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30 August, 2022

The relationship between start-ups and FDI

There is a strong correlation between locations that attract start-up businesses and those with high outbound and inbound FDI volumes.

By Jon Whiteaker

There is close correlation between the cities and countries that are the best at fostering start-up companies and those that achieve high foreign direct investment (FDI) volumes, new research suggests.

Comparing the latest FDI data from Investment Monitor with rankings of start-up locations compiled by StartupBlink, the results show that countries such as the US and UK, which achieve large volumes of outbound and inbound FDI, are also global leaders for creating start-up hubs.

Yet there are some notable exceptions of locations where being a start-up hub is not linked to a history of strong FDI volumes.

The close correlation between outbound FDI and start-up hubs makes intuitive sense. If a location helps a high volume of start-ups to set up, the most successful of them will look to expand overseas. The more start-ups a country helps to establish, the higher chance of increasing outbound FDI in the long-term.

The link between start-ups and inbound FDI is not as obvious, and the correlation is not as strong, but there is a clear link between being successful at establishing companies and attracting foreign ones to invest in a location.

US still leads, though San Francisco is losing its edge

The major outlier in the data is the US and its major cities. While the US is a global leader in both FDI and start-ups, its advantage in the latter is far more pronounced. In fact, according to our FDI Projects Database, Germany attracted more inbound FDI projects in 2021 than the US did.

When it comes to scoring start-up hub success however, the US still has a large lead over all other countries. Eli David, CEO of StartupBlink, says this huge lead is sustained by advantages in total volume of investment, the number of existing unicorns, and intangibles such as the number of global influencers.

According to StartupBlink, 120 of the top 150 influencers are based in the US, which David says “shows how the narrative of start-up success and celebrities is dominated by the US, reminiscent of the status of Hollywood and US music globally”.

The leading city for start-ups remains San Francisco, thanks to the legacy of Silicon Valley, yet its lead over other cities is declining. While in 2019 its total score from StartupBlink was five times higher than New York, that lead declined to just 2.5-times higher in 2021.

“San Francisco is on a constant value destruction path, and the more it does self-inflicted damage, the more its gravity pull is becoming weaker to allow other cities to gather momentum,” says David. “It is probably a natural process, that is accelerated by the cost of living in San Francisco and the exodus from there due to life quality issues.”

The US is the dominant source market for FDI, accounting for about 23% of total outbound FDI in 2021, but not as dominant as it is as a start-up hub. Glenn Barklie, chief economist at Investment Monitor, says other countries compete successfully with the US on FDI drivers such as producing and supporting talent, creating a pro-business environment, and creating business networks.

“Smaller countries can leverage closer clusters and networking to create a boisterous ecosystem,” he says.  

While the US is the long-established global leader in FDI, San Francisco has “never been a ‘best in class FDI’ location” according to Barklie.

“The extremely high cost of living, arising from the gentrification it has experienced, makes it difficult for foreign companies to justify,” he says. “For example, you are talking about a salary three or four times larger in San Francisco compared with western Europe for software developers, never mind other world regions.”

FDI and start-ups decline in China

China saw its status as both a start-up hub and FDI location decline in 2021. A main driver of this has been the ongoing decoupling of Chinese and US economies as diplomatic tensions rise between the two superpowers.

Barklie says: “China’s brand in the Western world has taken a hit in recent years”, adding that many investors, particularly US companies, have been rethinking their investments in the country.

“Many countries and regions have tightened FDI laws to stop Chinese acquisitions of domestic companies, which in turn is feeding into outbound investment consideration”.

China only ranked ninth for inbound FDI and sixth for outbound investment globally in 2021, according to the FDI Projects Database, and none of its cities ranked in the top ten as leading FDI destinations.

Of all of the global top ten start-up hub cities, Beijing saw the biggest decline in 2021, according to StartupBlink. Having seemed like it was closing the gap on leading US cities in recent years, the most recent data shows a reverse in that trend.

StartupBlink says most of the growth potential of Chinese ecosystems has already been realised, and its broader appeal as a start-up hub is being limited by the country becoming more inward looking. China’s start-ups tend to be domestic focused, perhaps understandably given the size of the local market, but the country’s ‘great firewall’ also limits the growth of its tech sector.   

Brexit not holding London back, yet

London was the second highest ranked destination city for FDI in 2021 and the UK was only behind Germany and the US in terms of inbound projects.

Barklie says that London saw a 17% decline in FDI levels in 2021 when compared with 2019 (pre-Covid) but not all sectors have been impacted the same. Financial services saw a rise in FDI over the period, and Barklie argues that the sectors the city specialises in, such as financial services and tech, are proving surprisingly resilient.

“Given the turbulent times the world economy is experiencing, London could be seen as a bit of a safe haven – low risk in an established market – by investors as it continues to maintain its brand as a leading financial centre and tech hub,” he says. “Also, London still has a lot to offer in terms of FDI factors such as talent, business friendliness and a relatively stable economy.”

Yet David warns that the impacts of Brexit on London and the wider UK’s ability to foster start-ups may just be delayed.

“In the short term, Brexit has had no substantial impact. The real worry is the long term,” he says.

“The most successful UK start-ups such as Revolut and Bolt were established by by foreign entrepreneurs. The UK might be losing out now on the entrepreneurs that would build its biggest start-ups in five years from now. The UK is fortunate enough that Europe is virtually refusing to create its own global start-up hub due to its confused policies.”

Notable divergences between FDI and start-ups     

Notable outliers in the comparison between FDI volumes and start-up hubs are a number of smaller, rich countries, such as Israel, Estonia and Taiwan. These locations punch well above their weight in terms of start-ups, yet attract relatively small volumes of FDI.

Barklie says the FDI underperformance of some of these countries can be explained by their proximity to other key FDI source markets and also the size of the jurisdiction.

“If we look at FDI per capita, Estonia and Israel would rank much higher,” he adds.

These locations are able to provide the tools and ecosystems to help entrepreneurs create outward-facing global companies, but lack the size of domestic market that would attract established businesses to open operations there.

David also highlights that while Israel attracts a lot of foreign investment in its start-ups, the country essentially has two economies.

“The second, non-start-up economy is generally not efficient and not enticing for investors due to its low productivity, market size and other risk elements,” he says. “Less than 20% of the Israeli economy is connected to high tech and that’s the only real attractive part of it [to investors].”

While there are exceptions to the rule, it seems that the secret to FDI and start-up success are broadly the same. Both new and established businesses are looking for established supply chains, a strong business environment, political stability, a healthy talent pool supported by a good education system, efficient and modern infrastructure, and a somewhere that offers a good quality of life.

At a time when the role of lower corporate taxes in enticing investment is being debated globally, it is important for policy-makers to consider all of these other investment drivers if they want to attract both new and established companies.  

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