The rift between the forces of innovation and their supporting financial structures is a topic of intense discussion in Switzerland. On February 18, 2016, the Law School of the University of Neuchâtel hosted the 7th day of start-ups, small and middle-sized companies and innovation (hereinafter referred to as “the conference”). During one busy day, a smartly-selected panel of experts, from lawyers and professors to VCs and CEOs, reviewed and assessed the state of the ecosystem in which Swiss start-ups attempt to develop today. Although some Swiss-based start-ups have made major breakthroughs, particularly in the field of medtechs and life sciences, many still do not see Switzerland as a business-starting-friendly country, thus breaking camp for new horizons abroad. The early nickname of “Silicon Alps” might have been given a little too early. But how to explain the scarcity of capital risk investment in the country that has maintained its 1st place in the Global Innovation Index for four years?
Here is an account of the current state of the start-ups’ ecosystem in Switzerland based on the topics that were dealt with at the conference along with personal views and research on the matter.
1. A complex costly conservative ecosystem
The World Bank Doing Business Project 2016 has nudged Switzerland out of the top 20 business-friendly countries. Globally, Switzerland now stands at the 26th position in the ranking of 189 economies on the ease of doing business. Worse, Switzerland is at the 69th position on the ease of starting a business and the 105th position on the protection of minority investors, according to the same ranking.
The lifecycle of a start-up, at its inception, usually comprises three steps :
- “Seed rounds” : initial capital contribution brought in by business angels, private investors, friends and family, accelerators or incubators. This is the moment of the proof of technology.
- “Valley of death” : period during which additional financing becomes scarce, leaving the firm vulnerable to cash flow requirements. This is the moment of the proof of market.
- “Early and later stage” : once the start-up has survived the break-even, it begins generating revenues so that financing rounds may be negotiated allowing products to mature and hopefully penetrate the targeted market. This is the moment of the proof of growth.
Swiss investors show considerable restraint when it comes to financing the most critical stage of the start-up’s lifecycle : the so-called “valley of death“. With a good high-concept pitch, young entrepreneurs can easily collect early seeds from enthusiastic investors. Associations such as the government-sponsored venture platform CTI Invest have proved to be useful tools in this respect. However, as the curve naturally declines after the first seed rounds due to the need of further investment, things become more complicated with a considerable absence of VCs ready to take the leap by investing in capital risk. This reflects the social, economic and legal background that Switzerland inherited from the post-war generation and which is still dominant nowadays. With a population that has been encouraged, during the last half of the century, to spare, take out leases and work as employees, social rights have become extremely developed, especially in labor law, and common conscience has always commanded people to not borrow too often, respectively to not lend without physical guarantees. Although, this seems to be common sense, no growth comes from no risk. Private equity investment is still seen with a wary eye in Switzerland, but this is about to change.
2. The changing conception of labor forces
3. Venture capitalism in Switzerland
Harald Nieder of Redalpine, the first speaker of the conference, asked the audience an easy question to all appearances : “Can you name any VCs in Switzerland”? A single hand was raised : “Well, yourself and… I don’t know”.
Numbers say it all. According to the KPMG Venture Capital Report Q3 2015, a total of CHF 676m of venture capital has been invested in Swiss start-ups in 2015. This is approximately the amount that was spent in California per week during the same year. For ICT start-ups, CHF 130m was invested in Switzerland in 2015. In California, the same amount was invested every 1.5 days.
What are VCs looking for in Switzerland? First and foremost: fast and high growth. Following a hands-on approach, VCs not only provide late seeds but also have an interest in entering the board of the targeted start-up. Young entrepreneurs should be aware that they may lose control of their company at this point. The early-seen goals of the company, the will of giving it a strong identity and the long term vision are approaches that may be replaced by a whole different perspective : that of the return-based approach. Second, VCs tend to look for scalable start-ups, which means structures with low or moderate capital requirements. Third, in order to achieve returns in time for their own investors, VCs will look for exit opportunities. Fourth, VCs are interested in start-ups that seek international expansion, knowing that Switzerland is not (yet) a viable place to grow further. This is the proof that the “Silicon Alps” lack some snow, just like this winter over here.
What are the benefits of VC investments in a country? According to the Swiss Venture Capital Report 2016, VC investments represent a bit less than 0.2% of the U.S. GDP. However, such investments generate a very strong growth of employment opportunities. Jobs that come out of such growth represent a global production of 21% of the U.S. GDP. So, one person in five in America would have a job thanks to the net job creation generated by VC investments.
If VC investment is so prosper overseas, why does it still represent 0.1% of the Swiss GDP? Ruud Riem-Vis of Kizy was a speaker at the conference and presented the view of some Swiss entrepreneurs. For Arnaud Bertrand of House Trip, Swiss-sized start-ups cannot compete with those that can be found abroad. Indeed, the big fishes tend to quickly rid the market of possibilities of similar companies to emerge. For Pierre Chappaz of Kelkoo, Swiss start-ups take too much time to reach the international market. There are 65 Israeli companies listed at the NASDAQ. How about Swiss companies? There are none. David Sidler of investiere.ch leans towards expansion in London, Berlin or the U.S. when the company goes from a dozen of workers to a hundred. Finally, for Fathi Derder, a Swiss liberal politician, there is a strong need of exempting certain stocks from taxation in order to compensate risk taking.
4. Other investors: angels, friends and family, incubators, etc.
While VCs are mostly untiringly seeking return, control of the company or exit within three to five years upon investment, some other investors might be interested in long term investments as well as creating industrial value and identity. Urs Hunkeler, who spoke at the conference, has favored this approach with his company Geosatis. Far from the hotspots of major financial hubs, Geosatis is a prison bracelet producer that has chosen to headquarter in the remote municipality of Le Noirmont in the canton of Jura. This made-in-EPFL start-up has given priority to strengthening its identity. The founders have thus preferred keeping control of their project. Seed rounds were initially carried out by insiders and angel rounds by early outsiders. Using Swiss patriotism, they have even been able to attract friendly investments, 0% loans or State support. Probably, their biggest hit is to have turned down a seven-digit bid from a major U.S. competitor.
Young entrepreneurs should always choose their strategy for the next three years, or at least define the final goal of the undertaking. They should bear in mind that there exist investors which will only support companies that seek long term operations, such as the State for example. Investing in a structure that we know will be sold at some point is not always interesting. Entrepreneurs should also take into account the customer’s loyalty. Why would anyone use the services of a company whose lifetime is ephemeral?
Thomas Steinemann of DuBois et fils explained during the conference that a successful start-up might want to show strong transparency. The emotion and the will of the entrepreneurs are critical features that define the success of the company.
5. Crowdfunding : definition, risks and regulation in Switzerland
Once used out in the streets of Manhattan by the U.S. military for raising funds and support the war effort, crowdfunding has recently acquired a reputation for being an effective means of collecting the necessary seeds to carry out one’s project. Individually invested quantities are small, however participants are numerous. How come? Digitalization. No more need to go onto the streets to shout about one’s project, online platform perform this task, such as the market leader Kickstarter, which now operates in Switzerland as well.
Crowdfunding is a form of alternative finance, which has emerged outside of the regulatory frameworks of financial systems. It exists in different forms:
- “Crowd supporting” : a reward-based method by which entrepreneurs pre-sell a product or a service in order to launch a business without incurring debt or issuing shares (for example Kickstarter).
- “Crowd lending” : a debt-based method by which young entrepreneurs substitute the bank, from which they are not able to afford a loan, with the crowd.
- “Crowd investing” : an equity-based method by which backers make a collective effort to support the start-up through the provision of finance in the form of equity. In exchange of the money pledged, they receive shares of the company, usually in its early stages.
- “Crowd donating” : a charity donation-based method by which individuals make a collective effort to support a charitable cause.
According to crowdsourcing.com, global crowdfunding experiences accelerated growth in 2014, expanding by 167 percent to reach $16.2 billion raised, up from $6.1 billion in 2013. In 2015, the industry is set to more than double once again, on its way to raising $34.4 billion.
In 2014 in Switzerland, 15.8 million CHF have been raised through 1’078 campaigns of crowdfunding, says the RTS (Radio Télévision Suisse). These figures represent an increase of 36% compared to last year, according to a survey by the University of Lucerne. However, in absolute terms, they remain proportionally low next to those of the U.S. and the U.K. markets. During the same year, crowd supporting and crowd donating equally represented 50% of the Swiss global crowdfunding activity. Crowd lending went from 1.8 to 3.5 million CHF.
How is crowdfunding regulated? Mainly, there are two groups of countries : those which put in place a specific regulation for crowdfunding (Brazil, Hong Kong or Singapore) and those which put in place ad hoc systems (France, the U.K., the U.S., Québec or Japan). In Switzerland, crowdfunding is neither expressively ruled by the law nor regulated by a specific authority. The consequence of this is that the activity of crowdfunding may fall under the rules of different laws, for instance the Swiss Code of Obligations for the contractual relationships, the Swiss Civil Code for the legal form of the company, the Banking Act for the possible activity of banking, etc. As in many countries, the law is adapted for traditional activities, however it does not keep up with the digital economic reality. Crowdfunding involves cross-border situations that may trigger the application of dozens of legal systems. But, once more, States do not adapt at the same pace to these new economic forces. “Where the U.S. make it a business, the Chinese copy it and the Europeans regulate it”, says the new adage.
For individuals there is a risk of a lack of transparency. The consumers may find themselves powerless if they never get what they invested for. Swiss law doesn’t provide for the possibility of bringing class actions. Therefore, such individuals are unlikely to take legal steps to claim something worth a hundred bucks. Things become worse when it comes to crowd lending. Indeed, the company may apply extremely high interest rates (more than 5%). There is usually no senior debt for creditors in case of bankruptcy. Moreover, in case of crowd investing, it should be recalled that there is no legal protection of investors as it is the case for collective investment schemes with the Collective Investment Schemes Act or the upcoming Financial Services Act (expected to come into force in 2018).
For entrepreneurs using crowdfunding is also a risky undertaking. In crowd donating for example, donations might fall under the scope of rules, such as those on inheritance in the Swiss Civil Code, which may trigger a specific taxation. But more importantly, the activity of raising funds from the public may be qualified as a financial activity subject to an authorization. Indeed, the Federal Banking Act provides that a natural person or a legal person may not accept deposits from the public on a professional basis without being granted a banking license by FINMA (Swiss Financial Market Supervisory Authority). Art. 5 of the newly-revised Ordinance on Banks defines the notion of “deposit from the public” as liabilities owed to clients. Art. 6 of the same Ordinance provides that natural person or a legal person shall be deemed to act professionally as per the Banking Act if it accepts on an ongoing basis more than 20 deposits from the public or recommends itself publicly to accept deposits from the public, even if upon doing so, fewer than 20 deposits result. In this connection, it is clear that internet-based platforms that offer crowdfunding services publicy call for deposits. More demanding, the company may have to observe certain duties according to the Anti-Money Laundery Act (AMLA), such as the duty to identify the account holder (Art. 3) and the beneficial owner (Art. 4), the duty to file a report with the Money Laundering Reporting Office Switzerland, the so-called “MROS” in the event of a suspicion of money laundering (Art. 9), the duty to freeze the entrusted assets that are concerned with the filed report (Art. 10) without informing the persons affected by the report (Art. 10a). Finally, the company may also be required to apply for a FINMA authorization under the Federal Law on Stock Markets and Securities Dealing (LBVM), should it act as a stock trader or broker. All of this goes without mentioning the new set of laws about to come into force and which will reinforce the duties of financial providers.
All in all, crowdfunding has fine days ahead of it. It is expected that many Swiss platforms will emerge, which would strengthen the trust of the customers. Indeed many still balk at using today’s big platforms, even for Swiss projects, because it involves abidance by U.S. law and, overall, payment to a U.S. banking account. The Cantonal Bank of Basle City is the first Swiss bank to have launched its own crowdfunding platform. More will follow.
6. The lack of success of the limited partnership for collective capital investments
Art. 98 ff. of the Collective Investment Schemes Act (CISA) defines the limited partnership for collective capital investments (LP) as a partnership whose sole object is collective investment. At least one member bears unlimited liability (general partner), while the other members (limited partners) are liable only up to a specified amount (limited partner’s contribution). General partners must be companies limited by shares (“SA”/”AG”) with their registered office in Switzerland. They may only be active as a general partner in one limited partnership for collective investment. The partnership conducts investments in risk capital. An LP must be authorized as an institution by FINMA before it can begin operations. The constituting document (partnership agreement) also requires approval. The general licensing and approval requirements set out in CISA apply. For Swiss income tax purpose, the LP is a transparent non taxable entity. Capital, income and gains derived from the LP are taxed directly with the investors. The issuance of LP interests is exempt from Swiss securities issuance tax and securities transfer tax. The repayment of invested capital is tax exempt anyway.
The LP is an Anglo-Saxon-like special purpose vehicle that has been created for venture capital investments. In 2007, the Swiss Private Equity & Corporate Finance Association (SECA) supported its introduction in the law considering it as “an attractive substitute for traditional offshore limited partnerships in view of the flexibility of the new vehicle, its attractive tax features and the obviation of the need to resort to complicated and expensive offshore structures”.
However, the LP never met the expected success. So far, we count a small dozen of them in Switzerland, mostly founded by the Ecole Polytechnique Fédérale de Lausanne (EPFL). The reason might be that the set-up of such entities must meet many stringent requirements. Qualified investors must use the services of accountants, lawyers and tax experts. Duties of independence require that a well-defined structure and organization be put in place. All of this gets away from the view that entrepreneurs have when launching a start-up : an accessible undertaking for accessible investors.
7. Hybrid investors : the lender who participates in the share capital
Another way of attracting investors is to use equity kickers. An equity kicker is a type of equity incentive typically issued in combination with privately placed subordinated or mezzanine debt to improve the return for subordinated debtholders (Divestopedia). Equity kickers can have a convertible feature exchangeable for shares or warrants to purchase shares at a set price at some point in the future. To summarize, it can be said that this hybrid capital lies between equity capital and debt. The conversion of debt into capital allows the company which runs short of cash flow to keep away from capital loss and overindebtedness. The clearance of some debt also decreases the risks for creditors who then become stakeholders.
8. The revision of corporate tax
In Switzerland, the ongoing revision of corporate tax may have a positive impact for start-ups. Among other things, this revision will in all likelihood implement a cantonal tax relief, or even a tax exemption, on revenues that come from R&D (research and development). The so-called “patent box” will strongly reduce taxes on revenues that come from patent rights. The exempted amount will be calculated based on a ratio between the elected R&D spending and the overall R&D spending, multiplied by a reduced tax percentage (maximum 90%). However, numerous questions remain open at the moment, such as the tracking and tracing conditions for R&D spending regarding the tax authorities.
Prof. Olivier Hari, a speaker at the conference from the University of Neuchâtel, thinks this revision might not be enough to act as an incentive for innovation in Switzerland. Indeed, at the present stage of the legislative work, cantons may have too much leeway for implementing such tax exemptions, he says to Le Temps. According to him, we should also partially exempt investments made by business angels from tax for they come into play at a very critical stage of the start-up’s lifetime.
9. Aspects of intellectual property : the “unitary patent” in the EU
Patent rights are a highly costly entry for tech companies. The reason is that, unlike trademarks or industrial design, patent rights are not subject to an internationally harmonized procedure. Prof. Daniel Kraus of the University of Neuchâtel presented, during the conference, EU’s unitary patent package that is about to see the light of day after having been in discussion for some thirty years.
The unitary patent – or “European patent with unitary effect” – is a European patent, granted by the European Patent Office (EPO) under the rules and procedures of the European Patent Convention, to which, upon request of the patent proprietor, unitary effect is given for the territory of the 25 Member States participating in the unitary patent scheme. The unitary patent will co-exist with national patents and with classical European patents. Patent proprietors will in future be able to choose between various combinations of classical European patents and unitary patents. The package will come into force after the deposit of the 13th instrument of ratification or accession (whereby France, Germany and the United Kingdom must be included among these 13 states).
The judicial organization will also change with the introduction of a decentralized Court of First Instance with local, regional and central divisions located in the Member States and a Common Court of Appeal in Luxembourg. The goal is to set up internationally composed panels, with legally qualified judges and technically qualified judges.
The most important impact of the unitary patent package is that it aims at decreasing the costs related to patent rights by 80%. That will undoubtedly favor innovation within small and middle-sized companies.
How will the European unitary patent affect Switzerland? Swiss start-ups will be able to initiate a single and fast procedure within the EU, which will dramatically lower the costs. However, in the opinion of the European Court of Justice, Swiss entities shall not join EU’s unified jurisdiction for patent rights. European patents with effect in Switzerland and Liechtenstein will remain under the jurisdiction of the Federal Patent Court, says the Federal Institute of Intellectual Property.
10. What happens when start-ups bounce back from the “valley of death”?
What happens to most of the Swiss start-ups which survive the break-even and start aiming at growth? Exile or sell. Some companies choose to leave Switzerland such as House Trip (London), Get Your Guide (Berlin) or apelab (Los Angeles). Other start-ups fall under the spell of generous offers by giant American bidders. We can mention Intel that acquired Lemoptix, Apple that acquired faceshift or Google that acquired Bitspin.
In the end, the outsourcing or offshoring of a company is like the case of a home-educated brain who leaves for another country taking with him his knowledge, the knowledge that Switzerland financed through its high quality public education. Needless to insist on the importance of keeping Swiss investments ashore.
As a conclusion
The Swiss regulatory framework is highly effective for traditional businesses, yet too shy for start-ups of the new era. Economic reality is now driven by digitalization and globalization. The law is as obsolete for start-ups as it seems to be for banks. Nevertheless, the aforementioned issues are being closely examined. Swiss investors will have to jump in or else foreign investors will. It is in my view easier to adapt a regulatory framework than to create innovation itself. Switzerland has an incredibly strong potential in this regard.
(Photo: blog.sprinklebit.com)
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