07 March 2016

Seed funding: the non-priced round

Tina Baker
Partner | UK

Early stage funding for start-ups is getting complicated.

For many years, companies have raised initial seed funding through convertible loans instead of selling shares. In this type of funding, the loan, together with interest, automatically converts into the shares a company sells in its next funding round at either a discount (ranges are between 10% and 30%) or the lower of a discount or a valuation cap.

There also may be specific limitations on the size of that funding. In recent years, following on to trends in the US with the Simple Agreement for Future Equity (SAFE) and Keep it Simple Security (KISS) documents, many companies are raising seed rounds through non-priced future equity instruments, which we are calling Advance Subscription Agreements or ASA’s in the UK.

They are similarly structured to a convertible note, except they do not bear interest and the funds are never to be repaid (more on this below). Instead, the ASA converts into equity at a longstop date at an agreed price if there has not been a funding round or other conversion event, like a trade sale.

The primary reasons for the popularity of the non-priced structure is that it postpones a valuation discussion and the paperwork may be less complicated (and thus less expensive). I have worked on some convertible loan transactions which have looked more like a Series A round and some of the SAFE documents we have seen contain extensive investor rights.

Non-priced rounds can be a good thing.

If shares are issued to angel investors at too high a valuation, it potentially scares off further investment and the company can become “too expensive”. The thinking is, let’s leave it to a proper funding with institutional investors and let the bigger investors decide. In some cases this may work out fine but there are some downsides to the entrepreneur.

Since non-priced instruments are generally issued with a discount on conversion, it may be that a company ends up giving more shares away to the angel investors than it would have if an equity round had been done in the first place. And, a company could potentially end up with more liquidation preferences sitting on top of founder shares than would have been there if ordinary or common shares were issued in the first instance.

Also, from an operational perspective, having convertible loans on a company’s books may disadvantage a company in connection with obtaining bank loans and discount invoicing.

And a “loan” generally has to be repaid if not converted (unless the investors agree that the loan only gets repaid on a sale or liquidation, which some companies have managed to do, but it’s not the norm).

If no further funding is available and the company cannot repay the loan, liquidation may be the result if the investors have no appetite to continue to fund the business. Although the result might be the same with equity if there is no further way to fund a business, some companies may manage to bootstrap their way forward and the investor-lender then is in a position of much greater leverage.

And although investor-lenders as creditors may be in a position to get the assets of a company on a liquidation if the loan does not convert or is not repaid, in most cases the assets are not that valuable when the company does not make it and investors are generally not best placed to deal with them.

From the investor’s perspective the non-priced financing may be just as risky as equity.

Equity takes the guesswork out of the process and some investors argue that convertible notes, even with valuation caps, are disadvantageous to a company. David Hornic, August Capital, states in his blog that convertible loans are basically flipping a coin so it only works if you are willing to gamble on your stake in a company (and this goes for both sides as discussed above). The same reasoning applies to SAFE or ASA instruments.

And in some jurisdictions, for certain investors, convertible note financings are actually disadvantageous. For example, in the UK, the Seed Enterprise Investment Scheme (SEIS) and the Enterprise Investment Scheme (EIS) give tax breaks to investors who purchase new shares in smaller, higher-risk trading companies, and the key word is “shares.”

Accordingly, the practice of using ASAs is increasing in the UK for those companies whose investors are seeking either SEIS or EIS tax relief. Extreme caution and tax advice are advised before using ASAs in these circumstances.

As you can see, the debate continues.

Tina Baker Partner | London

Category: Blog