Her Majesty’s Government enters the VC market

I have written extensively (here) about the cavernous gap between the Start Up Loan scheme (limited to £25,000) and the CB(L)ILs scheme intended for SMEs generating turnover of up to £45 million, but applying pre-coronavirus investment criteria to today’s loans. The now-modified CBILs scheme is not equity finance and we suggest is not directed at high-growth companies (or to us, start-ups) which do not tend to be asset-rich.

The UK Government is being lobbied extensively concerning increasing the benefits (or loosening some restrictions) under its existing SEIS/EIS schemes, enabling greater tax reliefs for UK taxpayer investors and encouraging equity investment to help address those financing concerns. An easy fix would be to increase the long stop period for ASAs from 6 months to 12 months, allowing more time for the subsequent qualifying financing round to be finalised. A revised guidance note from HMRC (reversing its recent reduction of the period) is all that is required here.

On 20 April the UK Government has announced its plans to bridge that financing gap with the Future Fund, a £250,000,000 venture investing scheme to be deployed by the British Business Bank.  The scheme is slated to come into effect “during May” and covers convertible loans in the £125,000 to £5,000,000 range.

Those plans involve investment by way of unsecured convertible loan.  This is unsurprising as the convertible loan is a familiar tool in the VC bag.  Not only is there no wheel reinvention required, but also convertible terms involve only modest negotiation and contain far fewer terms than a full-scale equity financing.

During the Coronavirus outbreak we have seen extensive use of the convertible loan both in terms of emergency financing and increasingly, given the difficulty of getting those financing rounds over the line, as a not-so-able substitute for longer term financing.

Helpfully, and in tandem with the VC community, the UK Government has published indicative terms relating to the loans to be provided.

To qualify for the funding a company must be an unlisted UK registered company, have previously raised £250,000 from private third party investors and have a “substantive economic” presence in the UK.  Clearly, the last part is intended to bolster (or save) UK trade and jobs, so it remains to be seen how much trade and how many jobs add up to being “substantive”.  Given the amount of overseas businesses establishing a topco presence in the UK as a gateway to access institutional finance and workforce, particularly in financial services - we expect a steady flow of questions on this issue.  It may well that the same test as used by HMRC for SEIS/EIS purposes is intended here, thereby requiring at least some form of meaningful HQ function.

The fact that the convertible loan offered must be matched with finance elsewhere is unsurprising.  It is re-assuring that some of the mistakes of the past are not to be repeated and only opportunities suitably qualified by institutional investors are to be considered.  This also avoids problems with state aid rules (which restrict simple cash injections by the UK Government).

Presumably those matched investments will also need to be convertible loans (or broadly similar instruments) as otherwise alignment of the terms would be problematic. Some have requested clarification as to whether angel, the crowd or other bodies of investors (i.e. other than VCs) can be accumulated to achieve the matching: but we suggest that there is nothing in the announcements to date to suggest that this is restricted to specific bodies of investors, and to seek to do so would be problematic. We also anticipate some questions regarding alignment with ASAs which qualify for SEIS/EIS tax reliefs and therefore can be a preferred mode of investment.  Convertible loans do not qualify for the same tax preferable tax treatment.

Many of the terms follow those of a conventional convertible loan (more details on typical terms can be found here and the terms of the Future Fund can be found here), but the following are of particular interest and may warrant further consideration:

• the loans will convert at the price paid by others on the next qualifying investment round discounted by a minimum rate of 20%.If, however, the other lenders have cut a deal by reference to a higher discount rate and/or a valuation cap then the UK Government is to benefit from matched terms. A valuation cap is a mechanism whereby the valuation used for conversion of the loans has a maximum, even where that is a lower valuation than used in the qualifying investment round, thereby creating an alternative – and sometimes excruciatingly high – form of discount.The point is also that the valuation cap method is an unknown form of discounting at the time the loan is made.In these circumstances we would expect the discount to drop away.

• the convertible loan is repayable on the maturity date (being a maximum period of 36 months from the date the loan is advanced).Equity-based loan notes (which convert whether or not a qualifying financing has occurred) are not repayable in cash at all, we will wait to see how this debt-based convertible loan will work if the matched funders prefer its equity-based cousin.

• the repayment point is especially important as on maturity (if that occurs) the cash repayment is two times principal advanced.We do consider that to be overly punitive and not to be the market norm at all. It may well be that the UK Government will need to row back from this position.With the matching principle our concern is this will drive the market towards this kind of term to the significant detriment of the start-up’s founders and existing shareholders.

• rolled-up, non-compounded interest is set at a minimum rate of 8 per cent. for the period the loan is outstanding.Our experience is many of the new loans made during the Coronavirus outbreak period are interest bearing, which previously was much less the case.Given that VCs are not likely to agree worse terms than those being offered to the UK Government, it seems likely that if this scheme gains traction, interest-free or low interest terms will dry up.

• the UK Government’s stake (whether loan or equity) is freely transferable. This feels eminently reasonable but this will be of concern to some growth companies that manage their shareholder base carefully. Those start-up’s with active trade investors (e.g. fintech) frequently have structures whereby their customers or competitors may hold full economic value shares but with limited information (and no voting) rights.How will this work if the UK Government can freely transfer voting and information rights?

As with any new scheme, there will likely be small changes, growing pains and more guidance, and applications that may be somewhat … inventive.

There is no doubt that the new scheme is badly needed for businesses requiring a little more runway.  The entry of a significant new VC into the growth company market must therefore be welcomed.  Let’s hope that the logistics of eligibility and application are in place at the outset and qualified persons will thereafter be able to manage the UK taxpayers interests effectively.  Refinancing large banks is a considerable enterprise, but operating in the risky sector of start-up financing has its pitfalls too.