The Brexit Effect: Salvaging Investment into UK Startups

22/06/2017 - 8 minutes

Since the UK voted to leave the EU a year ago this Saturday, a contributor examines how British biotech could keep afloat as Brexit looms ahead.

Presenting to the UK House of Lords Science and Technology Committee in March, acclaimed UK investor Neil Woodford described investing in early-stage biotechnology companies as an ‘extreme minority sport’. Unfortunately for fans of the ‘sport,’ the playing field is looking increasing unstable amidst the progressing political turmoil of Brexit.


Swapping Euros for Sovereignty

Brexit will have a major impact on the UK life science industry, impacting on regulation, finances, employees and research. For early-stage biotech, the effect is likely to be especially fierce with about 70% of EU research funding being allocated to UK universities.

This uncertainty is affecting projects already now. In August, anecdotal reports of discrimination against UK researchers led the treasury to underwrite Horizon 2020 funding for current participants. Such discrimination is understandable or even predictable – European funding applications are often evaluated based on ‘impact’ and the ability to exploit technology through collaboration, knowledge exchange and access to new markets. This is clearly more difficult with UK participants soon outside of the EU market and ineligible for subsequent funding.

UK life science projects funded under the Excellent Science or SME Instrument Actions tend to be funded for a two to three year period. Subsequently, a drop in the quality or number of investment opportunities arising from UK universities or science parks is likely to occur even before current funding is exhausted in 2020. But what steps could be taken to help those reliant on these Euros?

Evidently, any measures taken will ultimately depend on the type of access that the UK ends up with. If in the European Economic Area, it will still be subject to requirements surrounding EU competition law and state aid. Following a hard and painful Brexit, it would be subject only to WTO treaties – this might give it scope to expand its government funding and tax-reducing schemes currently used to incentivise early-stage investors.


Minimal Regulations

For early-stage biotechs, the UK’s ‘soft’ grant funding schemes such as Innovate UK and SMART play a big part in de-risking the projects that feed into the venture machine.

Currently, these schemes are subject to EU state aid regulations, designed to prohibit state funding being used to distort competition in the internal market. Consequently, any state funding schemes providing funding above the ‘de minimis’ threshold of €200K must be approved under the General Block Exemption, compliance with which can impose certain criteria on the funding, such as matching the percentage of the public money awarded with private investment (50% for SMEs).

It can be difficult to raise the required matched investment for such early stage projects in order to unlock the full funding and indeed, a common complaint from those awarded these types of ‘Proof of Concept’ funds is that the money is not substantial enough to fully explore and validate the idea.

In the absence of EU regulations, could we see fewer but larger awards to companies? Will these schemes adopt a higher ratio of public to private funding allocated in the award? The UK government has gone into purdah during the pre-election period, which means government lawyers aren’t supposed to have an official view.

However, according to sources close to the process, a lot of blame is attributed to state aid rules. In reality, these restrictions exist due to policy – making the money stretch further and ensuring that objectives from both sides are aligned. It was pointed out that Article 28 of the exemption permits 100% of some types of innovation advice and support to startups. In addition, under the previous regulations (800/2008), there was an exception permitting 100% funding for startups that was rarely used by state funding agencies.

So even though the absence of restrictions could provide more discretion to the UK, the implementation of heavy subsidies e.g. to startup incubators is, perhaps unsurprisingly, a question of political will.


Brexit Means Brexit, or Perhaps Very Low Taxes

…because my aim is not simply for the UK to have the lowest corporate tax rate in the G20, but also a tax system that is profoundly pro-innovation.” Theresa May, Prime Minister

The UK’s Prime Minister has proposed making the UK’s tax system “profoundly pro-innovation.” One way this could be implemented is through the expansion of two UK tax-reducing schemes currently available to incentivise early-stage investors – the Seed/Enterprise Investment Scheme (S/EIS) and the Venture Capital Trust (VCT).

Tax-reducing schemes effectively make many first-round angel investments in UK startups financially viable, facilitating the transformation of wealthy rookie investors into Duncan Bannatyne.

S/EIS is highly lucrative for those that qualify. Tax can be reduced by 30% (EIS) or 50% (SEIS) of the investment amount, and this can be applied either to the current tax year or up to 36 months prior. The investment itself is inheritance and capital gains tax-free, contingent on being held for 3 or 5 years, and any losses are tax deductible.

A VCT is similar, but the investment itself is targeted to companies at a later stage. The tax breaks provided effectively translate to a guaranteed return of about 6% per year. VCT funds are put to use by fund management groups such as Octopus Investments and Mercia Fund Management and are typically employed after a first round investment with a managed S/EIS fund. (Note, because your EIS investment is only used in rounds up to £5M, in this model your share will be significantly diluted by the fund’s subsequent investment, eating into your 6%.)


Post-Brexit Funding Schemes

For knowledge-intensive companies trying to raise money, state aid rules impose a limit of £5M per year, and £20M over the company’s lifetime – any investment above this will not qualify for the tax deductions under the above schemes. Does this state aid cap make a difference?

Looking at all sectors in aggregate, the median levels of investment obtained by VCT and EIS investees are £670K and £196K respectively – far short of £5M. In biotech, however, the average size of early-stage rounds which would otherwise qualify for these benefits can easily reach or exceed this e.g. Autifony Therapeutic’s £15M Series A round in 2015.

These sizes are too large for angel groups, but lifting this cap might offer a quick way for managed EIS/VCT funds to provide a stimulus to capital-intensive industries like biotech. More tangibly, the absence of EU-imposed rules could impact the qualification of ‘slow burner’ companies for these funds.

As Ian Haynes, accountant at Springfords, commented, “I’d also like to see a change in the relatively new seven year rule that can prevent slow burner companies from qualifying for S/EIS […] Last year there was a drop in the number of new companies raising funds, and the capital raised was proportionally lower. This is probably down to the seven year rule and the introduction of additional criteria in terms of what the money will be spent on.”

This could be good news for small biotech, which is often otherwise excluded based on the nature of its long-term R&D strategy. In this case, Brexit may open up investment by angels or through EIS-qualifying VCT funds.


The Citizens Innovation Fund

Finally, Woodford and the UK’s Bioindustry Association (BIA) step back in. For some time, but particularly now in the light of Brexit, Woodford and the BIA have been calling for the creation of a new tax wrapper for the public that incentivizes long-term investment in UK technology. They contend that historically only 20-25% of VCT and EIS funding has been directed at R&D-focussed companies and that UK incentives should be more similar to the Fonds Commun de Placement dans l’Innovation (FCPI), a successful French scheme.

Their ‘Citizens Innovation Fund’ proposal, a public ISA wrapper akin to a mixture of the FCPI and current S/EIS, should stimulate investment by the general public and increase the flow of capital to institutional funds that are looking to invest in early and midstage companies requiring capital to scale up, including those traversing their way through the biotech ‘valley of death’.

Although the idea has been around for a number of years, it would now chime nicely with Theresa May’s promises of adopting a more innovative tax regime.

With a protectionist Brexit becoming a likely option, the UK must take swift measures to underpin investment in the sensitive early-stage biotech space. While this might be achieved through a mitigation of rules surrounding soft funding to companies, expansion of existing tax schemes for investors, or some new combination of both, it seems like UK political uncertainty is not going away. For the industry, there may only be a few silver linings.

If Brexit is a disaster, I will go and live abroad, I’ll go and live somewhere else.” Nigel Farage, United Kingdom Independence Party

Screenshot 2017-05-18 at 12.27.10Thomas graduated with a degree in biology from the University of Edinburgh, where he subsequently worked in technology transfer. He is currently a law and finance student in Manchester.  

Images via / naum, IR Stone,  igorstevanovic, xtock

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