Startups: Upstarts

‘At the early stage, companies get lots wrong. Their corporate governance is often non-existent. Their contractual framework and intellectual property ownership can be messy. They often do not properly implement the legal frameworks necessary to deal with data. But that’s fine because they’ve got one objective at early stage, which is to grow the financial strength and reputation of their business.’

Representing emerging companies can be an arduous undertaking. As the above assessment from Ashurst corporate partner and tech M&A aficionado Jonathan Cohen suggests, when companies and their founders are first starting out, an immaculate legal framework tends not to be top of the agenda, as budgetary and personnel constraints see other areas prioritised.

Those constraints have only been exacerbated by the recent shift in economic outlook, which has seen the international public markets, fertile ground for tech companies in the last few years, all but dry up, and the free-flowing stream of venture capital investment begin to slow.

‘Vaccines were a very big area, not just for Covid but for other diseases. That made people recognise that Britain is a real industry leader in that area.’ Susanna Stanfield, Withers

And yet, without exception, lawyers in the sector speak glowingly of their experiences of helping companies grow. Legal Business canvassed opinion from partners to learn the current challenges and opportunities facing companies looking to disrupt the market and what it takes to be an effective legal adviser to them.

Breaking new ground

The startup market has been thriving over the last few years, to the extent that it is now a key pillar of the wider UK economy. According to government-backed growth platform Tech Nation, the UK is fourth in the world for investment into the tech sector, with the $40.8bn injected during 2021 well over ten times the value invested a decade ago. The recent boom has seen the M4 corridor branded the UK’s answer to Silicon Valley, and whether a company is announcing itself as the latest unicorn (a privately owned startup with a valuation in excess of $1bn) launching on the public markets, or being absorbed by a headline name, the financial press has been awash with success stories. On the unicorn front, highlights from the UK include digital bank Monzo, which was valued at $4.5bn in its latest funding round after being established in 2015, while the likes of takeaway food app Deliveroo and semiconductor company Alphawave have executed high-profile IPOs.

Fintech has been the biggest focus for investors and inventors for a number of years, spurred on by trailblazers such as Checkout.com, currently the most valuable fintech startup in Europe with a valuation of $40bn.

‘There are particular areas in the UK startup investment ecosystem that are much more popular than others. Fintech would be the most popular in terms of volume and certainly in terms of value. Some of the highest-value investments we’ve seen in recent years would be in that space,’ confirms Wiggin partner Ciaran Hickey, a specialist in the technology, computer games and digital media sectors.

‘The Covid pandemic was bad for lots of things, but it certainly wasn’t bad for getting capital flowing into early-stage research-based science.’ James Halstead, Covington

Life sciences is another hot area. The UK has done a good job of leveraging the talent in its leading universities to develop innovative products, as the role Oxford University played in developing a vaccine against Covid-19 demonstrated. ‘We did see a lot of activity and interest pick up as a result of Covid. Vaccines were a very big area, not just for Covid but for other diseases. That made people recognise that Britain is a real industry leader in that area. We’ve since seen companies from across the life sciences sector have very successful fundraisings,’ explains Susanna Stanfield, head of Withers’ Cambridge office.

Of course, for every triumph, there are many more companies that don’t make the grade. The reasons fledgling companies fail are many and varied – the tech may not be all it is cracked up to be, founders may fall out, or the burn rate may be unmanageably high. However, even when the going is good, it remains a high-risk, high-reward sector. ‘Some early stage companies never get to post revenue. They have a good product but can’t sell it,’ states Bristows of counsel Richard Swaine.

Nevertheless, it is important to remember that, from a founder’s perspective, success may not always be about money. ‘From just a financial viewpoint, the success points are selling to big pharma or getting to market, but for a lot of these companies, the founding scientists have a genuine desire to get the knowledge out into the world and hopefully deliver some therapy or treatment which is actually positive. I wouldn’t say just because their company doesn’t end up with a big exit they haven’t succeeded. If they managed to progress their science, it might be that somebody else can come along and learn from them how they developed it and take it forward,’ says Covington London managing partner James Halstead of life sciences companies.

The worm turns

After a long run of high valuations and seemingly infinite funding resources, the market came back down to earth with a thud earlier this year. Inflation, swelling energy prices, and geopolitical destabilisation have meant that the market is now in its first serious lull for years.

After a strong first quarter of 2022, which saw the UK overtake India and China for funds raised by tech companies, recent months have proved more difficult. The most striking change can be seen at the exit stage. ‘The IPO market is pretty much dead,’ observes David Strong, head of venture capital at Marriott Harrison.

The data backs up this view. Figures from Reuters suggest that IPOs by US tech companies have dropped to levels not seen since the 2008 financial crisis. It is a similar story this side of the Atlantic. A mere 26 companies made their London Stock Exchange (LSE) debut in the first six months of 2022, a 45% fall compared to the same timeframe 12 months previously.

This lack of activity is a complete reversal from a year ago. Halstead reflects: ‘If you’d asked me 18 months ago, I’d have said: “Everybody is going for an IPO.” The Covid pandemic was bad for lots of things, but it certainly wasn’t bad for getting capital flowing into early-stage research-based science.’

And yet, even in tough times there are positives. Though the market has slowed down, there are still good opportunities out there for ambitious and well-resourced companies. Several advisers we spoke to report a flight to quality whereby investors concentrate their interests on the best companies. Ashurst’s Cohen explains how those in a strong position can exploit the situation. ‘If you’re a tech business that has recently raised capital, this is a great time because, no matter what the economy is doing, you can grow fast. You can disrupt if you’ve got the ability, bravery and the financial firepower to say: “Right, how do we gain market share while everyone else is struggling?”’

Equally, companies do seem able to rely on investor support. ‘I’m definitely seeing investors wrap their arms around these companies much in the same way they did during the peak of the pandemic. None of these investors want to see these companies fail,’ confirms Ashurst fintech co-head Tara Waters.

It should be said that not all sectors see activity fluctuate in the same way. Life sciences, with its lengthy clinical trial process, tends to retain a little more stability as investors are forced to think long term. ‘In life sciences we don’t have the same doom and gloom outlook that some areas do,’ notes Halstead. ‘Certainly not compared to an area like fintech, if you look at the challenges those companies are having. The reason is that the time required to take a drug from the labs to the market is so long, that the short-term ups and downs of the macro-economic environment are somewhat less influential.’

‘It remains to be seen whether the recent reforms that have been announced are actually going to make the UK a more competitive market for tech IPOs.’ Tara Waters, Ashurst

New York, New York

Even amid market volatility, some things never change. When it comes to IPOs, the LSE has long been criticised for failing to attract UK tech companies looking to list, with the majority still being lured stateside to Nasdaq or Wall Street. There are notable exceptions, like cyber defence company Darktrace and review website Trustpilot (both of which listed on the LSE in 2021), but the fact remains that the most ambitious startups are looking across the Atlantic.

It is an issue of which regulators are well aware and looking to address. Tech leaders were invited to Downing Street earlier this year in a bid to prompt discussions on how progress could be made, and various reforms to listing rules have been mooted. Given the inertia so far, many are sceptical of real progress. Laments Ashurst’s Waters: ‘It remains to be seen whether the recent reforms that have been announced are actually going to make the UK a more competitive market for tech IPOs. This has been and is likely to be an ongoing challenge for the LSE, to be honest with you.’

For all that the LSE’s efforts have been met with mixed reviews, there is an argument that the horse has already bolted. Orrick tech partner Chris Grew describes a potentially fundamental issue: ‘The vast majority of technology companies want to be listed alongside their peers. There is a chicken and egg situation in that, on Nasdaq and the New York Stock Exchange, there are thousands of technology companies that are listed in the US, and all the competitors and comparable companies are listed there. Coming to London, there are precious few tech companies that are listed – which means that a tech company is exposed because it does not have all these other companies that are experiencing the same economic effects as it may be experiencing. The analysts outside of the US that are reviewing companies may not be as familiar with a SaaS company or an AI company or a company in the mobility space, whereas a research analyst looking at Nasdaq companies will probably have the 35 companies in the mobility space.’

That is not to say it is all plain sailing for those that journey across the Atlantic. Taylor Wessing’s Ross McNaughton warns: ‘If you go to the US you’ve got to make sure you’re really ready for it because of the cost of being listed. The fact the market is dominated by FAANG (Facebook (now Meta), Apple, Amazon, Netflix, and Google) companies is quite material. So you have to be pretty big in order not to get lost in the crowd.’

With IPOs off the table for the moment, the M&A market becomes a more attractive option for companies that have reached maturity. ‘Even in tough times, we find private equity often still has cash for deals but will likely be much more discerning in what they invest in. From our perspective we are seeing a lot more going on in private M&A [than the public markets] at the moment,’ as Bristows head of fintech Louise Eldridge puts it.

Board shorts and flip flops

Perhaps more so than in other practices, the relationship between client and counsel is of paramount importance. The experience is markedly different from working, say, with the multinational, extensively resourced companies that tend to be a big law firm’s bread and butter. Most clients, at least at the earlier stages, will not have in-house legal advice, meaning that lawyers are working with the founders themselves.

It is that direct relationship with decision makers that can be both the blessing and the curse of lawyers in this practice. As David Willbe, corporate and tech partner at Lewis Silkin, says: ‘It [working directly with founders] is the reason why I do it, to be honest. Harder might be the right word objectively, but I enjoy it.’

From the first meeting between founder and lawyer, cultural differences will likely be obvious. The movement away from sartorial formality across the City is well documented, but the startup world has pushed those boundaries further than most and increasingly, firms are finding that those clients expect their advisers to match their dress code. ‘You need to have that credibility and not just come in and say: “I’m in my suit and I’m the big corporate lawyer.” I come in and I’m usually casually dressed, much more similar to the founders. It’s not about being from a big fancy international law firm, but about saying: “Let’s talk about what you’re trying to achieve and how we can help,”’ notes Waters.

‘Working directly with founders is the reason why I do it, to be honest. Harder might be the right word objectively, but I enjoy it.’ David Willbe, Lewis Silkin

As is so often the case, the sector in the UK is taking its cue from stateside counterparts. ‘You can blame Silicon Valley for the demise of lawyers wearing suits,’ confirms Grew. ‘No lawyers working with tech companies wear business attire anymore (unless they are going to court). Everybody is in relaxed clothing with jeans or chinos, just like their clients. We often joke that in our Santa Monica office – which is within walking distance of the beach – we have a dress code of t-shirts, board shorts and flip flops because it’s not that far from the truth.’

Far more significant than the fashion choices, however, is the entrepreneurial attitude that makes clients in this sector stand out from the crowd. That can run counter to the perfectionist tendencies of many lawyers, and a more pragmatic approach is often required. ‘There’s a mindset acting for those startups where you need to accept that culture and risk appetite. Not everything is going to be perfect. It’s about making things work sufficiently well to protect the business without having a perfect shiny solution,’ explains Strong.

In the end though, the key to success acting for startups may not be so very different from any other sector – it is still fundamentally about responding to client needs. ‘Our role as legal advisers should not be limited to explaining the legal situation to founders or drafting legal documents,’ stresses Cohen. ‘Our role, at the early stage, is to empower founders to help their business be successful by finding the best path for their growth and helping them to avoid the land mines that could destroy their business or their ability to raise capital.’

In it for the long haul

There are also challenges when it comes to fees. Many early-stage companies simply cannot afford to pay the rates big law firms demand. Lawyers must get creative if they want to secure these clients, usually offering fixed fees or other atypical pricing structures.

The hope is that, by securing clients early, firms will reap the benefits later on when companies have matured and need more comprehensive support. Strong sums up the competing interests: ‘There is a question mark over whether you think that company is then going to provide more profitable work in the long term. It’s a balancing act between how generous you’ve been on the fee front versus how much you think they’re going to progress. You take it on a case-by-case basis.’

As a result, lawyers have to be judicious in who they agree to represent – there is no use getting into bed with companies going nowhere. Says Grew: ‘Here’s what we look for in a great client: founders that have passion, ambition and the desire to grow their company fast. We’ve developed this strategy over many years as a result of pattern recognition based upon the thousands of founders with whom we have worked that have been successful. We also rely on a strong referral network of trusted advisers and key players in the tech ecosystem.’

That high risk/high reward approach can work both ways: ‘We have turned stuff down if we think it’s rubbish. We have probably turned stuff down that has turned out to be excellent,’ admits one tech partner.

‘Do I think that over the next two years we’ll still do about as much work? Yes, absolutely. But there are too many variables to know how things are going to look over the next six months.’ Chris Grew, Orrick

While headstrong founders might cause their lawyers to tear their hair out (‘all founders seem to have read The Hard Thing about Hard Things and think they know everything,’ bemoans the same tech specialist), when working properly the relationship allows for learning on both sides. As Willbe explains: ‘One of the most fascinating things about working with founders is that, with people who have legal backgrounds, you can say: “Well, this term is like this, because that’s the way these deals get done.” Whereas a lot of the time founders who you’re working with directly, say: “OK, but why?” It’s really interesting to go back over some of your assumptions. A lot of the time, the way things are done probably is the right way. But some of the time you look at something and say: “You know what, actually it doesn’t make any sense any more.”’

The road ahead

In light of the uncertainty that surrounds the market, the next few months are harder to predict. Grew’s outlook reflects a common aversion to crystal-ball gazing. ‘The next six months is the timeframe that is pretty difficult to estimate. Do I think that over the next two years, averaged out, we’ll still do about as much work? Yes, absolutely. But there are too many variables to know how things are going to look over the next six months. Fortunately, we have the experience of going through several cycles in the technology sector and can advise our clients on how best to handle this downturn yet be prepared for long-term success.’

Even in leaner times, investors will also be scouring the market for the next big thing to take off. Says Eldridge: ‘Metaverse is still incredibly nascent. There is still a huge amount to come out of that.’ Meanwhile, the ever-growing ESG agenda means that innovation in areas such as cleantech and agritech will also be piquing interest. ‘We’re seeing the demand for green tech and sustainability focused businesses become really prevalent. That’s actually pervading infrastructure, real estate, and more traditional sectors like that, because people are really focused on net zero targets and how we can actually be building things in a more sustainable way,’ explains Waters.

Ultimately, it seems likely that the halcyon days of the last couple of years will take a while to return, but eventually company and investor expectations will come back into balance. ‘There is a school of thought that says this is now going to take a cycle to price through. if multiples really have come down and they’re going to stay down, which a lot of people believe is going to happen, then you’re going to need to see those big late private financings happening and valuations that take account of those exit multiples before IPOs are going to be back on the table,’ says Willbe.

In the meantime, companies and the lawyers that advise them will focus on what they can control. Cohen concludes: ‘There are always going to be unknowns. The mini budget and Ukraine conflict for example. The effects these events have had on the market have damaged many businesses. But you can proactively predict a number of likely events and you can prepare for those. Guiding founders down that path towards growth is the absolute core of what we do.’

charles.avery@legalease.co.uk

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