As the gilded elite of the UK’s start-up scene gathered for the launch of London Tech Week last month, Rishi Sunak was feeling nostalgic. In his opening address, the Chancellor said the “adventurous, optimistic and forward-thinking” attitudes of the UK’s entrepreneurs reminded him of the culture he had “lived and breathed” in California in the mid-2000s.
“I’ve been travelling a lot in the last few months, right across the UK, and wherever I go, I meet young people who are hungry, ambitious, unencumbered by timidity and orthodoxy,” the Chancellor told the investors and entrepreneurs in attendance. “And looking at all of you, I know that we’ll see that same spirit here at Tech Week, too. So I’m optimistic, and the statistics show there is good cause to be optimistic.”
In recent years, the Chancellor noted, the UK has created more tech “unicorns” – startups valued at more than $1bn – than any other country except the US and China. Between January and May, British tech companies raised £12bn, surpassing investment in Chinese tech companies for the first time in recent history.
But it is what comes next that unnerves those working in the UK’s start-up world. While the sector has continued to drive significant growth since the aftermath of the 2008 crash, a toxic cocktail of economic drivers now threatens to undermine confidence in the sector.
It is feared that the effects of the US downturn – where the tech-heavy Nasdaq Composite stock index has fallen by 29 per cent this year, at time of writing – will soon be felt on this side of the Atlantic. And there are concerns among investors that Sunak and his government have yet to acknowledge the scale of the challenge facing the British start-up sector in the years ahead.
“For the past 10 years it has been a continuous story of economic growth,” says Dom Hallas, executive director of the start-up trade body Coadec. “The British technology ecosystem is the third best technology ecosystem in the world. That’s great economic storytelling, and we should be telling it loudly and proudly. The challenge is that the narrative and the shift in the market over the next few years will run contrary to that story.”
Warning lights are already flashing. They shine most brightly among the subset of start-ups whose valuations ballooned during the pandemic. In 2020 Hopin, a virtual conferencing platform, became the fastest-growing British and European tech startup in history after reaching a $7.8bn valuation just over a year after its launch. In February, however, as lockdowns lifted and the demand for virtual events fell, the company took the decision to lay off 12 per cent of its staff.
The valuations of on-demand grocery delivery companies also skyrocketed during the pandemic as investors sought to capitalise on what they believed was the latest frontier of the gig-economy boom. But since the beginning of the year, Getir, Zapp and Gorillas – three of the most deeply leveraged players in the market – have announced hundreds of redundancies as they fight to prove their business models are sustainable post-pandemic.
It isn’t just entrepreneurs capitalising on pandemic trends who are now feeling the pressure. The “buy now, pay later” company Klarna, which offers deferred payments on fast fashion, furniture and other goods, raised funds at a $46bn valuation in its last round. But as interest rate rises squeeze its already ultra-thin margins, the company’s estimated valuation has fallen dramatically. After failing to secure funding at a $30bn valuation earlier this year, Klarna is close to raising funds at a $6.5bn valuation, according to reports.
The secrecy surrounding start-up valuations means that when news of such a ”down round” leaks, there is a significant ripple effect across not just the sector in question but the whole start-up ecosystem, according to Henry Whorwood, head of research and consultancy at Beauhurst, a platform for investment data. “An investor would be mad not to bring [Klarna’s valuation] to the table in any transaction,” Whorwood adds. “Obviously, the company might rebut it and say, ‘Well, that’s only applicable to fintech, or only applicable to unicorns of that size, or only applicable to buy now, pay later’. But that’s exactly how the negotiation plays out.”
Beauhurst’s analysis, however, suggests that there is not yet evidence of a significant number of down rounds in the British market. A more common trend, however, is what Whorwood calls “haircuts”, in which companies raise money at a higher valuation than their previous round, but at a lower valuation than they and their investors had initially anticipated. The scarcity of data on intended valuations makes this even harder to track. “We do in some cases hear of that happening,” says Whorwood, “and that’s the most pronounced place where we’re seeing the effects of a potential downturn.”
Start-ups aren’t alone in raising unprecedented levels of funding in recent years: so too have the venture capital (VC) firms that make long bets on their growth. However, investors are sceptical that the top-line public funding data cited by Sunak and others tells the whole story. “If you didn’t raise in 2021, and you need to raise this year, it’s going to be a lot harder,” says James Wise, a partner at Balderton, which has backed several high-profile startups, including Darktrace, Revolut and LoveFilm. “Although there were record numbers of capital and record numbers of new funds being raised, a lot of these funds are now going to be directed at investors’ existing portfolio, making sure that the investments we’ve already made and the funds we’ve already backed have the capital and the time to build the companies they need to.”
The biggest concern within the VC community is what happens when they next seek to raise funds from their institutional investors. VC investing is becoming more expensive at a time when returns may also diminish. A series of base rate rises by central banks means the era of free money is coming to an end, pushing up the cost of loans. But if the downturn in the public markets continues, the returns on those investments will also fall, because it will become more difficult for start-ups to “exit” via public listings or acquisitions.
This is a particular concern in the London market, because so much of the investment that flows into the start-up scene originates overseas, either from sovereign wealth funds via mega-investors such as SoftBank’s vision fund; the cluster of American VC firms that have set up shop in Mayfair; or more traditional institutional investors in North America.
“Ontario teachers are probably the biggest beneficiaries of the great companies and value being built in UK tech,” says Wise. He is only half joking. The Ontario Teachers’ Pension Plan has been one of the most significant investors in the UK tech scene in recent years. While the appetite for late-stage investments is diminishing fastest, the fund committed to doubling down on that part of the market in April. But Wise warns against complacency: “International capital can also disappear quite quickly in times of crisis.”
Leo Ringer, a partner at Form Ventures, shares Wise’s concerns about the difficulties venture capital funds will face when they next raise money. “It might be that the LP landscape is still much thinner,” he says, referring to the limited partnerships that invest in VC funds. “It may be less resilient than the venture capital fund landscape has become in the UK in the last five years in particular. We’re going to find out how resilient it is, and that’s really for me the longer-term structural question.”
The UK’s outsized dependence on foreign investors is both a structural and cultural problem. Caps on the fees pension funds can charge retail investors incentivise them to invest in passive funds rather than those managed by venture capitalists and other active investors. The debate over reforming these rules is as old as the start-up sector itself and investors are awaiting the government’s response to a consultation on reforms. Wise says “the direction of travel is great, but the speed of travel is not”. He says “we don’t yet have final decisions or policy in place, which obviously creates some uncertainty for venture capitalists”.
This isn’t just a policy problem, however. There are deep-rooted frustrations within the tech sector that, despite its growth over the last ten years amid the challenges presented by Brexit, the City establishment still treats it with hostility. Many of London’s financial institutions “want to invest in real estate and old-school City brokerages because that’s what they’ve done for the last 40 years,” says Wise. “That is a cultural challenge and while the government is doing a bit, it could do a huge amount to overcome it.”
Hallas agrees. “This is part of a much longer term conversation about why the City of London as a financial institution has become much more conservative,” he says. “You have a financial market that 30 years ago was perceived as one of the foremost in the world. And now we have a stock exchange that’s just miners and banks and has seen no real growth in the past 20 years, because it doesn’t have those technology companies.”
Encouraging pension funds and institutional investors to invest in the scene would reduce its reliance on funds that have been blamed for over-inflating the value of certain sectors. Hallas says the question is “how you build a more sustainable market that allows for UK investors, pensioners and others to benefit from the growth of the ecosystem – and yet do it in a more sustainable way than we might have seen with foreign capital inflows into technology ecosystems everywhere”.
When technology companies do list on the London Stock Exchange, as Deliveroo and Darktrace have in the past 15 months, they face a challenging market. Deliveroo’s valuation has fallen 67 per cent since it listed in April last year. Darktrace’s market capitalisation is down by 10 per cent and is valued much more conservatively than comparable companies on the US’s Nasdaq exchange. In response, British companies are increasingly likely to list on the American exchange instead.
Nevertheless, like many members of the community, Hallas is ultimately optimistic about the sector’s future. “Even though there are going to be jitters and there are going to be challenges, the reality is that the sector will continue to be the heart of the British economic growth story,” he says. Companies in the on-demand delivery, fintech and cryptocurrency sectors are expected to be hardest hit. But there are “some sectors which remain incredibly competitive and incredibly buoyant”, says James Wise, citing those developing software applications for biology and technologies to accelerate the green transition.
Meanwhile, Sunak’s championing of the sector is welcomed by investors and entrepreneurs. The government has pursued a range of start-up friendly policies during the course of the pandemic. However, it is the pace at which policy is formulated and the delays in its execution, such as with the roll-out of start-up visas, that creates barriers for the UK’s high-growth tech businesses.
If the structural and cultural issues aren’t resolved, the next wave of entrepreneurs may also find it much harder to raise funding. Start-up creation, Hallas notes, has remained largely flat over the past five years. “There are policy fixes,” he adds, “but they’re long-term policy fixes and you have to put the work in now in order to create the environment that allows us to benefit and grow the most next time round, when the market rebounds – which inevitably it will.”
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