09 November 2016

The new world order of innovative financing

James Shaw
Partner | UK

According to data from London & Partners, UK tech companies raised more than $2.1 billion in the first nine months of 2015. In January 2016, London & Partners released new data indicating that since 2010, UK technology companies have collectively raised almost $10 billion.

Inc Magazine published an article about the 10 growing VC trends to look for in 2016. Among them was early and seed stage funding. Whether it’s via a crowd sourced platform, seed investor or super angel, the options for early stage capital isn’t slowing down.

This type of funding increasingly takes the form of quick, efficient and innovative funding instruments enabling investors to invest into companies outside of and usually in advance of a full investment round.

In the US, this sort of funding is well established. Market-recognised documents such as Y-Combinator’s SAFE (Simple Agreement for Future Equity) and 500 Startups’ KISS (“Keep It Simple Security”) have helped promote and widen the use of such instruments in the US market.

In this post, we’ll highlight the top five key features of two of the most popular UK instruments being commonly adopted, which are the convertible loan note and the advanced subscription agreement. The latter can also be Seed Enterprise Investment Scheme (SEIS) or Enterprise Investment Scheme (EIS) compliant.

Convertible loan notes

1. Convertible loan notes are short-term interest-bearing loans. They sit as debt on the company’s balance sheet. While this could hinder the company from attracting future investment or from marketing itself as being debt free, convertible loan notes may be preferable to investors because they stand as creditors of the company if things don’t work out and so less risky than equity.
2. The loan becomes repayable based on certain events, such as a company liquidation, event of default or on a longstop maturity date (where conversion has not already occurred).
3. On certain trigger events like a funding round, exit event or an IPO, the loan will often convert into the most senior class of equity in issue or to be issued in the round.
4. Conversion on such an event can be automatic or at the discretion of the lender. Often, this can depend on whether the value of the funding round exceeds an agreed financial threshold, beneath which the lender can elect whether the note is to convert on that round or not.
5. The note will generally convert at a lower price per share to the subscription price paid by other investors on the round or at a subscription price based on a pre-agreed valuation cap (or at the lower of these two). There are of course other variables and these are just an example.

Advance subscription agreements (ASA)

1. Rather than converting from debt to equity, like a convertible note, the ASA is more like an advanced subscription for future equity but without a price. Think of it as a blank IOU for shares.
2. Because the ASA isn’t a debt instrument, the advance subscriber may still be eligible for SEIS or EIS relief on its investment if certain other criteria are met. As usual, the availability of these reliefs are subject to the way that the rights of the shares to be issued are structured and so it’s best to involve tax advisers early on.
3. The ASA has a similar structure to the convertible note in that the advance subscriber pays its cash without receiving shares at that time. However, the ASA doesn’t bear interest.
4. The ASA is also generally not repayable. An ASA can be stated to be repayable on a liquidation, but not in circumstances where SEIS/EIS relief is being sought.
5. And similar to a convertible note, the ASA will convert into equity on the occurrence of certain trigger events for conversion and on similar discount terms. However, unlike a convertible note, the ASA (unless repayable) may only be converted into equity and so if no conversion has taken place before the longstop date, the ASA should convert at a pre-agreed price.

James Shaw Partner | London

Category: Blog