Sir Humphrey Appleby, Wyatt Earp’s Advice for Start-Ups and UK R&D Tax Credits

When the chancellor announced his changes to R&D tax credits, I was on a conference call with a client. The CFO joined late and relayed the news. Thirty seconds later, the company’s engineers in the Czech Republic had become a lot more important and U.S. investment was also looking attractive.

Employing about thirty engineers and selling into engineering-intensive industries, my client is a good example of what the government intended when it introduced R&D tax credits back in 2000. In its own words: “Increasing the amount of R&D carried out by companies is a key part of the government’s aim to increase productivity and promote growth.” I could join the choir of whingers complaining about the recent changes. But I’m not going to.

Most people complaining about the reduction in R&D tax credits forget that that it is only recently that the scheme has been so generous. Were these people equally vociferous back in 2014 when the SME payable credit rate rose from 11% to 14.5%? Or in 2015 when the SME enhanced expenditure was put up to 130%? Being completely rational, one shouldn’t complain too much about the most recent changes.

Instead, let us be constructive. Or do I mean controversial enough to stimulate debate? Now the dust has settled, here are some reflections on the implications of rebalancing the R&D tax credit system in favour of larger companies. My R&D experience goes back well before the dot com boom, and certainly before the tax credit system was introduced, so I’m well aware that research and development can be done without government support. The best entrepreneurs always find ways to innovate...although they may of course choose to do it elsewhere.

Compliance and Fraud

Firstly, let’s talk about abuse, compliance and fraudulent claims. This is one of the things explicitly mentioned in the Treasury's January 2023 review. I spend a lot of time with finance directors and accountants. Yes – my social life is that good! Most accountants have stories about how a client got their R&D tax credits wrong. I've yet to see an ACCA branded cape, but typically, these stories feature a heroic accountant rescuing a struggling start-up. In all cases, the errors the accountants had to fix were accidental rather than malicious – cock up, not conspiracy!

While this is anecdotal evidence, it is definitely inside information. It seems implausible that fraud levels are that high. Even if there were a high incidence of fraud, why not fix the cause rather than chop off the symptom by downsizing the SME scheme? Is the Government unable to identify fraud? If not, then how does it know there’s a problem?

On the other side of the divide are the larger companies which take advantage of the RDEC system. Companies with less than 500 employees, turnover of under €100m or assets less than €86m are classed as SMEs. I’m not sure what this definition says about the Government’s understanding of SMEs, but does anybody want to come in on a pre-seed round for stand-up comedians from the civil service?

Regardless of where you draw the line, companies using the RDEC usually have enough support staff to get their applications right. They also have the resources to lobby Government. By contrast, if you are a software team whose office is GitHub and Zoom, your support staff may be no more than a co-founder’s pet labrador. The labrador probably only works Tuesdays and Thursdays and is unlikely to go along to meetings of the CBI. For this reason, the Government’s 2021 consultation, which asked for responses from firms that undertake R&D, business groups and trade associations, accountants, accountancy bodies and academic institutions is biased in favour of larger companies.

It does seem plausible, however, that large companies might be less likely to commit fraud. After all, larger companies have the support staff to be tax-efficient which can be just as lucrative as more nefarious alternatives. Historically, IP arising from R&D was often transferred to one of the sunnier tax regimes. This reduced the Government’s tax take just as surely as fraudulent SME claims.?But it was certainly not illegal. Of course, many jurisdictions, including the UK, realised they needed to compete somehow and have introduced patent box schemes which reduce taxation of IP assets. This is a good example of the Treasury being smart. The legislation pertaining to the British Patent Box scheme has even been amended in line with the tax credit scheme to include data and cloud-computing costs.

Parking IP in a friendly tax regime is rarely relevant to startups though. When kicking the tyres on a start-up (due diligence ‘lite’), I often see companies with something patentable. They can rarely afford to prosecute a patent application or, potentially more importantly, pay for advice on a patent strategy, let alone move their IP offshore.

Timing

What certainly is relevant to start-ups is timing. The change in R&D tax credits comes into effect in April 2023. There is a certain amount of breathing room because corporation tax and tax credits are calculated retrospectively based on the previous year’s results. To many in the start-up world, though, this seems precipitate. Mark Zuckerberg famously may have encouraged startups to ‘go fast and break things’. This is fine in context, but I sometimes think Wyatt Earp's advice on gunfights might be more appropriate to start-ups.

"Fast is fine, but accuracy is everything....You need to take your time in a hurry."

What does that mean in this context? Well, for VC-backed startups it often makes sense to plan based on how much money you need to get to the next significant milestone. On average, this is something like two years – the typical time between investment rounds. So it makes sense for start-ups to push their R&D as fast as possible but take the time to plan a couple of years ahead. That takes us well into the new tax credit regime.

Based on 2020 data, the mean amount claimed under the SME scheme was just under ￡50k a year. According to HMRC's 'Evaluation of the R&D Tax Relief' this total figure is remarkably stable. For a small tech startup, where employees have options as well as salaries,?this is equivalent to one or two employees. How are they going to get paid under the new regime? Does the company fire them and fail to meet its R&D goals or risk a down round to make up the shortfall? Some jobs will probably be lost.

So, at least for SMEs, the timing sucks. But are these changes really a bad thing? Recent studies by the Treasury show that, for each pound spent, the RDEC scheme incentivised ￡2.4 to ￡2.7 of additional private R&D expenditure compared with only ￡0.6 to ￡1.28 for the SME scheme. On the face of it, the Government has significantly increased the amount of R&D which will done in the UK.

That’s fantastic, isn’t it? Shouldn’t spending more of our taxes on research be lauded? Surely all R&D will benefit our country? Actually, that question turns out to be rather complicated, particularly for those who don’t have an innate and visceral understanding of power laws.

Power Laws for Those in Power

You see, the thing about venture-backed startups is that they are selected to have the potential to grow by at least an order of magnitude. Most will fail miserably of course. But those rare few which are successful will grow by orders of magnitude. They will employ hundreds or thousands of people and contribute to the economy out of all proportion to their original size.

More mature companies generally don’t have the scope to do that. Companies mature enough to be backed by private equity are more likely to go for a quick flip – a high IRR but with relatively small cash on cash returns. Public companies are even more pedestrian. Anything more than about 15% a year is likely to beat the market.?

Let’s make this more concrete. Suppose we have a start-up working out of a garage and called, for the sake of argument, 'Cadabra'. Let us further suppose that it has half a dozen employees trying to develop ways to make retail supply chains more efficient. Friends and family invest quarter of a million but have no more money to give. Should HM Treasury support this firm’s research efforts? Or would it be better to back a more established retail company like Tesco?

If the fictional Sir Humphrey Appleby were seconded to the Treasury, he would probably argue that backing ‘Cadabra’ would be “extremely courageous”. Of course, reading Greats at Oxford does not give one a particularly visceral feel for power law returns from venture capital. In this case, Sir Humphrey just rejected Amazon, which Jeff Bezos originally wanted to call 'Cadabra'. Amazon now employs 1.5 million people whereas Tesco only employs 350,000. It is true that this is an extreme example. Yet in a country the size of the UK, the likelihood of start-ups contributing disproportionately to employment is statistically overwhelming.

Unfortunately, even though now is one of the best times to invest in VC for decades, VC investment has slowed. The smarter and more experienced VCs are making hay but others have pulled back and the mean time between rounds is increasing. This makes the start-up world particularly vulnerable to changes it has not had time to plan for. Had the change in R&D tax credits been implemented more gradually, the market would have had time to adapt.

Yet let us not be too unkind to our notional Sir Humphrey figure. He or she may be more attuned to the laws of power than power laws, but one does not read Greats at Oxford without a fine intellect and the ability to learn. He would swiftly surmise that his political masters might prioritise jobs over ROI from R&D. We have already seen how Government consultation was (perhaps inadvertently) biased. And it is too late for a Royal Commission. Yet perhaps a free and open debate over the merits of jobs versus ROI might be instructive. Sir Humphrey might even envision that, in the fullness of time there might be some form of technological platform linking those who might contribute to such a debate.

Provocative as they may be, hopefully these stream of consciousness (and occasionally tongue in cheek) musings are controversial enough to stimulate debate. In the meantime, while breakages are as yet unclear and the start-up world continues to move swiftly, we must also be philosophical. In the words of that great sage of the start-up world Sir Humphrey Appleby:

“The Prime Minister Giveth, and the Prime Minister Taketh Away. Blessed be the Name of the Prime Minister...”

For those who want a non-TLDR summary of the changes to R&D tax credits, there's a neat summary by BDO here.

For those who want a more in depth discussion of R&D tax credits, there is a discussion paper by the think tank Onward here.