This morning, HM Government announced two schemes for high growth startups: an increase to the pot available to Innovate UK for grants and loans, and a new Future Fund for startups providing convertible loans to high growth businesses. This note relates to the latter.
HM Government announced £250m for a new “Future Fund” for startups administered by the British Business Bank. The Future Fund for startups will invest between £125k and £5,000,000 in high growth UK companies. The investment from the Future Fund for startups will take the form of a convertible loan note and will be subject to the following eligibility conditions:
(a) the investment will be matched 50:50 by new private sector investment. This could include VC money;
(b) in the past 5 years, the startup must have raised at least £250,000 from third party investors; and
(c) the startup must be a private UK company i.e. unlisted.
The Treasury published a draft term sheet which is intended to give an overview of the likely approach of HM Government as the Future Fund is launched. The term sheet raises a number of questions which HM Government will need to clarify when detailed guidance is published.
As referenced above, in order to be eligible to a loan from the Future Fund for startups, a startup must be a private unlisted company registered in the UK that has raised at least £250,000 in aggregate from private third party investors in previous funding rounds taking place in the past 5 years and it must have a substantive economic presence in the UK.
The requirement to have raised £250,000 previous investment will exclude startups who have grown organically and/or via debt. This may be problematic as those businesses may now be struggling to access the COVID-19 business loan scheme.
The requirement for a startup to have a “substantive UK economic presence” requires clarification. It is not clear whether this means a “permanent establishment” (in brief that the company is present in the UK for tax purposes”) or whether this is a more onerous requirement. If the latter, will tech startups who are owned and controlled in the UK, but are pre-revenue with their development team based abroad qualify for a loan from the Future Fund for startups? What about startups based in the UK whose initial market is abroad? This requirement has the potential to exclude from the Future Fund a number of high growth startups that would otherwise be eligible to fund raise under schemes such as EIS and VCT.
The funding provided by HM Government through the Future Fund for startups is to be matched on a 50:50 basis by private investors. The minimum amount of the loan provided by HM Government will be £125,000 (meaning a minimum round size of £300,000) and the maximum will be £5,000,000. The matched funding must be lined up in parallel with HM Government’s loan.
The term sheet for the Future Fund refers to the entire round of which HM Government’s loan is a part as the “bridge funding”. The term sheet states that “the bridge funding shall be used solely for working capital purposes and shall not be used by the company to repay any borrowings, make any dividends or bonus payments to staff, management, shareholders or consultants, or in respect of the Government loan, pay any advisory or placement fees or bonuses to external advisors.”
This wording is highly significant as it appears to state that none of the money (including from investors making up the matched funding) can be used to repay any debt. HM Government need to clarify whether this includes sums owed in the normal course of business arising prior to the date of the round. If repayment of such amounts is prohibited, companies may need to raise further money from private investors in order to pay off any such amounts before the round in which HM Government participates. This is potentially problematic as many businesses will be incurring significant debt (for office space and other ongoing costs) as the lockdown continues. Being unable to repay that debt risks their solvency.
The term sheet for the Future Fund contemplates a convertible loan for a term of 36 months subject to an interest rate of 8% (non-compounding) per annum with interest paid on maturity. However, if a higher interest rate is agreed with other investors, HM Government will benefit from that higher interest rate.
Interest can either be repaid or can convert into equity on a conversion of the loan.
The loan converts (is used to buy shares in the Company) at the next investment round where the company raises an amount equal to the amount of the bridge funding (by which HM Government appear to mean the total size of the round of which HM Government’s loan is a part). This is referred to as a “qualifying round”. If the Company raises a round of a smaller amount, the matched private investors have the opportunity to decide whether or not to convert HM Government’s stake.
It appears to be the case that a company could raise consecutive rounds at just below the threshold and avoid converting HM Government’s stake. That is perhaps surprising and may be dealt with by HM Government when they provide further detail in due course.
The loan converts at a discount of 20% to the price paid by investors in the next (qualifying) round. However, if a higher discount is offered to the matched investors (or any later investors), HM Government get the benefit of that discount rate.
The loan also converts if the business is sold or listed, and there is an automatic conversion of the loan at the end of the 36 month term, unless HM Government ask for it to be repaid (or the private matched investors elects for it to be repaid). However, if the loan is repaid, there is a 100% redemption premium payable to HM Government.
Nature of the matched funding
The term sheet appears to contemplate the private investment being made using convertible loan notes. This may not be the intention, but there are explicit references to private investors investing by way of a loan in the term sheet. If this is the case, individual “angel” investors will be discouraged from providing the matched funding as they will be unable to claim using the Enterprise Investment Scheme (EIS). A key feature of EIS is that convertible loans do not qualify.
It may be that HM Government are taking the view that as the Government is matching the investment, the risk of investors is reduced by 50%. However, the reduction in risk does not mirror the effect on angel investors of claiming EIS. Using EIS, angel investors receive a 30% tax credit on their investment and pay no tax on disposal of their shares (subject to continued compliance with the rules of the scheme). Under the Future Fund for startups, angels would not get any relief and either the loan made by HM government would be repayable, or it would convert into equity diluting the stake of angel investors. If this is the intention of HM Government, it will limit the scheme to VCs.
The Future Fund for startups is to be welcomed as a positive cash injection for high growth startups. However, HM Government should urgently clarify the issues detailed above. In particular whether matched funding can be provided by instruments other than convertible loans and whether EIS investors can provide the matched funding.