them out. Since the unfolding of Covid-19 and the rapid demise in business activity – and entrepreneurship in particular – startup founders and investors alike have made desperate calls for help from the government. So far, no unified response has been launched for startup companies in the UK, in stark contrast to other European countries such as Germany, which put together a €2bn package already.
It seems inadvisable to let startups bear the brunt of Covid-19 given their impact on (current and future) jobs and innovation. What the government has announced so far follows a rather unimaginative path that has been trodden under comparable crisis-situations before, last after the 2008 financial meltdown: tax breaks and suspensions, coverage of sick pay, free grants, loans. In other words: free money on all fronts, almost without any conditions beyond eligibility criteria. Not only is it a question of fairness that standard SMEs – think a small manufacturing company or a simple bakery – are treated in the same way as highly risky startups, it is economically unsound.
In the US, critics have raised their voices amidst the enormous almost-no-strings-attached state-funded bailout of over $6 trillion to industry, including airlines and hotels (that have spent billions on share buybacks in recent years). The bailout mirrors in its structure and likely effects the bank-bailouts from over a decade ago. It is as such nothing but a gift to executives and shareholders, in other words: people that already have lots of money (and capital) in their pockets.
So, if we agree that statups as much as any other company are in need of help, what’s the alternative? Startups – particularly early stage ones – should not be bailed out but bought out. They are used to equity investors, so-called venture capital funds, exchanging cash for a portion of their equity. This is undoubtedly a risky process – between 60-90% of startup companies fail without making any profit for their investors – but there is at least the possibility of an upside that any grant or loan or other form of non-equity bailout is missing. In addition, there is another benefit that comes with equity (particularly if it is a substantial amount): governance.
Grace Blakeley has recently written the government set conditions for the companies it gives money to; this could be baked into any possible state-VC-system. Once you own 20% of a company, you have a say what its strategic direction looks like. So not only does equity investing come with the same downside as handing out free cash (you could lose all your money); it has the big advantage of being able to profit from any (financial) success, and gives you a say in the future direction of the company.
Public Moonshots
Curiously, there are some historical examples of states – specifically the US – deploying comparable mechanisms in the past. A recent book about Silicon Valley by Harvard historian Tom Nicholas, VC: An American History, introduces government-sponsored SBIR investments as a precursor to commercial venture capital. In many ways, Small Business and Innovation Research is comparable to the highly-lauded DARPA (Defence Advanced Research Projects Agency).
First tests for SBIR were run in the 1950s and 1960s (together with the establishment of SBIC, Small Business Investment Companies, in 1958) before pilots started in the 1970s and the programme was established in 1982. The idea is simple: all government agencies with more than $100m research budgets are required to set aside between 2% and 3.5% per year specifically for small firms. Through a competitive, multi-phased sequence of investments, agencies select projects with high potential and attempt to bring them from concept development to commercialisation – very similar to any commercial venture capital.
There are contemporary models for a public-VC vehicle, two of which are worth mentioning: CalPERS, the California Public Employee Pension fund, and HTGF, the German High-Tech Gründerfonds, established with significant investment by federal and state money in 2005. To begin with, CalPERS announced its direct investment programme in 2018, which will put up to $20bn directly into late-stage startups, as well as more established companies. Since the 1990s, CalPERS have been undertaking secondary investment in late-stage companies as well as co-investments with existing general partners in venture capital and private equity funds. These assets have made up slightly under 8% of CalPERS $366bn portfolio so far.
In comparison, HTGF or High-Tech Gründerfonds is a public-private German VC firm whose focus is on early (seed) stage companies with a deep technological core. They are mainly working with new ventures in the life science and hardware industry, such as Amal Therapeutics or Blickfeld. Investment sums are small (typically €250-500k) in exchange for significant equity to increase governance rights and decrease risk. Since 2005, HTGF received funds from federal ministries as well as blue-chip German companies (e.g. Bosch, Bayer, BASF, Daimler, Siemens). Within 15 years, they invested in more than 600 companies and over 100 of them had successful exits returning capital into state pockets among others.
In theory, two vehicles not too dissimilar from this model have been established in the UK too. Since 2011, the Angel CoFund, an initiative by the government’s Regional Growth Fund and the British Business Bank, has been making equity investments in new businesses. So far it deployed £41.5m to 82 businesses enabling £138m from so-called ‘business angels,’ wealthy individuals who invest personal capital in early-stage development. The British Business Bank itself, a government-owned business development bank only established in 2014, has two additional VC-focused investment vehicles worth more than £3.5bn altogether. Both enable – but don’t execute – equity investments through fund-of-fund vehicles, mostly into established VC funds.
What the UK government has deployed as crisis-response, however, is nothing but loans, including what the BBB is offering with its Coronavirus Business Interruption Loan Scheme (CBILS) for SMEs. Through established ‘lenders’ such as Barclays, Bank of Scotland, NatWest and Co, companies – including startups – can apply for up to £5m of asset finances, invoice finance and term loans. For early-stage startups, the Start-Up Loans programme (£500-£25,000 with 6% interest p.a.) ‘may be more suitable’, as the BBB’s website advises. It is not clear why.
More encouraging steps have only appeared with the announcement of the £250m ‘Future Fund’ this week, which is to be established in May and administered also by the BBB. It is similarly going to be based on loans but they have at least the chance of converting into equity (so avoiding repeating the Tesla-mistake in the US from ten years ago). The problem with this investment vehicle is that it is missing the crucial governance angle. As Check Warner from Diversity.VC points out rightly: there is a chance that diversity will be sidelined with this support which doesn’t attach conditions to its funding.
The best case scenario for loans is that the company survives and the loan is repaid. The best case scenario with equity investments is that the company survives and thrives, and the government is able to realise a high multiply on its original investment and have a say in the kind of company that develops. The worst-case scenarios are the same: the money is lost. Why has no government so far been willing to make this bet? We are in a time of deep crisis when failures and misjudgements are common-place – this is exactly when something like proper government-venture capital should be tested.