Publication - Independent report

Scottish technology ecosystem: review

Review of the Scottish tech ecosystem by Mark Logan, commissioned by the Scottish Government, with recommendations on how to develop a world-class tech sector.

Scottish technology ecosystem: review
Chapter 4 – Ecosystem Supporting Categories – Funding

Chapter 4 – Ecosystem Supporting Categories – Funding

The technology ecosystem’s third dependency is on Funding. As with the other supporting categories, we’ll first define the scope and state of the category as it currently operates in support of our tech ecosystem and then identify areas for improvement. In the final major section of this document, we’ll present consolidated recommendations alongside those in the other supporting categories of the ecosystem (Education and Infrastructure) to address those deficiencies identified.

The Tech Ecosystem depends on the Funding System
This diagram has the ecosystem funnel narrowing from left to right, with the funding system funnel sitting underneath to portray how our tech ecosystem depends on the education funnel. The funding system funnel doesn’t narrow and includes venture funding and grant funding.

Definition and Context for Ecosystem Funding

There are two main components to the Funding category within the scope of this review. The first is Venture Funding, which proceeds, approximately, through the stages shown above, in line with the growth of a start-up. The second is grant-based funding.[27] We now examine each of these in turn.

Venture Funding

Scotland’s existing investment framework can boast several assets. It’s angel investor networks and syndicates rank amongst the world’s most developed. The country also operates two separate, publicly funded investment/co-investment vehicles through Scottish Enterprise’s Scottish Investment Bank (SIB) and Techstart, part of the Scottish Growth Scheme.

Nevertheless, the ecosystem still exhibits problems in supporting start-ups from a funding perspective. We’ll now examine these and their causes, before developing a strategy to address them.

We previously introduced the concept of a “tipping point” in technology ecosystems, when the ecosystem reaches a certain number of well-run, non-frivolous start-ups and later stage companies, and virtuous network effects begin to kick-in. These network effects strengthen the performance of businesses within the ecosystem and attract both external talent and investor interest. In effect, after that tipping point, the ecosystem essentially “takes care of itself”, requiring little intervention to support it. In contrast, a pre-tipping point ecosystem struggles to overcome “funnel-collapse”; it is characterised by a relatively large number of very early-stage start-ups, with few making it through to later stages of scale.

A contributing factor to funnel collapse is funding starvation at key stages of the pipeline. Therefore a pre-tipping point ecosystem can be accelerated towards its tipping point with the application of appropriate interventions in these areas, in conjunction with others in Education and Infrastructure.

As we explored earlier, Scotland’s technology ecosystem is still pre-tipping point. Therefore, our ecosystem funding strategy should be concerned with interventions that take the ecosystem towards and then past the tipping point. These interventions should then be carefully tapered-down, to avoid impairing the health of the ecosystem through inadvertently establishing a “dependency culture” that suppresses the development of a vibrant private venture capital environment.

We can summarise the difference between the pre-tipping point and post-tipping point states of an ecosystem as follows:

Pre-tipping Point

  • Mostly “angel” capital
  • Small investments
  • Poor discoverability of prospects
  • Higher friction for investors
  • Low pitching expertise among founders
  • High-level of government funding

Post-tipping Point

  • Mostly VC capital
  • Small to very large investments
  • High discoverability of prospects
  • Lower friction for investors
  • Higher pitching expertise among founders
  • Low-level of government funding

With the above context in place, we now examine each stage of Scotland’s investment funnel, identifying areas where interventions and adjustments are required.

Venture Funding – Stage Analysis

Relative to need and accessibility, the funding landscape in the Scottish Tech Ecosystem consequently operates as shown below. Similar to the case with ecosystem infrastructure, the under-provision of funding in the ecosystem is concentrated in the earlier stages of the pipeline.

The Tech Ecosystem depends on the Funding System
This shows the ecosystem funnel sitting above the funding system components which are ‘pre-seed’, ‘seed’, ‘Series A’, and ‘Series B’. It demonstrating the required provision level the ecosystem funnel needs from each stage of the funding system and how this varies by funnel stage.

Pre-Seed Stage

The very earliest-stage start-ups have very low operating costs and typically fund themselves by traditional means (founders, friends-and-family, the occasional angel investor, etc.). In this respect, Scotland’s tech ecosystem is not particularly worse-off than any other. It could be argued that this funding mechanism locks out potential founders from more disadvantaged backgrounds. However, in these very early stages of a start-up, it remains a difficult problem to attract other sources of funding to an unproven founder with a non-demonstrable idea, even if there are more investors in the ecosystem.

Seed Stage

As start-ups move beyond the pre-seed stage, funding in the early seed stages immediately becomes relatively difficult to obtain before becoming easier in the later seed stages. The main reason for this is that seed funding is largely provided in Scotland through angel investors. Increasingly, angels are operating in syndicates, which tend to prefer larger investment quanta (and, therefore, later-stage start-ups) for reasons of efficiency. There are many benefits to so doing, but it does mean that early stage seed requirements must be met largely by a smaller group of remaining individual angels (with additional support provided by government). There is a “discoverability problem” between the start-ups and individual angel investors – it’s difficult for individuals to have full visibility of investible seed-stage start-ups. Our strategy must therefore include measures to address such issues encountered at this stage of the investment pipeline.

Series A Stage

As start-ups begin to scale, the environment again becomes more difficult. Scotland’s ecosystem is dominated by angels and angel-syndicates, complemented by government investment through SIB and Techstart. As part of a well-balanced investment landscape, such angel activity is of course a key and welcome ingredient. But when angel investment dominates the mix of investment types, it results in a relatively low upper limit on the capital that can locally be invested in a given business relative to a post-tipping point ecosystem. Angel investors are also typically unable to support the further growth needs of businesses beyond the start-up stage. Syndicates have more reach, but the same general limit problem still applies.

So, at this point, it’s desirable to be able to hand the investment baton to larger VC funds. But here we encounter problems:

  • There aren’t enough VC firms in Scotland. Of those that are based in Scotland, most of their investment activity is outside Scotland.
  • External VCs are not focussed on the Scottish ecosystem, and do not have a meaningful presence in Scotland, nor do they spend much time here.
  • The cap tables of Scottish start-ups can be off-putting to some external VCs because they look different to those that the VCs are accustomed to seeing elsewhere. Specifically, they often include a large number of passive investors (because of earlier syndication) instead of, for example, one or two active angel investor and some VCs, as is more typical. Those cap tables also frequently include a relatively large percentage that is public money.

A pre-tipping point ecosystem suffers from poor discoverability of potential prospects at the Series A stage as well as higher friction and opportunity costs for external venture capital companies in pursuing investments. These act to reduce their involvement level. The VC industry works on the basis of high sifting ratios. A very large number of potential prospects must be reduced to a handful of annual investments. The smaller the scale of an ecosystem, the more remote that it is from where VCs are located, and the lower the density of interesting prospects within it, then the greater the friction encountered by VCs in identifying them. Simply put, they can better invest their time elsewhere. This is disruptive to the process of rapidly sifting prospects, which results in VCs being less willing to engage in the ecosystem.

Contrast this state of affairs with an ecosystem where VCs either have a local presence because the scale of the ecosystem merits having one, or where the ecosystem’s scale justifies regular travel to it. For a VC based in London, it’s possible to physically visit five or more interesting prospects per day on the tube. A full daytrip to Edinburgh to visit just one prospect can seem like a poor economy in comparison, so it tends to happen less often.

Likewise, from a start-up’s perspective, the cost to Scottish start-ups of meeting London-based VCs “on their turf” is obviously higher than for London-based start-ups, and often prohibitively so. In considering this point, bear in mind that a start-up typically has to build a relationship with VCs over an extended period of time before moving to raise a round so the time and cost is higher than it might at first look[28].

Of course, our start-ups do connect with external VCs, and deals do get done. However, until our ecosystem passes the tipping point – i.e., until VCs either establish a presence in Scotland or can justify a regular visiting schedule because a sustained, critical mass of credible start-ups exists – then the Series A investment stage carries greater friction than experienced in a post-tipping point ecosystem. So, less investment happens at the Series A stage as a result. Therefore, the Venture component of our Funding strategy should also focus on this critical stage of the investment pipeline.

Finally, we also note that the Scottish European Growth Co-Investment Programme (SEGCP), set up relatively recently in a joint initiative between SE and the European Investment Fund (EIF) to, amongst other goals, support Series A funding for Scottish start-ups, is now discontinued due to Brexit. Analogous schemes are, of course, still available to other European start-ups. This is a disparity that should be addressed by a replacement mechanism; we’ll explore options here in the recommendations section of this report.

Series B+ Stage

Even in a pre-tipping point ecosystem such as ours, those businesses that do break through to larger scale will attract both domestic and international investor attention due to their higher visibility and relative success. Additionally, interventions that address the Series A issues just discussed will also benefit the later stages of the funding pipeline. Therefore, no special additional measures are required for these later stages in our opinion.

Grant Funding Analysis

The second category of funding available to the ecosystem is grants made by government through Scottish Enterprise. There are two areas here where improvements could be considered to better align the grant system with the needs of the Scottish tech ecosystem.

Alignment of grants to start-up requirements

Undoubtedly helpful as they are to early-stage businesses, there is nevertheless a misalignment between the criteria and mechanisms through which existing grant categories are awarded on the one hand, and the needs of technology start-ups on the other. This is not to say that these grant categories should be deleted but, rather, that the overall portfolio of grant funding options should be adjusted to include those that are specifically tailored to the needs of tech start-ups. That is to say, additional money isn’t necessarily required; but instead that existing funding should, in part, be re-purposed to more appropriately tailored vehicles.

For example, one category of grants is awarded when a start-up reaches certain pre-agreed headcount goals. This is a convenient metric by which the grant’s effectiveness can be justified within the awarding organisation. But it frequently acts as a perverse incentive for tech start-ups. The grant naturally incentivises the start-up to hire more people. But that is often the very last thing that a start-up should be doing in its earlier phases. What a start-up needs during that period is runway to be able to stay in business for as long as possible with a small team until it can demonstrate product-market fit. After that point, the start-up can begin to scale as dictated by the needs of its market strategy. Incentivising the start-up to hire more people, in isolation of these considerations, risks making the business more fragile and can distract the executive team from these imperatives.

Another grant category involves constructing the definition of a research or innovation project, with a fixed, measurable deliverable. This requires a non-trivial level of effort to define such a project. But, for tech start-ups, it is usually an artificial exercise and a distraction because, in fact, the start-up itself is the project.

These examples are both typical of the conflict between local and global-system optimisation that we discussed previously. Generalising from these examples, there is a category problem in aligning what’s measurable in a short-term, clear manner from the perspective of the grant-funder (with due note to regulations that they must adhere to) and what’s useful and aligned to business goals for the recipient.

Difficulty in navigating the grant map

Another, albeit lesser, concern put forward by start-up founders is the perceived complexity in navigating the available grant options across Scotland and the UK as a whole. This translates to friction in receiving grant support which, in turn, means that there are start-ups which should have received grant support but that miss out. We should bear in mind that start-ups typically do not have personnel they can dedicate to this exploration.

Funding – Strategic Framework for Improvement

The above points, taken together, suggest the following strategic framework for funding interventions. We’ll make specific recommendations based on this framework in the final section of this review document.

Interventions in Investment Funding

Interventions in this category should be designed to achieve the following:

  • Increasing Early-Seed: by improving discoverability between angels and start-ups. We’ll review ways that this could be done in the recommendations section of this report. Given the favourable SEIS and EIS tax incentives available at the early-seed and seed stages, we do not consider it practicable to create further financial incentivisation to invest at the early-seed stage.
  • Increasing Series A One way to do this is to support start-ups in much more intensive engagement with the VC community in London right from the outset of the company. This is likely to favourably alter the balance of investor types in early-stage cap tables and educate both the start-up founders themselves and the London-based VCs about each other much earlier in the funding journey.

Another mechanism worth examining is a partnership model which partly leverages government funding combined with the expertise of private local and external VC firms that are accustomed to operating at the Series A level. We’ll explore one such mechanism for how this could be achieved in the recommendations section of this report.

  • Measures to reduce friction for start-ups and venture capital firms through improved discoverability and ease of access for start-ups and external VCs.

In considering this general strategy for addressing the issues identified above in regards to investment, we note here some difficulties peculiar to this category:

The first is that it is not effective for government to incentivise external VCs to establish a presence in Scotland. Nor is it effective to encourage indigenous VCs to invest more time and money in Scotland. For VCs, opportunity cost trumps all other considerations, and the returns from the right investments hugely outweigh any incentivisation that may be on offer.

As we have already discussed in this review, we will only attract more inward investment activity towards our start-ups when we fix the problem of not having enough credible start-ups in which to invest. That is why this review places such a strong emphasis on the education element of the ecosystem, followed by having the right infrastructure to support the fruits of that education.

The second difficulty is that “too much” public financial support for Scottish start-ups may undermine the credibility of the ecosystem to external parties. If the ecosystem is worth investing in, this argument goes, then why does the government need to support its start-ups to such a high degree? There is a balance point, beyond which this perception may take hold. A related note on this last point: Scotland currently operates two innovative, but separate and uncoordinated mechanisms to deploy public money into start-ups – SIB and Techstart (the latter of which operates to the same model as VCs, but whose sole Limited Partner is the Scottish Government). It would be sensible to pay attention to the relative future success of these respective approaches, in terms of return on overall investment, and to increase/adjust funding support as appropriate, in consequence.

In developing our strategic framework above, we are conscious of all of these points. We also recognise that the COVID-19 crisis shifts the normal balance point to some extent.

Interventions in Grant Funding

Interventions in this category should be designed to achieve the following:

  • Adjustments to grant systems to better align to the needs of start-ups, optimising for what’s needed within the ecosystem rather than what’s most measurable for the grant-awarding body. Rationalisation of grant options as part of this exercise would also be helpful to reduce discovery friction and increase uptake. Again, we’ll illustrate this point with specific proposals in the recommendations section of this report.
  • Adjustments to grant funding levels. We note here that, in the COVID-19 era, it is probably necessary to increase the general provision of grant, EDGE and similar funding to start-ups. However, great care must be taken to not artificially support start-ups that would have failed anyway, regardless of the COVID-19 crisis. To do so is detrimental to the ecosystem because it reduces the circulation of experience and creates a dependency culture. We are aware that these points are currently being addressed by SE separately to this report.

Contact

Email: loganreview@gov.scot