Farrer & Co are proud to act for a thriving community of entrepreneurs and investors. As part of our support for this community, we hold regular Entrepreneurs & Investors Brunches, offering our clients and associates the chance to discuss their challenges and opportunities. In this article, we comment on their response to the UK Government’s Future Fund following our latest Entrepreneurs & Investors Brunch.
This article does not seek to rephrase the Government’s own summary of the terms of the scheme, which can be viewed here. The full terms have not yet been published and this article is based on the current information available. It is not legal advice and specific legal advice should be taken.
The Future Fund
The Future Fund has been proposed by the Government as a means of providing cash to UK start-ups, which so far have largely been unable to access other forms of Government support.
In designing the scheme, the Government’s dilemma was that it had to put in place a proposal that would both protect the position of taxpayers and be simple to access and implement for young and growing companies which are temporarily starved of liquidity.
Having discussed the proposals with our clients and contacts in the start-up world, our view is that many start-ups who can stretch their funding runway will decide, on balance, not to take advantage of the scheme. It may though be attractive to some and it is worth keeping a close eye on how the scheme develops in response to initial feedback.
We have set out below a brief summary of the five characteristics of the scheme which will require careful examination by any founder considering the scheme as an option.
In addition to the availability of the Future Fund, the feedback we have received is that the Government should also consider some temporary expansion of some of the tax incentives that are currently so successful in encouraging investment in this sector, to provide a boost to liquidity over the next six to twelve months.
The form of investment proposed by the Future Fund is largely based upon the structure of an Advanced Subscription Agreement (ASA, or a SAFE in the US). This is an initial advance of debt that is convertible into equity at a discount to the price established by the next qualifying round (or other exit event).
The notable difference is that ASAs are usually deliberately structured so that the investor’s return only derives from the conversion discount and no interest accrues on the debt itself – mainly to comply with the Enterprise Investment Scheme (EIS) rules.
In this scheme there is a combination of:
- a discount of at least 20 per cent on conversion;
- an annual interest of at least 8 per cent; and
- the potential for a 100 per cent return on the principal in certain circumstances.
The result of this combination is that many of our clients view the price of this investment as too expensive to be attractive – with an element of double counting of both 8 per cent interest and 20 per cent discount leading to a potential return of almost 30 per cent if the debt converts after one year.
Of course, the economic appeal of the proposals will vary from company to company, depending on the growth projections of the company and the anticipated change in valuations between rounds. For some companies the additional runway provided by a smaller bridging round now (the size of which could be increased by accessing the Future Fund) may provide them with headroom to enhance their proposition, in which case the ability to then undertake a larger round at a significantly higher valuation later in 2020 or during 2021 might make the economics more attractive.
The second potential difficulty with the Future Fund is that the scheme is only available to companies who can raise matched funding of 50 per cent or more – it is therefore of no benefit to start-ups who are unable to attract at least some additional equity investment. In other words, the Future Fund can help increase the size of a capital raise but does not provide a standalone capital injection.
The question therefore arises as to how many companies will be able independently to raise at least half of the funds they are seeking but also sufficiently keen to increase the size of that investment to be prepared to work within the constraints of the structure proposed. The Future Fund might be a welcome add-on for current or planned bridging rounds but will not help companies presently unable to raise finance.
Founders need to be aware that this scheme will only be available if they are able to attract matched funding and that those funders are willing to invest within the structure of the proposed scheme.
Another key commercial concern is the effect of Future Fund financing on the future control of the recipient company.
For most companies contemplating a fundraise, one significant issue is to be comfortable with the identity of the proposed investor. In this instance the scheme expressly allows the Government to sell their interest to an assignee who will acquire a portfolio of similar investments.
As well as lack of control over the identity of the potential shareholder, companies will also have to contend with a lack of control over the terms they can exert over the Government and its future assignee. While small companies often seek to agree certain principles with all major shareholders through a shareholders’ agreement, it seems likely that the Government will not be prepared to sign up to the terms of any existing agreements. The company, and its existing shareholders, will need to judge whether they are prepared to accept an incoming shareholder who will operate outside of these rules of engagement.
Consent of existing shareholders
Any company considering the scheme will need to review their constitutional documents (including articles and any shareholders agreement) to establish whose consent will be required to undertake a new equity issue in the form contemplated.
Given that the incoming investment is structured as convertible debt being issued at a discount (with matched funding also we presume being provided on similar terms), the parties who will bear the cost of the discount will be any existing shareholders who do not participate in the round. Where existing investors are able to participate in the matched funding, the participating investors will share in the conversion discount helping to allay concerns as to dilution. The attractiveness of the scheme to existing investors will therefore depend in large part on whether existing investors are able and willing to participate in the round.
Companies able to raise further bridging funds from existing investors might see the Future Fund as a useful opportunity to do so.
But where a company is seeking fresh investment, existing investors are likely to be concerned by the dilutive potential of the scheme funding. In such a scenario, existing investors might prefer the company to extend its runway and implement cost control measures rather than accept funding on the basis of the Future Fund proposals.
Taxation and SEIS / EIS
The ability of UK start-ups to raise equity funding has been greatly enhanced by schemes such as the Seed Enterprise Investment Scheme (SEIS) and EIS, which encourage private investors to take increased risks and participate in fundraising carried out by young start-ups with a high risk/reward dynamic.
At present the proposed scheme is incompatible with SEIS and EIS, as (i) interest arises on the debt and (ii) the period of time during which the debt is convertible to equity is outside of the period normally recommended for an ASA.
We understand from conversations with our contacts that the Government is actively looking at this point and we await the outcome and any changes proposed.
The Government’s announcement of a scheme to assist start-ups is a welcome recognition of the value of this community to the UK economy; however, the proposed terms means that it will not have universal appeal and for many it will miss the mark in certain respects.
Companies wanting to take advantage of the funding would need to have a good track record, have already found investors willing to contribute at least £125,000, and be able to accept the economic and structural terms on offer. These may not be the companies most in need of immediate assistance.
The Future Fund does seem an interesting proposition for companies contemplating bridging financing – particularly where the matched funding can be provided by existing investors (who will be able to share in the conversion discount).
At this stage our advice is to wait for the full terms to become available but to continue to explore other options, as the Future Fund will not be right for all start-ups.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, May 2020