For many years, a key landmark on the UK startup funding landscape has been the Enterprise Investment Scheme (‘EIS’ for short). This is a wonderful piece of tax legislation wizardry that gives tax breaks to angels investing into qualifying startups both on downside outcomes (i.e. if the company fails) and on upside outcomes (i.e. if the company succeeds). As I recall, the figure I saw quoted for 2009 said that 76% of UK angel investments into UK companies went through EIS, which makes it a pretty popular scheme.
All the same, when I started structuring my own company (Nanodome Ltd) pitch to make it angel-ready, I priced up all kinds of non-obvious corporate structures (options, debt, convertible debt, etc), but honestly – the EIS makes everything else so second-best that it was kind of embarrassing. Hence the EIS is something I’ve long told other entrepreneurs is the only sensible way to go forward: it’s pretty much gold-plated.
However, funding is changing. Paul Graham (of Y Combinator fame) put up an essay last month about what he calls High Resolution Funding, by which he means startups’ selling convertible notes at different prices to different people (and at different times). Convertible notes are a kind of debt equity that can be converted to common stock at a future round (though you have to be careful that you’re not effectively trading insolvently and that you will still have access to overdrafts / factoring / etc). ‘Capped convertible notes’ refine this further (so that seed round angels’ investments don’t get diluted down to nothing on big up rounds). Graham’s finesse on capped convertible notes is that startups can choose to give earlier or particularly-useful angels a better price than later or not-so-useful angels, which makes a lot of sense to me – as he says, few angels nowadays want to lead. But for him, the #1 attraction of this ‘high resolution funding’ is that it means startups don’t have to pre-decide how big a round to raise – instead, you can size it up based on how well angels react.
Of course, you’ve probably already worked out that this is precisely the kind of non-obvious financing trickery the EIS was designed to discourage: to be precise, only common shares held for at least three years in an all-common round qualify (though of course this is not legal advice, read the HMRC guide for yourself), so EIS and Paul Graham’s brave new entrepreneur-centric investment world don’t easily overlap.
And that is where the core problem lies here. While funding is rapidly changing in the US, the EIS supplies a strong disincentive to change in the UK, even though the UK funding picture has changed dramatically over the last few years:-
- no realistic bank funding (whatever our banker chums say to Vince Cable)
- hardly any local grants (unless you live in a deprived area)
- hardly any national grants (unless you happen to be female)
- unwieldy, overspecialized, glacially slow EU grants (where the size can be exceeded by the bureaucratic effort needed to gain it)
- regional development funds being dismantled
Hence, R&D tax credits (which are great if your enterprise is just the right size, and with enough PAYE employees) and the EIS are just about the only two bright lights in an otherwise uniformly dark sky. So, it may initially seem somewhat ungrateful of me to say that I think the EIS may currently be turning from a stepping stone into a millstone round startups’ necks. However, it is true insofar as it serves to accentuate the increasing funding gap between the UK angel scene and the US angel scene. In Thomas Homer-Dixon’s phrase, there’s a funding structure “ingenuity gap” here which I think the EIS disincentivizes anyone from filling.
What nobody in the UK government seems to grasp is that things like AngelList (and other routes opening international startup dealflow to US angels) are not ‘high concept theoretical conceits that may possibly become practical in a decade’. They are happening right now, and frankly you don’t have to engage with them for very long to see that they make the UK’s attitude to financing look utterly parochial, utterly dead in its own stagnant water. UK entrepreneurs are now able to jump on a plane and – for much the same cost as, you guessed it, presenting to a single UK angel network – pitch to US angels who they’ve probably already networked with via Twitter, LinkedIn, Facebook, email, etc. And any guesses as to which side of the Atlantic they’d find funding first?
Much as I love the EIS, and much as I understand exactly why the taxman wants to reward equitable investing practices, I can’t help but conclude that the EIS has become one of the things impeding UK startup financing innovation, simply because the startup financing world around it is moving so rapidly. I hate having to say such heresy, but it’s true, every word of it.
Really, if the EIS is the best we can do, what kind of madness would have to take hold of my mind for me to advise a UK entrepreneur in the current climate to pitch to UK angels at all? If you’re building a world-beating company (and you’ve gone just about as far as self-financed bootstrapping will take you), surely your most rational next step would be to hone your pitch until it can slice through a telephone directory at forty paces, network with US angels like crazy, and get on that plane? But then… if the top 10% of UK startups all do this, where next for UK plc?
PS: up until a few days ago, I wondered whether my heresy was just some personal ‘reality distortion field’ affecting my judgment: but chewing the far with other entrepreneurs after Eric Ries’ talk at TechHub helped me realise that no, this is exactly how a lot of other UK startups also read the funding situation. Just so you know!