On June 24th, 2016, the geopolitical landscape in Europe shifted in such a way that plunged global markets into chaos. The United Kingdom held a referendum on whether or not to leave the European Union (EU), and it was recently announced that the “Leave” movement won with 52% of the national vote, and that the UK will be officially withdrawing from the EU. The referendum turnout was 71.8%, with more than 30 million people voting. It was the highest turnout in a UK-wide vote since the 1992 general election.
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The frightening revelation being faced by global investors is that we have never seen a country leave the EU, and therefore there is a massive sentiment of uncertainty, which has sent the UK Pound plunging against many major currencies (Figure 1), and depreciated global markets across the globe. Uncertainty is an investor’s worst nightmare, and unfortunately the EU Treaty Section which addresses the process of withdrawing from the EU was purposely drafted in a vague manner – discouraging member-nations from leaving. This vague language within the treaty has left Britain with relatively no idea how or when it will be able to sever its ties with Brussels; and human nature has motivated investors to simply cash-in their portfolios rather than waiting to “see how everything turns out.”
Figure 1 – GBP/USD Exchange Rate, June 24th @ 2:07PM EST (Yahoo Finance)
The Startup sector never responds well to uncertainty, and therefore the immediate implications of the decision to leave will likely be negative. Investors are willing to fund new projects in safe and secure economic climates, however when the stability of their own assets comes into question (as it has with Brexit vote,) this funding often-times dries up. Cash reserves become critical, and only the startups with secured funding and reasonable burn-rates are able to weather the storm. Similarly, many start-ups utilize global talent pools to staff their operations, and with the highly-depreciated GBP, many of these foreign employees will be made redundant as cash is shifted to maintain the status of daily operations. Finally, there is the issue of trade. While leaving the EU does not necessarily mean that UK companies can no longer sell to EU customers, it does mean the introduction of tariffs. Tariffs will likely reduce demand for UK exports, hurting any startup within this sector to a much greater scale than it would a well-diversified conglomerate.
The vote has happened, and the world did not end. The key now for start-ups is to look forward, manage cash flow effectively, and operate on a lean and efficient business platform.
Survival of the Leanest
With the recent turmoil in the global financial markets, risk capital, be it venture or growth capital, will be even more difficult to come by. Even though there still remains substantial liquidity, we expect that most capital will be re-allocated to safer investments; typically US bonds, gold, and government securities from other relatively stable countries. With this decreased capital availability, start-ups will not be able to justify and maintain excessive monthly cash burns, and will have to rethink every expenditure.
Operating with a lean business model is important for any start-up, however in times of economic turmoil it is mandatory. A large proportion of start-ups rely almost exclusively on investor funding during the early stages of development, and therefore their cash inflows are directly correlated with the economic climate in which they operate. The Brexit has shattered investor confidence across the globe, and we are seeing the mass-reallocation of capital to safer assets already. This does not imply the demise of all start-ups, however, it necessitates being prudent with cash.
Foreign currency hedging
Unfortunately, for the majority of technology companies in the UK, a significant portion of expenses are denominated in USD; and with the GBP plummeting against it, the GBP expense will increase. Start-ups need to try and build natural hedges in foreign currency where possible (i.e. try to arrange business model so that revenue and costs are denominated in the same currency, wherever possible.)
There are many ways to mitigate the risk of currency appreciation/depreciation for UK start-ups, in a post-Brexit world. Many start-ups will likely consider converting their international payroll so that all employees are compensated in GBP; removing all risk of future volatility in the GBP/USD rate. Similarly, larger start-ups may wish to employ the use of derivatives to build hedges against future exchange rate volatility; locking in a set exchange rate today to remove that notorious uncertainty.
Re-evaluate your location strategy
While not every start-up has this luxury, many UK companies will contemplate whether or not it still makes sense to operate out of the UK, with limited, or even no access to the single European market, declining professional talent and the resulting inflated salaries. There are several stable nations that provide start-ups with grants, equity, and professional support if you move operations within their borders. Contingent on which sector you operate within, there are many other geographical segments from which a start-up could choose. This is going to be an especially big challenge for fintech companies within the UK, as several global financial institutions are also reconsidering whether the UK is still the place to be.
Survive through the winter
The global economy is like a wave in the ocean, with natural ups and downs. Occasionally geopolitical events such as the Brexit vote disrupt this natural cycle to plunge the economy into an artificial downturn, however the cycle has been proven to continue and it is likely that this economic downturn will-to pass. Start-ups have a much tougher time weathering these man-made downturns compared to larger conglomerates, however, through the implementation of the above strategies and a clear strategic drive, any start-up can adapt to changing economic conditions and come out of a recession stronger than ever.
While the Brexit vote shook investor confidence worldwide, and this is likely going to have negative implications on the start-up sector, there is absolutely no reason to lose hope. The world has been through many of these black-swan events in the past, and with proper cash-flow management, hedging strategies and managerial skills; any start-up should be able to weather the storm and recover in the years to come. The Brexit vote brought with it a lot of uncertainty, however as the months go by and the regulatory situation becomes more clear, we expect investor confidence to recover; and with it the ease-of-access to risk capital.