How a slowdown in economic activity impacts the tech sector

Answer

Global trends

During the global pandemic, technology companies enjoyed an abundance of inexpensive capital along with favourable valuations and terms. More recently, however, most sectors have experienced increasingly challenging conditions as the market faces a downturn.

UK focus

Tech investors, on the whole, remain optimistic despite the broader UK market entering an economic downturn and a year of falling stock prices for publicly traded technology companies. There is, however, a noticeable shift away from soft tech towards ‘hard tech’, such as, self-driving cars, quantum computing and cryptographic authentication, because their intellectual property tends to be more valuable than traditional e-commerce or enterprise software businesses. Although, early-stage companies are typically less susceptible to global stock market shocks in the short term, they’ll nevertheless experience turbulence in the medium to longer term.

Nonetheless, a larger number of tech deals are being conducted at high liquidation preference multiples. This provides investors with a guarantee of a certain multiple of their invested capital upon exit or with price-based anti-dilution provisions to protect them in the event a company sells equity at a lower price. This is exacerbated by fewer funding sources and investors tightening their investment criteria for valuing businesses through strong fundamentals such as cash flow, capital efficiency and unit economics. 

As venture capitalists and other investors prepare for an economic downturn, businesses should consider having sufficient funds to continue investing. Typically, businesses aim to have funds that could last at least three years to protect against a reduction in capital inflow even if the market falls. Notably, venture capitalist fund, Andreesen Horowitz announced its $4.5 billion web3 fund seemingly unabated by recent layoffs in prominent tech companies in the cryptocurrency exchange and media spaces, such as, Coinbase, BlockFi and Netflix.

UK stimulus

Despite challenging headwinds, the UK’s Digital Strategy has set out the government’s intention to finance digital growth, enhance technology adoption and focus on digital infrastructure, data, regulation and digital markets, and security. Other areas that are seeing continued investment are climate tech and fintech.

With nearly 1000 UK tech companies collectively raising in excess of £12 billion within the first five months of 2022 against a backdrop of slowing growth in global public markets, this demonstrates the resilience of the UK’s tech industry. By comparison, in the first three months of 2021 UK tech firms raised £6 billion, whereas in the same period in 2022 this was £9 billion. During that quarter, the UK overtook India and China for tech investment holding second place globally, only behind the US.

Outlook

Historically, there are few initial public offerings during an economic downturn and the value of shareholder/founder exits drops accordingly during the same period. Thus, start-ups looking to pursue follow-on funding will be faced with a smaller exit value and an increased pressure to raise funds on smaller round sizes.

Despite less favourable conditions in the market, the global drive towards environmental, social and corporate governance standards will remain, this is bolstered by Westminster’s commitment to net zero that make up the foundations of continued investment.

On the whole, outlook in the technology sector remains positive. Issues such as climate change, drive for net zero, and the acceleration of digital platforms rooted in various environmental, social and corporate governance standards will remain resilient irrespective of economic uncertainty. Therefore, businesses looking to address these issues would appear well placed to continue to attract investment.                                      

Aaron Lee is a solicitor in the corporate team at Burges Salmon LLP.