The UK is prioritizing startup investors over startup entrepreneurs

And I think it’s a huge missed opportunity.

The UK Prime Minister, Rishi Sunak, has exciting ambitions for the role of tech in the UK’s future. He went so far as to put a joke in binary on the door of Number 10 Downing Street. It seems the priority is to attract external investment.

I’m a big fan of deep-pocketed investors arriving with bucketloads of cash and generating loads of jobs.

But I would also like to see an environment where startup entrepreneurs and early stage staff go on to build 2nd, 3rd and even more companies. I’d like to see a virtuous circle which encourages home-grown entrepreneurship.

Sadly, the current regime favours investors so much that it discourages serial entrepreneurs from build a vibrant startup ecosystem in the UK.

Here’s a story about how great government support is for UK startup investors:

I was recently involved in a pre-Series A funding round. It was into the 7 figures, so not a tiny round, but equally not a huge institutional round. The investors came from various countries around the world. Investors could choose to receive preference shares or ordinary shares. We don’t need to go into the details of what the differences are between these types of share. It’s enough to understand that preference shares are better for investors than ordinary shares. The clue is in the name.

Sure enough, the non-UK-taxpayers all chose preference shares. No surprises there. The UK taxpayers all chose ordinary shares. Bizarre behaviour. Why would you choose to have a share that would likely make you less money?

The answer is a pretty amazing tax incentive for UK taxpayers: SEIS/EIS or [Seed] Enterprise Investment Scheme. It gives an investor in early stage companies a credit on their income tax bill. It also comes with extra downside protection in case the investment goes under.

The UK taxpayers chose ordinary shares to guarantee that they could benefit from this EIS tax incentive¹. Let that sink in: the tax regime is so pro-startup-investor that, as an investor, you’re better off limiting the value of your investment so you can maximise the tax benefits. Still, as they say, “don’t hate the player”, so I am absolutely not surprised about why people chose what they did.

So much for the incentives available to investors. What about the entrepreneurs and startup employees actually doing the work?

There used to be something called Entrepreneur’s Relief. This was a preferential rate on the capital gains tax that business owners would otherwise have to pay when selling (parts of) their business. It used to have a very generous lifetime limit of £10m. It’s now been rebranded as Business Asset Disposal Relief and the lifetime limit reduced to £1m². Employees typically get EMI share options that share similar capital gains tax benefits to Business Asset Disposal Relief.

“So what”, you might say, “all these tax breaks are for the 1% of the 1%, why should I care?”

For sure, this is a very niche concern, which presumably is why the rules are the way they are. But, if you want to take a long-term view and build up a tech startup ecosystem, then surely you want to encourage more serial startup founders, rather than discouraging them?

To be clear: I’m not advocating for the abolition of anything here, nor for free money for anyone. I’m simply pointing out an imbalance that the UK needs to fix if it wants to encourage serial entrepreneurs. As things stand, UK taxpayers in 2023 are better off getting a regular income and then using the money they earn to make EIS investments, rather than doing the hard graft of creating a business themselves.

I can understand, if you’re taking a transactional view of individual taxpayer decisions, why you’d want to prioritise investors vs entrepreneurs and employees. An investor is making a conscious decision to invest into startup A vs in index fund B (or whatever) with every investment. On the other hand, tax planning is something that factors into the decision-making of approximately zero first-time founders and early stage employees. It’s the second-time (and later) founders where this kicks in. All that expertise and energy is actively encouraged to become semi-retired rather than starting new businesses.

This is not an isolated case. There are other examples which show how the UK takes startup entrepreneurs for granted these days:

1. R&D tax credits are becoming less attractive for SMEs.
2. The future fund that was supposed to encourage startups but didn’t: Some of the deal terms are awful, the sort of thing a VC’s lawyers would come up with and your lawyers would tell you to never agree to.
3. Oh, and even rebranding “Enterpreneur’s Relief” (exciting, aspirational) to “Business Asset Disposal Relief” (boring, administrative). What genius came up with that change? Why consciously go to the effort of changing something that sounds cool to something that sounds tedious?

I hope this whole area gets a good going over and somehow we move more towards an environment that makes life easier for startup entrepreneurs to build business after business after business.

Footnotes

1. There was some debate amongst the lawyers if you could structure preference shares in such a way that they would just about qualify for EIS, but none of these investors were prepared to take the risk ↩︎
2. As a comparison, £1m is the annual limit for EIS investments (or £2m if in “knowledge-intensive” firms) ↩︎

That’s not a business, it’s a hustle

“That’s not a business, it’s a hustle.”

I’m paraphrasing Dan Lyons speaking at a recent Chew The Fat event. He was talking about his time at HubSpot and wondering how a loss-making company could grow so fast, list, and make a lot of investors a lot of money. In his view its business model is fundamentally flawed: he describes it as buying dollar bills at face value and selling them at 75 cents each. That sort of model may well get you hyper-growth but it’s a hustle, not a business.

The image of the hustling, zillionaire tech entrepreneur who has never made worried about profits has become dangerously deeply ingrained. I recently got talking to a graduate – evidently a bright individual – who ran a business idea past me. It was to do with optimising a retail shopping experience. Quite a neat idea so I asked the obvious question: where would the revenue come from? The consumers or the retailers?

He didn’t have an answer.

He assumed that all he’d have to do is somehow get some VC money, spend it on scaling a platform with loads of users, then sell out and walk off into the distance with $50 million in his pocket. Now that’s a hustle, not a business. There are cases where this has happened. But there are also plenty of cases of people winning the lottery and I suspect that on a risk-weighted basis, winning the lottery is more likely than being a part of the next Whatsapp.

Please, if you want to become an entrepreneur, bear these two things in mind:

1. You stand a better chance of making a successful business if you have intimate knowledge of the problem you are trying to solve. If you’re targeting students then, fine, as a recent student you might have more than enough knowledge to build a viable business. But if you’re not then probably you would need to work somewhere for a few years to get that deep understanding first (“domain knowledge”, in the jargon)
2. You will stand a better chance of success if you can create something that makes revenue, profit and cash. All those things are different so make sure you have a clear idea of how they will interplay in your business. In fact, you might even end up with more money in your pocket if you build a niche, profitable, growing business than if you go chasing unicorns.

This doesn’t mean you need a detailed business plan. You just need to be articulate those two points in as straightforward a fashion as possible. Here’s a classic DHH talk to hopefully get you thinking along the right lines . Incredibly it is still as valid today as it was in 2008.

Startup Lessons from the English East India Company

The Company of Merchants of London trading into the East Indies was founded in 1600 as a scrappy startup trying to disrupt a spice trade dominated by the Dutch. Over the next two centuries it evolved into a solid financial performer, a regulated monopoly and then into a branch of government.

Please put aside for the rest of this post any concerns about the various and many reprehensible things done by, or in the name of, this company. Just look at it from the perspective of what it can tell us about growing and evolving a business.

Turns out that plus ca change. Much of what we obsess about in the world of startups today would be very recognisable to an observer in the 1600’s. In the 21st Century how companies get created and develop is not all that different to 400+ years ago. Shouldn’t be surprising as ultimately we are still people and people haven’t changed all that much over the centuries.

The quotes below are from John Keay’s The Honourable Company.

On being an early stage investor

The first voyage didn’t live up to founder or investor expectations but it was a pretty impressive feat nonetheless. Now there’s a sentence that could easily apply to every MVP I’ve seen. It set out in 1601 in search of the spice islands and their cloves. Didn’t quite make it but managed to return in 1603 with plenty of pepper.

[T]he 218 petitioners who in 1600 had become the Company of Merchants of London trading into the East Indies had subscribed for only one voyage. The majority now wanted their money back; they were not amused when instead they were told that for every £250 they had subscribed, £200 must be reinvested in a second voyage. (p25)

Same lesson applies today to any early seed investor. Make sure you’ve kept enough money aside for a top-up later on. Whatever you put in now won’t be enough.

On the importance of dog-fooding

England had one huge commodity at the time: wool. The Company was desperate to find a market for wool and thought that Japan might be a good bet. Unfortunately not so. Keay quotes John Saris, leader of this expedition who in 1613 wrote that:

The natives were now more backward to buy than before because they saw that we ourselves were no forwarder in wearing the thing that we recommended to them. ‘For’, said they, ‘you commend your cloth [wool] unto us but you yourselves wear least thereof, the better sort of you wearing silken garments, the meaner fustians [made from cotton] (p58).

Product Managers take note: use your product and be seen to use it 🙂

On the roller-coaster of investing in a growth stock

“£100 of stock purchased … in 1657 had slumped to £70 by 1665 but thereafter appreciated dramatically. By 1677 it was valued at £245 and by 1683 was selling at anything between £360 and £500.” (p170)

Now look at the stock price chart of Facebook 2013 vs Facebook 2016.

On becoming a solid financial performer

If the 17th Century was about a scrappy startup trying to figure out its business model, in the 18th Century the bean counters took over.

By 1710 it was regularly sending to the East ten to fifteen ships a year, each of around 300 tons… Thirty years later the number of sailings had risen steadily … to around twenty, each ship being usually of 490 tons. (Over 500 tons and the ship’s company had to include a chaplain.) … Naturally prices and profits fluctuated but there was none of the erratic boom and bust so typical of the previous century. Shareholders came to expect their annual 8 percent dividend and when in 1732 it was proposed to reduce it to 6 per cent there was such an outcry that the directors had to think again. India stock had become the eighteenth-century equivalent of a gilt-edged security, much sought after by trustees, charities and foreign investors. (p220)

Interesting to see the emphasis move from capital appreciation to income generation.

On dealing with the haters

Naturally success breeds detractors and the Company had plenty of those. From a 21st Century perspective it’s really interesting to see 17th Century people struggling with trying to make sense of international trade. When the first voyage returned in 1603 it faced some hostility back home: “Already there were those who failed to see how exchanging precious bullion for an inessential condiment like pepper could possibly be in the national interest.”(p24).

One recurrent criticism … was that the Company must be impoverishing the nation since it exported treasures and imported only luxury items. In the case of Indian cottons these were manufactured goods which must be killing off English manufactures… But in 1620 Thomas Mun, a director of the Company, met … objections in his Discourse of Trade unto the East Indies. Mun argued convincingly that there was nothing inherently wrong with exporting precious metals provided that values of such exports was less than the value of the imported goods. ‘For let noe man doubt that money doth attend merchandise, for money is the price of wares and wares are the proper use of money, so that coherence is inseperable.’ (p119)

We may not be so worried about exporting gold any more. But there are plenty of similar debates about trade vs. protectionism still going on.

On the role of telling a good story to the financial markets (and of investing in yourself)

Robert Clive, already a powerful presence in the Company, was sent from England to run their interests in India in 1764. He was so excited at the opportunities he found that he “gave instructions for ‘whatever money I may have in public funds or anywhere else and as much as can be borrowed in my name’ to be invested in Company stock.” (p376)

Clive was massively over-optimistic about what he could deliver. The huge annual surplus he foresaw was “sweet music to the ears of the directors” and when news of these predictions reached London in 1766 they had a profound effect on Company stock.

[T]he Company’s stock, a normally unexciting performer on the financial markets, suddenly began to climb. It added …. about five percent in a single day and it went on climbing, nearly doubling its value over the next eight months. Clive’s friends …. bought heavily; but as word of his optimistic calculations … leaked out, outside investors also leapt on the bandwagon. On the Amsterdam and Paris markets the bubble went on growing and as the wilder speculators moved in, the greater became the pressure to keep the bubble from bursting.

An obvious way of preventing such a catastrophe was by boosting confidence still further with a hefty increase in the annual dividend … Accordingly, in September 1766, the General Court of Proprietors moved from an increase from six to ten percent… As a result, stock values continued to climb. (p378)

Turns out he had been massively over-confident and the stock price crashed later on. But just goes to show much people have always been driven by story telling and their animal spirits.

And finally, on how to eventually turn philanthropist

Of those who remained in the Company’s service the American-born Yale brothers proved the shrewdest operators. In the late 1680s Thomas Yale handled their affairs in Siam while Elihu Yale maximised their profits as Governor of Madras. Eventually both attracted the Company’s censure and were dismissed for abusing their positions. Elihu was not, however, disgraced and … he was able to retain his Indian fortune. Part was donated to his old school, then known as His Majesty’s College of Connecticut. In 1718 the grateful trustees renamed it ‘Yale College’ in his honour. (pp199-200)

 

Valuing Sweat Equity, 1100 AD

Find a valuation for a startup is a thorny and emotive subject. How much is the idea worth? How much is the founder(s) working for many months without any income worth? How much is your advisory board worth?

So I enjoyed coming across this keep it simple approach from Genoa around 1100AD

From David Abulafia, The Great Sea, p277

Often … merchants engaged in what they simply called a societas, or ‘partnership’, where a sleeping partner would invest three-quarters of the total and his (or her) colleague would invest one quarter, while also agreeing to travel to whichever destination had been agreed, and to trade there. On his return, the profits would be divided in half … [A]nother arrangement became even more common: the commenda, where the travelling partner invested nothing more than his skills and services, and received a quarter of the profits.

Using this model you come out with the “sweat” part of the valuation being worth between 25% and 33% and the “investment” part representing the rest. Of course this doesn’t take into account that in 1100 being the travelling partner put you at risk of serious bodily damage rather than just a few all-nighters and stressful pitches. Nor does it take into account the fact that there are bound to be differences between fitting out a ship and cargo for a sea voyage in 1100 and turning a software MVP into a self-sustaining business.

But (coincidentally?) the relative weights between cash and sweat do feel about right.