A few weeks ago the Government announced the launch of a £250m Future Fund that will provide matched funding using a Convertible Loan Note (CLN) to the high growth companies.
To be considered eligible for the fund, businesses must have raised equity of at least £250,000 in aggregate from private third party investors in previous funding rounds over the last five years and have a substantive UK presence. To put it in the respective, if we look at all the UK companies that raised equity funding at this level only 27% of the companies qualify for this condition (Source: Beauhurst).
The British Business Bank (BBB) will administer the scheme which will open for the applications at the end of May 2020, with more details to follow soon.
According to Government sources, the key terms that have been laid out should not deviate when more details are released:
- The convertible loan will be at most equal to the funding provided by private third parties at exactly the same terms – this means that the funding from the third parties cannot be issued as equity. In other words, that narrows the third party funders list to institutional investors and their funded companies. Quite a bit of controversy was seen by the funding community raising issues of diversity and the cut out of Angel Investors.
- The size of the government cheque will be at least £125,000 and at most £5m.
- This is bridge funding for working capital purposes only – no dividends, bonus’, adviser fees, consultant fees etc. To demonstrate what is working capital, businesses will need an up to date financial forecast. The Government was very clear about the purpose of this loan being a bridging loan with commercial terms. Thus, the founders should keep this in mind when considering this option as it is not intended to be seen as state aid rather another funding option available.
- Like for like terms. It is very important to note that the third party investment needs to match the terms and conditions of the government loan. Therefore, it is not eligible for EIS relief. This was a big shock to the start-up community and Angel Investors since it narrowed the pool of the companies that could benefit from the Future Fund even more. Unfortunately, not much hope for this to change because the government stand is quite clear that these two schemes shouldn’t be mixed.
- The CLN turns into the most senior class of shares when:
a. In the future, the business raises further capital that is equal to the whole bridge funding round;
b. On sale or IPO;
c. After 36 months, the loan will likely turn into shares, or, be repaid with a premium. In essence, the premium looks quite high so, again, this needs further explanation, so equity investors can understand what the consequences are to cash and/or dilution on refinancing. From the conversation with the government agencies, it was indicated that the government expectations are to convert the loan into shares rather than be replayed. It seems that the Government is taking a VC approach to this loan and hopes for some winners.
- Conversion will be at a 20% discount to the conversion event’s share price. In English, this means, when the loan converts to equity, the Government get a 20% share price discount (i.e. more shares). This is similar to most CLNs or Advance Subscription Agreements (ASA).
- The interest rate on the loan is 8% pa, unless investors lend at a higher rate. The interest does not compound and does not convert into equity.
- The Company will have to provide warranties. No indication so far that management will need to provide any.
- Covenants look quite light at the moment though there is a Most Favoured Nation clause which means that if someone else invests and gets better terms than the Government, then their terms must be improved to match.
- The ability to raise further debt that is more senior (and in reality, this is CLN is very junior, so most new debt will be more senior) is restricted to new external stakeholders only.
What does this mean:
- Turning to existing shareholders – the Future Fund is a Government initiative that is clearly not there as a solution for all the early stage companies affected by Covid-19. If you don’t meet the criteria or you are not willing to accept the commercial terms set by the Future Fund then it might be a good time to reach out to your current investors with a rights issue offer. They are collective owners of the business thus it is in their interest to help business to weather this period. Our advice is to ignore preference shares and quirky instruments of the past to avoid mismanaging the point on the most senior class of share, and instead focus on the ‘real’ ordinary shares in the business.
- Alternatives for new investors – to reach out to the new set of investors might be an appropriate next step for majority of the companies but in these circumstance a new arrangement and deal structures might be used by investors to hedge their risks. For examples, a private investor wants a discounted share price, and EIS relief too. In this case, you could run an Advance Subscription Agreement that provides cash now in exchange for shares issued later at the same 20% discount to a future event’s share price (but without any interest paid along the way). ASAs don’t always comply with EIS rules, though. They can be argued to be a loan and, with newer ‘Risk to Capital’ tests, the 20% share price discount may be viewed less favourably. There will still probably be a way to get EIS compliant ASAs agreed for many businesses, but it will take longer, cost more in adviser fees and all sides – including the investor – will have to be happy with the risks.
- New fundraising activity – new fundraising activity is happening and considering the limited number of companies that are eligible for the Future Fund majority of the companies will be increasingly looking at this option . This suggests that it can continue and, indeed, continue with some success. However, the investors are taking longer to evaluation the companies and are much more picky when making their investment decisions. Therefore, it is more important than ever to show how the business is adapting to the circumstances accompanied with a proper financial model, a fully diluted ownership table in different scenarios and have valuation research. This will allow and support investors in conducting thorough diligence.
- £250m won’t go far – the Future Fund is really small; and already considered to be expanded depending on the success of the delivery and demand. Worth to keep an eye not only on the Future Fund releases but also on a various initiatives that are being considered such as expanding Regional Angels Programme (administered by BBB) in order to address the funding gap that remains for majority of the early stage companies. More news on the Future Fund and other alternatives to follow.
This article was written by our Growth Manager, Agne Pakalniskyte. If you need advice on structuring the ASA, a rights issue or assistance with equity fundraising, then please contact Agne on the form below.
We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.