Brexit could mean the extinction of unicorns in the UK

Brexit, as the British referendum to exit the EU is widely called, has caused turmoil in politics and stocks and head-shaking among the UK’s partners. All of this, of course, comes on the heels of many overlapping crises afflicting Europe.

In addition to the ones regularly in the news, I have argued earlier in HBR that there is a fundamental crisis unfolding over the longer term: the continent is suffering from a “digital recession” – a loss of momentum in their evolution toward a digital economy. Of the 50 countries we studied using a Digital Evolution Index we created, 15 European countries have been losing digital momentum since 2008 and EU countries occupy the bottom 9 spots in our ranking of digital momentum (starting from from Norway is ranked #42, and after them it’s Denmark, Spain, Hungary, France, Belgium, Finland, Czech Republic, and finally, the Netherlands).

With the UK at 34 out of 50, it is worth asking: what is the impact of the Brexit referendum on this already dismal state of affairs?

The prognosis is not good. The UK tech sector has been among the groups most vigorously opposed to exiting. A survey of members of Tech London Advocates, an industry group, revealed that 87% opposed Brexit. Gordon Ross, a lead tester on the Grand Theft Auto game, reportedly characterized it as “madness.” Vodaphone is considering moving its headquarters out of the UK and its CEO Vittorio Colao had told the BBC that a Brexit would preclude it from a giant new single market. One of the UK’s top unicorns – startups with more than $1 billion valuation – TransferWise is considering alternatives; “Headquartering elsewhere is a possibility but we haven’t made a final decision yet,” according to TransferWise CEO, Taavet Hinrikus. These are real concerns for the UK economy overall as the tech sector accounts for around 10% of British GDP.

The UK is also disproportionately influential in Europe’s digital industry. According to estimates by McKinsey, if France (for example) were to shift into a higher gear and equal the UK’s digital state, its hypothetical economic gain could be about €100 billion. The UK tops the list of major countries in Europe with the highest “birth rates” of new enterprises; only Romania, Latvia, and Slovakia fare better. It is home to over 40 per cent of Europe’s unicorns. A third of VC investments in Europe were focused on the UK in the first quarter of 2016, according to CBInsights. The UK leads Europe in “app economy” jobs. In certain areas of technology, the country is the undisputed leader for the continent: with London as the center of fintech in Europe, for example, fintech investment in the UK was $5.4 billion as compared to $4.4 billion in the rest of Europe over the period 2010-2015.

In front of this backdrop, I see five likely outcomes of Brexit on the UK’s and the continent’s digital economies:

1. Decision-Making Will Be Held Hostage to Uncertainty

The single biggest challenge for the digital future of the UK and Europe is the lack of clarity in the years ahead. While after a period of policy adjustments and re-negotiation, much of the relationship with the EU may well remain intact, the endgame is uncertain — and there is a wide gap separating the worst and the best-case scenarios.

The UK will formally break its ties with the EU no earlier than 2018; this means that the business environment will remain fluid for a while, which could be devastating for many firms, but especially for digital players that operate on tight time-frames at the intersection of several fast-moving industries – software, media, gaming and fintech. Currency movements may have an impact on the valuations of enterprises and could freeze investments in ways that could be debilitating. Advertising, hiring and capital expenditures could be delayed until the dust settles, jeopardizing the growth models of many enterprises.

The uncertainty could have an impact on a wider ecosystem that affects the attractiveness of the UK as a tech hub: retail, hospitality, healthcare, and financial services. Given the digital recession in Europe, the post-Brexit uncertainty alone could accelerate the region’s loss of competitiveness. It will be felt most acutely in the UK, which, in turn, is bad for the EU, given the disproportional role of the UK in the continent’s digital industry.

2. Digital Talent Will Be in Shorter Supply

Engineers from the EU have been key to the successes of many UK companies. A 2015 survey by Wayra, a startup incubator, last year found that over a fifth of startup talent in the UK came from other EU countries.

The digital talent market in the UK is already tight. As it is, software developers in a UK tech startup earned about 26% more than the industry average and those in sales and development in the UK earned 12% more than the industry average – making the country one of the more expensive locations to launch a venture. The coming squeeze on talent will make this situation much worse.

Unless the new administration in the UK manages to work out some form of a deal on immigration and work permits with the EU, its digital industries will be hobbled by a talent shortage and a steeper cost disadvantage.

3. Scaling Up Will be Harder Without Common Platforms and a Single Market

Even if the UK’s digital industry adapts to the new reality, as it no doubt will, it will be precluded from many existing and emerging platforms critical to scaling-up and competitiveness.

UK entities will be shut out of the “Digital Single Market” (DSM) initiative across the EU that intends to eliminate many of the obstacles that have caused the digital recession. The DSM will facilitate data-sharing “safe harbor” agreements, bank licensing agreements, and uniform rules affecting digital traffic ranging from e-commerce to digital streaming across the EU. The DSM is also expected to mobilize over €50 billion of investments. UK firms could be precluded from using the new European cloud. Also out of reach: a €500 million network of digital innovation hubs and the Digital Agenda for Europe initiative (a €2.8 billion R&D fund ). The UK gaming industry could be cut off from the Creative Europe Fund, established by the European Commission. UK fintechs would lose the benefits of financial services “passporting,” which allows a firm regulated by one EU member-state to offer its services across the EU without additional authorization.

The UK will, in effect, be on the outside looking in as the EU tackles the central problem of fragmentation that hobbles its digital value chain. As a result, consumers will pay higher prices for buying products – or even making phone calls– across the UK / EU boundaries. This combination of forces is likely to throttle the industry in the UK and across the continent.

4. Innovation Hubs Will Fragment

It is tempting to think that the UK’s loss would be the EU’s gain. After all, Berlin, home of Rocket Internet and SoundCloud, is already London’s closest rival for attracting tech startups and is likely to become more attractive as a startup capital following Brexit. Other cities could compete to become hubs for key verticals; new fintech hubs could emerge in Frankfurt, Amsterdam, and Dublin.

And yet the net effect of Brexit could weaken European tech hubs as well as London. There are benefits to having the clustering of innovation capacity, talent, resources and cultures and deriving economies of critical mass. London’s departure hurts the whole ecosystem.

In tech funding, the EU already lags the U.S. by five fold and Asia by two fold. A post-Brexit fragmentation is likely to further increase that gap.

5. Hostility Between US Companies and EU Regulators will Increase, and Britain’s Influence Will Wane

In recent years, the EU has been at loggerheads with major U.S. digital players – Google, Facebook, Amazon, and Uber, among others. Germany and France have been the most zealous in their pursuit of regulations and legal initiatives against US tech firms, while the UK has been a moderating, market-friendly influence. In the absence of the latter, the frictions between US firms and the EU are likely to increase.

A major point of contention in recent years, brought to a head by the Edward Snowden revelations, has been the question of how US firms process the data of EU citizens. The EU has been unable to finalize an “adequacy” decision that declares the US safe as a destination for personal data. The EU is working on a new set of privacy rules in the form of General Data Protection Regulation, which will not apply to the UK directly. This means the UK will not be able to contribute to the regulations and will have to negotiate its independent privacy provisions.

Aren’t there any possible upsides to Brexit for the tech industry? There may be some silver linings; here are a few to consider:

-UK companies could access EU funds using the models drawn from, say, Israel and Norway, which are both part of the Horizon 2020 innovation and funding initiative of the European Commission.

-Being detached from the EU could open other doors, in particular with the much more dynamic clusters in Asia, particularly in China and India.

-Without EU regulations tying its hands, the UK tech industry would have new degrees of freedom to compete against and collaborate with US and Asian counterparts.

-The crisis could be a boon to disruptive forces. For example, as the traditional financial services sector struggles to deal with Brexit, this could create an opening for the fintech upstarts to win market share.

Those are long-term possibilities, but at least for the next two years, Brexit will unquestionably deepen Europe’s digital crisis. Unless visionary steps are taken, Techxit, i.e. the flight of digital talent and money from Europe and the UK, will follow.