Nothing Ventured, Nothing Gained: Choosing the right investment mechanism for early-stage companies

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For many early-stage companies, the question on every founder’s lips as the company seeks growth is “how does the company get money in and how does it do it quickly?”

For companies receiving larger investment, the investors will typically expect a set of complex legal documentation and may require extensive due diligence. Where large amounts of money are being invested in a company, investors will often seek various protections in exchange for making their investment. But what about companies that are not yet ready for a full-scale investment round? What are the options where a company needs funding, rapidly, but in a way that is cost-effective for both the company and its investors?

For many years, the go-to arrangement was a convertible loan agreement: this is a type of debt instrument which will typically either be repaid or, in most cases, convert into equity at a future date. In early-stage companies where investment is perceived to be risky, investors may be attracted to investing on a debt basis where they would rank as a creditor in the event the company does not succeed. This can be a practical way to raise cash quickly in the early stages when larger funding rounds are not achievable.

There are, however, disadvantages for the company:

  • the company might have to repay the funds: if the company fails to raise sufficient investment, the investor can either ask for the loan to be repaid or, in the event of insolvency, rank ahead of the company's shareholders;
  • as a debt, the loan will also sit on the balance sheet as a liability (less desirable when trying to attract future investors); and
  • convertible loan funding does not qualify for the Enterprise Investment Scheme (“EIS”) or Seed Enterprise Investment Scheme relief (“SEIS”) making this a less attractive option for certain investors.

So, what are some alternative funding options?

Advance Subscription Agreement (“ASA”)

An ASA allows investors to pay for shares that will be allocated later, typically on a funding round, exit or a specific date. They can be a good way for a startup to get a quick injection of cash, especially as a funding bridge to a planned round, because ASAs tend to be relatively short agreements which are quick to negotiate. Moreover, investors may receive an additional incentive through a discounted price for shares issued at a later date (ranging from 10% to 30%), in exchange for assuming the initial risk. However, unlike a convertible loan, provided the ASA is structured properly, an investor can also benefit from SEIS/EIS tax reliefs when the shares are issued.

The plus-side for the company is that, in order to qualify for SEIS/EIS tax reliefs, in contrast to a convertible loan, interest cannot be charged and there cannot be repayment terms as part of an ASA: the ASA must not offer other benefits to the investor such as investor protections and cannot be varied, cancelled or assigned. This obviously benefits an early-stage company tremendously on the basis that the ASA itself must be simple and offer little protection to an investor and, once the ASA is in place, there is no going back on the deal unless the investor wants to jeopardise the tax reliefs available to them.

What’s not to like?

Founders should consider the following characteristics of ASAs:

  • Allows quick and easy investment without having to negotiate lengthy investor protections.
  • Can be SEIS/EIS qualifying for investors.
  • Prospective investors may be deterred by a lack of investor protection and prefer to invest later on a main round.

From a founder’s perspective, because the ASA shares are often offered at a discount against the next round, the founder’s own shares will be diluted when the ASA shares are issued (depending on the size of the discount). This will make it difficult to determine how much of the company the founders will own at a later date.

ASAs need to include a longstop date (no later than 6 months to maintain SEIS/EIS status) so that if a fundraising does not complete by that date, the shares have to be issued to the investor at that time. The consequence of this is that the company may end up having to issue shares to investors at an inopportune time (immediately before an investment round for example) and the issue of new shares will, unless switched off, trigger the pre-emption rights of existing shareholders meaning that all existing shareholders will also need to be offered new shares as well.

Are there other options?

Simple Agreement for Future Equity (“SAFE”)

The startup accelerator ‘Y Combinator’, established in the US, introduced the ‘SAFE’ in late 2013, and since then, it has been used by many startups as the main instrument for early-stage fundraising, although others in the ecosystem have also created similar form documents, sometimes under different names.

In essence, a SAFE is a financing contract that gives the investor the right to receive equity of the company on certain triggering events, such as an equity financing in which a threshold amount of funding is raised. SAFEs are frequently used by start-up companies to raise capital in seed financing rounds and are one of the preferred instruments for early-stage seed funding in the US (though they are increasingly being used in the UK, too). SAFEs are viewed by some as a more founder-friendly alternative to convertible loans as they do not have to be repaid if the venture is unsuccessful.

Because SAFEs are relatively easy to draft and negotiate (the word “simple” is in the name for a reason!), they are a pretty flexible way to raise funds: SAFEs are a form of convertible security and are not debt instruments and therefore don’t attract interest or have a maturity date by which they are expected to be repaid. They can remain in place indefinitely and, in the meantime, investors don’t have any leverage over the way founders run the company.

Additionally, investors generally do not have broad rights to recoup their money or have other protections, although companies do sometimes negotiate a set of limited circumstances in which an investor might be entitled to the return of the investment, or some limited protections, in order to sweeten the deal.

A further enhancement of SAFEs for investors is that the price of the equity that the SAFE holders receive on conversion is typically lower than the price of the securities issued in a future financing round due to common SAFE features such as discounts or valuation caps. As SAFEs were designed in the US where investors are not concerned about UK tax reliefs such as SEIS/EIS, SAFEs are generally not compatible with SEIS/EIS but they could be designed to offer compatibility provided, amongst other things, that the investment converts to shares within a longstop date of no more than 6 months, and there is no way the investor has a right to their money back i.e., no limited circumstances for the return of funds as mentioned above and no investor protections.

Do we have a deal then?

Much like with ASAs, investors might feel that entering into a SAFE offers them insufficient protection compared to a direct investment for shares: any investor in a SAFE is relying on later investors to protect their rights by piggybacking on later investment terms. Additionally, the company will want to consider whether the lengthy negotiation that can come with preparing investment documentation may still be unavoidable further down the line when it comes to conversion and issuing shares in the company. As well, if the company has issued multiple SAFEs with varying terms, these will all need to be reconciled at the time of the investment round, which can add to the complexity and cost. A SAFE or SAFEs may simply be kicking the can further down the road.

So, which one is best?

Founders would do well to consider the following before deciding:

  • How quickly do we need the money?
  • When are we realistically going to be progressing to a full-scale investment?
  • Where are the investors located and what do they consider ‘market’? Are they more familiar with ASAs rather than SAFEs?
  • What will our potential investors actually agree to?
  • Will an ASA/SAFE/convertible loan put off potential future investors?

The answers to these questions will vary tremendously depending on the company (and the investors for that matter) and mean that the choice between investment mechanisms will vary, too.

Perhaps the most important takeaway, therefore, is to be aware of the options available, be conscious of the pros and cons of each and price them in accordingly and, of course, always get professional advice to avoid unintended consequences.

If you would like to speak with one of our experts about investment mechanisms for your company, get in touch.

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