A hot topic right now in the UK startup scene is the need for a government-backed equity fund, specifically targeted at seed stage startups. For varying reasons, many of these startups don’t qualify for some of the funding options already offered by government e.g. the Coronavirus Business Interruption Loan Scheme (CBILS).
The need for this fund is something that, on balance, I agree with. This is because so many seed stage founders are currently struggling to keep their businesses afloat due to private capital markets closing off — many of these startups could provide value to the country even in the short-medium term, and also currently provide jobs to so many people.
That being said, any fund will need to be limited in size, as the government will not be able to fund all the seed stage startups desperate for funding. So, if the fund is created, a set of criteria will need to be established to help the government choose which startups to fund.
To-date, it has been the views of a number of highly successful founders and people in the VC industry that have garnered the most attention in this debate.
This makes sense, as both groups tend to be smart, notable people, who have built or funded successful companies themselves, and amassed large followings as a result — so, when they share their views, they command a lot of attention.
In my opinion, it’s important that others in the startup ecosystem have their views shared widely too, particularly those seed stage founders who are going through the anguish caused by the crisis themselves. This will help give a more balanced viewpoint on which startups should receive funding.
Why Venture-Backing Shouldn’t be a Criterion
A number of VCs have suggested that the startups that qualify must be VC backed, as the due-diligence VCs put in mitigates the risk of funds going to startups with less potential.
My personal view is that the decision around which startups should be funded by government is a multi-faceted problem that needs to index heavily on the reasons why government intervention is important for economies in the first place:
1. To correct for market failures
2. To achieve a more equitable distribution of income and wealth
3. To improve the economy’s performance
Based off of this, VC-backing shouldn’t actually be a criterion for which startups should be funded.
This is largely because, when making investment decisions, the vast majority of VCs put a high weight on expected financial return over an investment horizon that is often a number of years — I have heard the phrase ‘10x return’ countless times.
Whereas public spending has to heavily weight social return, particularly due to positive externalities that are overlooked by the private market. Public spending also should carry a higher degree of certainty of putting taxpayers’ money to good use, whereas venture is inherently a high-risk business.
The biggest testament to this is the difference in the questions asked when filling out application forms for government grants vs those of a VC.
For governments grants (e.g. Innovate UK), a high proportion of the questions focus on the social return of your project, as well as the specific details of the project in the near term; whereas, oftentimes there isn’t even a section considering social returns on VC application forms and the focus tends to be on the long-run vision of the startup.
Crucially, also, many early stage founders have opted to go down the angel route, as it gives them more freedom in the early days — these founders shouldn’t be punished for this decision, as in the early stages it oftentimes isn’t clear what the optimal route to funding actually is.
Many of these startups would also have undergone extensive due-diligence from angel-groups and shouldn’t necessarily be considered riskier investments.
My Selection Criteria
Instead, I would propose a different set of criteria to help governments decide which companies to fund, ranked in order of importance.
1. Expected medium-term social & economic return — I would prioritise startups that will help provide value to the country over roughly the next 18 months. This is the typical runway length of a seed round, and so the period the government will be able to guarantee the startup’s existence for.
During the next 18 months, the services of certain startups are going to be more important than others as the country battles and recovers from the deep economic, physical, mental and social effects of the pandemic.
A set of key sectors and sub-sectors could be chosen as high-priority. For example, a startup that could help with providing testing related to coronavirus would likely receive priority over a startup revolutionising the dating industry.
I would put a substantially higher weight on this criterion over others. If a startup cannot clearly demonstrate how it can help the country in the near-term, I would question its suitability for government funding.
2. Current Runway — Those seed stage startups with shorter runway (expected time till cash runs out) should receive higher priority, as those are the startups most at risk of going bust. This could be calculated by cash in bank divided by average burn/month over the last 12 months.
3. Team Size — Startups that currently employ more people should be given higher weighting, as the economic damage of them going out of business will, on average, be higher. More of their staff will have difficulty in finding work in an economy that, for the foreseeable future, will struggle to soak up jobs.
4. Burn-rate — We don’t know when the private investment markets are going to stabilise. So, I would prioritise startups who will last the longest with any allocated government funding (i.e. those with lower burn rates). A historical average monthly burn rate over the past 12 months could be used as an indicator of how much the startup needs to spend to provide value.
Some of the selected startups will have venture backing, but others would not. I would limit the scheme to startups that have completed at least a pre-seed round and are at seed stage.
This would reduce the riskiness of the startups that the government is funding. If the VC sector is unable to support ‘scale-ups’, I would potentially have a completely separate government equity vehicle for these scale-ups, as it doesn’t make sense for startups to be competing with scale-ups for funding.
The scale-ups could be assessed on similar criteria.
How the government reacts to the seed-stage funding crisis is hugely important, as many of of the UK’s startups have the potential to create economic and social returns for the country even in the short-to-medium term.
The process for deciding which startups receive government funding should have robust criteria that startups are scored on (similar to applying for an Innovate UK Smart Grant) and crucially the criteria should take into account both the short-to-medium term social and economic potential of the startups.
In the long-term, it is very difficult to predict which early-stage startups will have the biggest social and economic impact.
As such, we shouldn’t be trying to ‘pick winners’ with taxpayers’ money, especially at this time where there is so much uncertainty about what the world will even look like over the next few years. Instead, I would focus on the short-to-medium term where uncertainty is lowest, giving priority to those seed-stage startups that could help the country overcome the pandemic and its aftermath over the next 18 months.
I would also allocate resources to those startups who could benefit most from a cash injection in the near term i.e. startups with short runway, who provide employment for a larger number of people and who will be able to survive longest with the cash.
The exact mechanics of the investment is beyond the scope of this article. For example, the investment could take the form of a convertible note, a traditional equity investment or potentially even a grant.
About the author
Nii Cleland is CEO of Flair Football, the UK’s leading app for young football players. Prior to that, he worked for Goldman Sachs in emerging market credit sales. He holds an Economics degree from the University of Warwick (1st Class) and an MSc in Technology Entrepreneurship from University College London (Distinction). Follow him on Twitter and Instagram