RESEARCH: The scale-up challenge:
Professor Thomas Hellmann
The UK is very good at supporting the launch of start-ups, but needs to do better when it comes to helping these new businesses grow. Opening up sources of finance will help.
Words: Nicholas Neveling
Illustration: Toby Morrison
In January 2008, Skyscanner, a search engine for flights and hotels based in Edinburgh, received £2.5m from Scottish Equity Partners (SEP) in a series A funding round.
The company has come a long way since then. Skyscanner is now one of the UK’s best-known "unicorns" – a start-up business worth US$1bn or above. It employs more than 250 people across offices in Scotland, Beijing, Singapore and Miami, and has secured two further funding rounds from an increasing number of blue-chip investors.
Skyscanner is the perfect example of how young, rapidly growing companies, known as scale-ups, can boost employment and create wealth. Research by Deloitte and innovation charity Nesta shows that just a 1% increase in the number of scale-ups could create 150,000 new jobs in the UK and contribute £225bn towards GDP by 2034.
‘The UK has not been very good at helping companies transition from start-up to scale-up’
Yet, despite the huge impact that successful scale-ups have on economic growth and employment, the UK has not been very good at helping companies transition from start-up to scale-up.
In her 2014 report commissioned by the UK Government, serial entrepreneur Sherry Coutu found that, although the start-up scene in the UK was thriving, with more than 600,000 new company registrations between 2012 and 2015, the scale-up community was not nearly as vibrant. The Coutu report found that there were only 10,170 British companies employing ten people or more and growing turnover or employee numbers by 20% a year, and could thus be defined as scale-ups.
‘The entrepreneur is normally touted as the engine of economic and employment growth, and that is true, but a new business only really makes an impact when it enters the scale-up phase,’ says Thomas Hellmann, Professor of Entrepreneurship and Innovation at Saïd Business School and co-author of Scale-up UK: Growing Businesses, Growing our Economy, a landmark study, following the Coutu report, on the state of scale-ups in Britain published by the Saïd Business School and the University of Cambridge’s Judge Business School, convened by Barclays.
1. Increase the number of UK venture capital funds that are sufficiently large to finance scale-ups
Professor Hellmann’s work looks specifically at the financing bottlenecks that have hampered British scale-ups, and makes six recommendations for improving access to funding for scale-ups.
‘While early-stage investment in the UK is strong, there is a funding gap for later-stage deals, which needs to be tackled’
He and his research team found that, while early-stage investment in the UK is strong, there is a funding gap for later-stage deals, which needs to be tackled. Analysis of data from Beauhurst shows that the share of growth-stage deals as a proportion of all seed, venture and growth deals in the UK has fallen from 30.7% in 2012 to 24.5% in 2015.
Data from Preqin, meanwhile, showed that, while domestic investors accounted for 62% of funding for seed round investments, by the time companies reached a Series E funding round, British investors only backed 25% of deals, with US investors backing 50% of deals in this phase.
‘There is no doubt that the UK has become very good at supporting start-ups, but my concern is that the second piece of the puzzle is missing. Without the second piece, the first piece is in danger, because the returns are not there to sustain the start-up activity,’ Professor Hellmann says. ‘The next challenge is to take those start-ups into the scale-up phase, and one of the concrete issues holding Europe back when it comes to scale-ups is financing.’
2. Grow the number of experienced UK investors with in-depth sector expertise and strong international networks
Bigger is better
Professor Hellmann’s first recommendation is that venture capital investors in the UK need to raise larger funds, of £200m or more, so that they have deep enough pockets to fund scale-up growth over time. Preqin data shows that in the US, which leads the world in scale-up success, less than 50% of venture funds are smaller than US$100m. In the UK, by contrast, more than 60% of venture funds are smaller than US$100m.
‘Scale-ups need "smart money" from investors who can bring knowledge to the table as well as capital ’
Professor Hellmann is quick to emphasise, however, that building increasingly larger war chests alone will not secure success, and his research’s second recommendation is that scale-ups need "smart money" from investors who can bring knowledge to the table as well as capital.
UK venture firms should focus on working with venture talent with global networks, building out their own international networks and positioning themselves as investors with deep expertise in specific sectors in order to support scale-ups more effectively.
The value of "smart money" cannot be underestimated. In the case of Skyscanner, for example, the business was cash flow positive soon after its first investment round from SEP and did not need additional financing. Yet it still chose to bring in US firm Sequoia in 2013, and another group of investors in 2016, specifically so that it could leverage their international networks and sector knowledge to accelerate growth.
‘Scale-ups require particular skills and experience that are quite different to start-ups. Money on its own is not enough to secure success. Taking a company from five employees to 5,000 requires specific expertise,’ says Professor Hellmann, noting another recommendation of the report.
3. Develop a UK venture debtmarket to complement equity funding
Professor Hellmann says that although equity should remain the primary source of funding for scale-ups, venture debt, which provides senior loans to companies with negative cash flows, has a key role to play. But although venture debt is well-established in the US, it is still in its infancy in the UK. Preqin data shows that, in the US, 20% of venture-backed companies obtain debt at some point, versus just 8.4% in the UK.
‘Scale-ups and investors could raise venture debt more successfully by simplifying capital structures’
Venture debt is attractive as it does not dilute ownership and can provide tax advantages, making it an appropriate source of capital for rapidly growing companies. The risk and capital weightings at which lenders have to hold venture debt, however, deter many. Professor Hellmann says governments can help by creating more certainty around how venture debt should be ring-fenced, while scale-ups and investors could raise venture debt more successfully by simplifying capital structures. Better data on venture debt would also make a significant difference.
4. Establish the London Stock Exchange as the leading pan-european stock market for scale-ups
The report’s next two recommendations look specifically at the availability of liquidity for investors, namely the need to foster a more supportive IPO environment and build up private liquidity so investors can trade funding stakes before target companies list or are sold.
Like venture debt, the IPO market has also been underutilised by UK scale-ups. IPOs account for only a fraction of venture capital exits in the UK, yet in the US they provide a significant source of liquidity. Figures from trade body Invest Europe show that, between 2010 and 2014, there were only six venture exits via an IPO. In 2014 – the best year for venture-backed IPO, when there were three listings – IPOs represented just 8.6% of all UK venture exits. In the US, by contrast, data from the National Venture Capital Association shows that the average IPO rate for venture companies is 13.3%.
‘A big challenge for UK scale-ups seeking an IPO was a lack of investor interest in backing companies in the scale-up phase’
A big challenge for UK scale-ups seeking an IPO, the report found, was a lack of investor interest in backing companies in the scale-up phase. Many institutions are still cautious about investing in this space after losses sustained during the dotcom boom, and there are only a handful of investors looking at scale-ups, which constrains the ability to trade scale-up shares. Attitudes must change if the number of scale-up IPOs in the UK is to increase.
‘Investors need to become more dynamic and leverage their expertise and knowledge instead of looking backwards and using historical returns as a reason not to invest more money in venture-backed IPOs,’ Professor Hellmann says.
The report recommends that scale-up listings will increase if the London Stock Exchange (LSE) is established as the leading pan–European stock market for scale-ups, an ambition that will be aided by LSE’s recently announced merger with Deutsche Börse. A pan-European approach will create a deeper pool of buyers and sellers, which will help to boost liquidity and attract more analyst coverage and institutional interest.
Liquidity in the private market, meanwhile, also needs to be improved, the report recommends. Often scale-ups may not be ready for an IPO, so the ability to trade stakes in these companies privately in the secondary market will offer an added incentive for investors to move in. The secondary market has thrived in the buyout market, but when it comes trading stakes in smaller businesses, it remains opaque and fragmented. Professor Hellmann says this can be addressed by looking at new approaches to secondary trading. Setting up electronic trading platforms and revising the regulation and taxation of secondary trades could help.
5. Develop new approaches for creating liquidity in private company shares
‘As it stands, data is incomplete and figures from different providers are often not comparable ’
Finally, he calls for a vast improvement in the collection and accuracy of data monitoring the financing and performance of scale-ups. As it stands, data is incomplete and figures from different providers are often not comparable. ‘Data is very poor and misleading. Investors can’t make investments if the data isn’t there to support decisions,’ he says. But despite the need for an overhaul of the way scale-ups are financed, Professor Hellmann believes the UK is on the right track. ‘It has successfully achieved the first step,’ he says. ‘Start-up activity is healthy. Now it is time to work on the second piece. The UK is already leading Europe when it comes to supporting scale-ups and there are clear areas where positive steps can be taken. It will take time, but the UK is moving in the right direction. Moreover, maintaining close contact with both continental Europe and North America will be extremely important.’
6. Collect systematic data about the financing of scale-ups