International VC trends: The UK experience. Interview to Zickie Lim of Mills & Reeve LLP
- How did the UK startup/VC market evolve in 2022? Have you noticed any changes in terms of numbers, size, sectors, and types of investments compared to 2021? What are the main expectations for the UK VC market in 2023?
There has been a significant slow down in Q1 2023 with fewer VC investment deals being done and less being invested as against this time last year. 2022 in itself was down from 2021 which really was a boom year for Venture Capital investment deals globally. This slow down has been caused by a number of factors – high inflation and ballooning energy costs, the turbulence in the US market with the stumbling of BigTech stocks and the continuing global uncertainties caused by the Ukrainian / Russian war and heightened US/China tensions. The jitters in the global Banking Sector and the speed of the collapse of Silicon Valley Bank (SVB) and, thankfully, its rescue in the UK, by HSBC, have also added to the concerns. Consequently, Venture Capital and early stage equity investors are feeling very cautious and investment deals are taking longer to complete. The amounts being raised by companies are slightly lower, with investors pressing more conservative valuations on companies in an effort to ensure they can still recover the multiples they are looking for, notwithstanding the challenging market context. Investors are also putting a greater emphasis on management teams which can demonstrate disciplined capital efficiency, a focus on long term value creation and some level of revenues (many investors are now looking for Annual Recurring Revenues (ARRs) in the region of £750k to £1m as a filter for any potential investments). Many investors are therefore looking to invest at a later stage where the risk is less about technology development and more about market risk.
However, the landscape is not all doom and gloom. This is because there is still significant ‘dry powder’ available (meaning a lot of UK based or focused venture capital funds were successful in raising large pots of money over the last year or two and that pent up capital needs to be deployed over the next few years). In addition, there are still large numbers of new companies being formed, so the pipeline for future investment remains very strong. In addition, various new funds have been launched/announced to specifically support spin-outs from various universities in the UK which should help support a strong spin-out ecosystem (eg Northern Gritstone, a £245m investment fund created to invest in spin-outs from the Universities of Manchester, Leeds and Sheffield and the most recently launched Midlands Mindforge, looking to raise up to £250m for predominantly investments in 8 Universities in the Midlands, including the Universities of Warwick, Nottingham, Birmingham and Aston). Furthermore, the UK Government has recently extended and expanded the Seed Enterprise Investment Scheme (SEIS) so that more money can be raised over a longer period from investors using that scheme. SEIS gives certain tax reliefs to investors who invest in certain high risk early stage businesses that meet the SEIS criteria. This will encourage more investment into UK start ups and spin-outs at the earliest stage. Added to all this, we continue to see lots of interest from US and European investors in life sciences and deep tech in the UK, attracted by the quality of technology and R&D, the strong eco-systems and clustering which has been built up around these businesses to support them and the attractive valuations which are now being discussed.
- Which sectors were most attractive in 2022? And which sectors in your opinion will be more attractive in 2023?
Life sciences and deep tech (particularly AI/machine learning) continue to remain popular and we do not anticipate their becoming less popular. We think green/clean tech and businesses promoting sustainability will become increasing popular through 2023 into 2024. Space also seems to be raising its profile, but is likely to remain fairly niche for the time being.
- Which financing instruments are more often used by UK investors when investing in emerging companies?
Equity remains the most popular, with the traditional “alphabet” share classes dominating the majority of rounds (eg Seed, Series A, Series C, Series C). Convertible loans notes have also been widely used, along with advance subscription agreements (known as ASAs) (or its US equivalent, SAFE – Simple Agreement for Future Equity) – both of these are used to provide bridge financing of a business at a time when the investors are not clear what the valuation of the business should be. Typically, on a next equity funding round of the Company, that will set the price at which the money advanced under convertible loan notes or ASAs is applied for the subscription of shares in the company, often at a discount (of between 10% and 30%) to take into account the risk taken by the loan notes or ASA investors. We have not seen much venture debt funding, and suspect that these rounds may be less popular given this often accompanies a significant VC led funding round, and the issues with SVB (who were one of the primary venture debt providers).
- What is your experience with VC cross-border transactions (i.e., sector, size, and typology of investments)? What are the most common legal issues when assisting a UK investor in investing in a startup not based in UK?
We as a firm can only advise on English law matters so the way in which we’re able to support UK investors looking at investing in businesses outside of the UK is by connecting them with our best friend firm’s in other jurisdictions, such as Portolano Cavallo and working with them. We have seen some UK VCs increase their focus abroad, however the issue of valuations remains a problem for UK funds looking at opportunities in the US. Europe is perhaps an area of increasing interest and focus for UK funds, especially in areas like deeptech and greentech. We recently advised one of my UK deep tech fund managers who has set up a Pan European fund on an investment by them into a Danish company. We worked closely with their Danish lawyers to effectively create a set of investment legal documents for their investment into that business which works with local Danish law and investment practice but which incorporates their typical provisions and approaches in respect of the rest of its UK portfolio.
We have also worked with UK companies who are receiving investment from overseas investors, as well as helping overseas companies relocate their businesses to the UK in order to enable them to attract investment from UK investors and take advantage of the active Venture Capital investment scene in the UK, as well as some of the tax advantaged investment schemes the UK Government has put in place to encourage investment in early stage high risk ventures (ie SEIS and its sister scheme for later stage investment opportunities, Enterprise Investment Scheme (EIS), and the Venture Capital Trusts scheme (VCTs)). One example is our work with API management platform provider, Gravitee.io, which was originally set up as a SARL company based in France. We helped re-structure them to put an English private company limited by shares in as its parent company and secure first a Series A Round of US$11m and then secondly, more recently, a US$30m Series B Round, including c US$10m of venture debt funding.
5. What advice can you give to an Italian startup looking for VC funds in UK?
- For early stage UK based businesses, the availability of SEIS and/or EIS relief will be very important in order to access a wide range of early stage investment funds. This would require the company to have a permanent establishment in the UK. A company incorporated outside the UK (eg in Italy), may be eligible to raise money from SEIS / EIS investors but sufficient operations/staff would need to be in the UK to qualify for permanent establishment. From a practical point of view investors, especially early stage investors such as business angels who are private individuals investing their own money directly into businesses, like to be able to spend time with the management teams of their investee businesses. So even if it is possible for an overseas business to raise money from UK investors under these tax investment schemes, you should consider how the location of the business / its key management can increase (or decrease) the chances of your company achieving this.
- There are funds that do not require SEIS/EIS relief to be available, so can invest in businesses outside of the UK but this is a much smaller pool of investors at the early start up stage. Otherwise, the start-up would likely need to have revenues or very exciting IP that would enable start-up investors to depart from their usual investment mandates.
- A greater amount of early stage funding will be available for startups if they are able to relocate into the UK (although it would be advisable to have certainty of investment prior to moving). Before doing so, you would need to do your research to understand where geographically in the UK may be the best place to re-locate your business to (aim to be within one of the clusters relevant to your area of business and it may be that a location outside of London is preferable from a costs and ability to secure premises and attract talent perspective). Also, you will want to ensure you have one or two key people in the business who will be permanently based in the UK and are or will ensure they can get well networked within the UK tech / life sciences eco-systems, so as to fully leverage the opportunities available to start ups in the vibrant UK tech scene.