Brexit: New insights on implications for the early stage tech sector

The digital economy is the UK’s engine of growth, with £190 billion in turnover and a growth rate three times that of the broader economy. As venture capitalists (VCs) investing in early-stage digital technology companies in the UK, we have sought to understand deeply the sector’s relative advantages and challenges as the UK leaves the EU. Below, we share new insights following our latest research — which included discussions with international trade experts and detailed analysis of the sector’s largest source of capital.

1. Relative advantages in trade

Sector exposure to European revenue is lower

Early stage technology companies in the UK typically expand first to the US, not within the EU, given the linguistic and legal customisations required to address multiple member states relative to the size of the market. 92% of the UK software companies in our portfolio, for example, expanded first to the US or beyond the EU — a relative advantage regarding exposure to Europe.

Software sales to the EU will avoid tariffs even in a ‘hard Brexit’ scenario

If the UK does not achieve a new politico-economic agreement before leaving the EU — a ‘hard Brexit’ scenario — the trade of goods between the UK and EU will default to the rules of the World Trade Organisation (WTO) of which the UK is a member. Tariffs on goods would apply, ranging from over 40% on certain dairy products to 1% on wood and paper.

However, software hosted and consumed online — known as ‘cloud’ software or ‘Software-as-a-service’ — does not involve provision of a physical good and is classified as a service rather than a product. Cloud software would fall within the General Agreement on Trade in Services (GATS), which specifies that the international sale of services between WTO members is tariff-free.

“Cloud software would fall under the General Agreement in Trade in Services (GATS). International sales would be tariff-free.”

Packaged software, such as a DVD with software for installation on a local machine, would be classified as a product. Significantly for the technology industry, however, the 1996 Information Technology Agreement was developed. Accepted by 82 participants including the WTO, it eliminates tariffs on a broad range of high technology products including packaged software and computer hardware. Whether cloud-based or sold on physical media, software sales will remain tariff-free.

“The 1996 Information Technology Agreement eliminates tariffs on packaged software.”

In practice, to sell overseas many companies have and will continue to establish local subsidiaries in those markets. Companies are familiar with managing the transfer pricing considerations involved. These are unlikely to change materially post-Brexit, although in certain circumstances dividends remitted from a European subsidiary to a UK parent company could suffer withholding tax — for example, 10% on dividends from Greece and Portugal.

2. Risks around capital must be addressed

The European Investment Fund (EIF), which provides high growth companies with financing via intermediary VCs, is an important source of funds for UK VCs. In 2014, for example, the EIF directly contributed 12% of the capital raised by European VCs. The EIF has kindly undertaken a new, geographic analysis for us and confirmed that its direct contribution to the total capital raised by UK VCs is comparable with this European average.

“The proportion UK VC capital contributed directly by the EIF is comparable with the European average of 12%. Its impact, however, is broader.”

Its impact, however, is broader than its direct contribution. The EIF’s willingness to serve as an early investor in new funds helps to catalyse investment from others. In 2015 the EIF directly committed €656m to UK VCs, but believes this helped mobilise up to €2.87b of capital (4.4x). While the EIF has stated it will “not change its approach to operations in the UK” before the UK has completed its withdrawal from the EU, material changes thereafter would be damaging.

Post-Brexit, there is a mechanism by which the EIF can continue to invest in the UK through its core initiatives if it wishes. The EIF’s statutes specify that it can conduct its activities only within the member states of the EU, in candidate and potential candidate EU countries such as Turkey, and in European Free Trade Association countries (Norway, Iceland, Liechtenstein and Switzerland). However, articles 23 and 28 also allow the Fund to make agreements with organisations in countries “outside the territories set out” if a decision is made to do so at an EIF General Meeting. There is precedence; in February 2016, the EIF completed a new loan guarantee agreement with Bank Leumi in Israel.

“Post-Brexit, there is a mechanism by which the EIF can continue to invest in the UK through its core initiatives if it wishes.”

The UK’s formal influence over the EIF is limited. The EIF is 60% owned by the European Investment Bank (EIB), 28% by the EU and 12% by 30 individual financial institutions in member countries, with votes cast proportionally. Decisions by the EIB’s Board of Directors require the agreement of one third of EU members. Post-Brexit, therefore, extending the EIF’s core activity to the UK will require at least one third or more of EU members to be supportive. Given the extent to which UK VCs invest across Europe, the attractive returns available from UK funds and the UK’s informal influence, they may well be. Alternatively, other countries may assert their interests to the detriment of the UK.

Post-Brexit, extending the EIF’s core activity to the UK will require at least one third of EU members to be supportive.”

Given its reliance on coordinated action by multiple EU members, disruption in EIF capital is a more significant risk for the UK’s digital technology sector. In 2014 the UK Government established the British Business Bank (BBB), whose programmes include the provision of capital to VCs establishing new funds. Expansion of the BBB is a significant step the UK Government can take to mitigate the risk of reduced capital from other EU members.

3. Tech personnel are attractively positioned for post-Brexit immigration requirements — but visa schemes must expand

One in five London tech workers is an EU national from overseas, according to London Tech Advocates. The UK must continue to fight for the EU’s best talent, but has significant assets to attract them including the world’s fifth largest economy, the biggest internet economy in the G20, 41% of Europe’s $1B ‘unicorns’ (23% by value), the world’s most competitive financial services sector that interacts with local companies and a multicultural society with extensive personal freedoms.

“The UK must continue to fight for the EU’s best talent, but has significant assets to attract them.”

Notably, the workers sought by technology companies are highly skilled — among the “brightest and best” the UK Government seeks to attract according to Brexit minister David Davis — and therefore attractively positioned to meet more challenging post-Brexit immigration requirements that appear likely. Indeed, under the existing Australian-style points system for immigrants outside the European Economic Area, the information and communication sector has been the largest beneficiary of ‘tier 2’ visas for skilled workers, with 42% of the total allocation. Existing visa schemes provide a foundation on which to build but it must be a priority to expand and streamline them.

“The workers sought by technology companies are highly skilled — among the “brightest and best” the UK Government seeks to attract.”

Overall, as Brexit unfolds it is clear that high growth digital technology companies will have distinctive advantages (in trade) and challenges (around capital and personnel). Notably, VC investment in the UK has remained robust since the Referendum. Compared with the same period last year, $941m in investment via 164 deals is consistent with funding trends in the US and Europe — and reflects continued confidence in a sector offering extensive opportunities.