How to Rescue Startups During the Pandemic

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This article was first published on the Oxford Business Law Blog on 5 April 2020

By Dorothea Ringe  (DESY – Deutsches Elektronen-Synchrotron, Hamburg) and Wolf-Georg Ringe (University of Hamburg)

The global startup sector looks back on a decade of rising VC investment and favourable economic conditions. Many new technologies and innovative products were recently launched by startups and have already benefitted societies around the globe. High growth startups seek, effectively develop, and validate a scalable business model—and may hopefully contribute to innovation that will eventually help overcome the current Covid-19 pandemic crisis. Yet many new firms that were hyped just a few months ago are now in an existential crisis. But the risk profile of startups makes it very difficult to design any effective state support for them. As more and more governments are stepping up their efforts, whether and how to help startups remains controversial.

Why help startups?

Directing rescue efforts specifically at startups certainly is a divisive issue. However, at the starting point it is undisputed that startups are severely hit by the corona crisis, maybe more so than mature firms. According to a recent survey, 70% of German startups said that they are threatened in their existence. And a global study revealed that 42% of startups globally are affected in a way that they will not survive the next three months if they don’t secure any additional capital. This vulnerability of the startup sector is related to the specific situation that entrepreneurial ventures are in. Startups typically are not profitable in their early lifecycle, nor do they have any large capital reserves. What is more, they are usually ‘not bankable' since their business model is highly risky. Thus, they would not normally obtain a loan from a regular commercial bank. Typically funded instead by Venture Capital firms (VCs), even those high-risk investors are presently showing restraint in funding commitment. In short, the funding prospect for most startups looks bleak.

Adding to that, most current rescuing efforts by governments are geared towards large corporations. This may certainly be due to efficiency reasons but may equally well be related to possibilities of influencing the public opinion: large firms are typically much better connected and able to sway community sentiment through lobbying efforts. They will also have more lawyers and financial advisors that set everything in motion to secure government funding. In contrast, startups usually represent a tiny proportion of national GDP and have only recently stepped up their joined lobbying efforts.

Why not help startups?

There is of course a strong case against government support for startups. The key problem is one of a potential waste of public resources, since 90% of startups go bankrupt within 3 years after creation even during normal times, not to speak of the effects of a major pandemic crisis. How can a government then justify that public expenditure? Or, in other words, how can the government ensure that it is not subsidising firms that would fail anyhow? Add to this the well-known problem that bureaucrats are not known for making the best choices when it comes to business decisions.

These problems have led commentators to argue that public money for startups is not really fulfilling its purpose. Rather than financing startups, the claim goes, it is their financiers—ie VC firms—who benefit from government funding. Put differently, rather than waiting for public money, the VCs themselves should ensure the survival of their portfolio companies.

The critique thus boils down to two questions: if we want to rescue startups, how can we identify the right ones? And how do we avoid that those receive money who don’t need it?

Elements of an efficient rescue package

In the light of this debate, it is obvious that a lot depends on the right design of any rescue operation. Governments worldwide are discussing the details of such plans, and some jurisdictions have already started implementing them.

A first important point is that whatever funding operation is implemented, it should not be based on conventional loans: an equity-based system or a direct subsidy would be much preferable. It is for several reasons that a conventional loan-based regime would fail to reach its objectives. First, as mentioned above, due to their business model, startups are typically not bankable. Even where a startup does retain a traditional bank as a financing partner, many startups do not fulfil the criteria for bank-operated loan programmes in terms of profitability, the availability of collateral and other metrics. Another problem is that most banks would look for accounting information—yet in the fast-moving startup world, the most recent balance sheet from 2019 does not necessarily give a representative picture of a startup’s current business situation or financial solidity. Finally, and most seriously, loans that are provided to startups limit young firms’ long-term viability: small firms burdened with a large pile of debt will be constrained in their financial leeway and their scope for possible expansion. Further, they will drastically reduce their attractiveness for any future funding rounds.

Additional consequences are that funding programmes for startups, where implemented, should be designed in a way that comes as close to a market-led process as possible. If governments are successful in reinforcing support for those firms that would normally be backed by the private sector, they avoid the problem of poor selection and the waste of public resources. One instrument that is currently gaining support worldwide is to initiate co-financing models or ‘matching’ rounds, where private investors’ funding is matched by the government.

The German rescue programme

On 30 April, the German government announced the establishment of a dedicated fund amounting to €2bn specifically targeted at startups. The new package of measures includes the following elements:

1. The main element is additional public funding for startups’ future funding rounds as part of co-investments made jointly with private investors ('Corona matching facility')—by reinforcing public VC investors (both individual funds as well as funds of funds, eg KfW Capital, the European Investment Fund (EIF), the High-Tech Gründerfonds and Coparion). The government has promised that financing decisions will be made by VC experts, thus avoiding the risk of political influence. Further, the risk of opportunistic VC behaviour in selecting only bad investments for co-financing is tackled by an obligation to tender: the state is then entitled to participate in any of the VC’s investments.
2. Further, the package will provide KfW Capital and the EIF with additional public funding that enables them to take over the stakes of any private funds that may pull out.
3. Finally, VC financing and equity replacement financing will be facilitated for small businesses and new startups that do not have venture capitalists as shareholders.

In parallel to the implementation of the new package of measures, the German government is also continuing to work on the design of its ‘future fund’ for start-ups, which in the medium-term will help businesses to emerge successfully from the crisis.

Israel

On April 1, the ‘Startup Nation’ Israel also decided to take action to support its important tech-startup sector. It is dependent on investment inflow from international VCs, which is forecast to drop by 25% during the crisis. The government announced a NIS 650m support package which includes NIS 50m for grants for projects directly related to tackling the current pandemic. The main part of the remaining NIS 600m will be used to fast track grants to R&D intensive startups, which have excellent prospects but are in urgent need of funding due to the crisis. Both programmes are managed by Israel’s Innovation Authority. The Innovation Authority will co-invest the grants together with VCs or other investors.

UK

The UK government’s response includes a £500m ‘Future Fund’, which will partly come from public money and the other half from private sources. UK-based firms can apply for convertible loans between £125k and £5m as long as at least an equal amount is raised from private investors. Those loans will be converted into shares at the startup’s next funding round at a 20% discount unless the money is repaid within the next three years. To qualify for the scheme, businesses will at least have to have raised £250k in the past five years.

France

France launched a €4bn rescue package for its startup sector as early as in March 2020. It includes the following measures:

1. Startups in the process of raising a new financing round get access to public funding by raising a bridge round from the public investment bank BPI. The scheme amounts to €80m from public sources co-invested with the same amount of private money.
2. Startups can access the national liquidity support for small business which enables them to borrow up to two years of payroll or 25% of annual revenue (whichever is higher). €2bn have been earmarked for this support measure.
3. Startups can apply for quicker tax returns (including VAT returns and tax returns on R&D expenditure) of up to €1.5bn
4. BPI will speed up public support payments of €250m quicker than originally planned.

Assessment

Most governments are united in their objective to rescue national startups and to keep creative ideas and innovative firms alive. The various programmes launched at the national level are different in their approach yet mostly follow a sensible approach. All rescue efforts are informed by the desire to avoid excessive risk-taking for the public purse, and most use the tool of equity co-investing with private partners (and the convertible loan scheme in the UK). One open question is to what extent the private sector will and is able to invest at all—if private financing rounds are cancelled, the best co-investing round is not worth anything. One crucial detail that will be important therefore is the ratio between required private funding and government support. Germany has decided on a ratio of 30% private versus 70% public, whereas the UK has early on set a 50:50 ratio. Given the current scarcity of liquidity in the market, a lower quota of private funding appears more realistic and would move away from a ‘parity’ co-investment to a scheme where some private ‘skin in the game’ appears necessary to indicate worthwhile targets.

One interesting trend is that most countries that now launch a specific government-backed package for startups lack a strong domestic VC sector. This certainly is the case for Germany, where most growth funding comes from foreign funds that presently care much more about their home markets. Israel is also heavily relying on VC funding from abroad. As these sources are drying up, governments step up their efforts to keep local startup markets alive. Contrast this with the Unites States, home to the most vibrant VC market in the world, where no government-sponsored startup rescue package has been announced to date.

In sum, as we have argued, design questions matter. The coming months will show whether governments are able to overcome the current squeeze for the startup scene. Overall, government efforts are laudable and worth the effort. Attempting to rescue startups is certainly risky, but missing out on future unicorns is even riskier.

Dorothea Ringe is a startup consultant at DESY – Deutsches Elektronen-Synchrotron in Hamburg.

Wolf-Georg Ringe is a Professor of Law and the Director of the Institute of Law & Economics at the University of Hamburg and a Visiting Professor at the University of Oxford.