Commencing in May, this fund will back early stage, innovative companies that have been impacted by Coronavirus by match-funding up to half of a bridge round completed with other, third party investors.
The fund is most suited to early stage companies that are loss making, cash depleting and reliant on external private or venture capital investors in order to continue to trade. As a result of Coronavirus, many private investors and VCs have reduced the amount that they are willing to invest and this has made it harder for innovative, high growth companies to raise equity.
The Future Fund attempts to provide a "bridge" for these businesses, allowing them to continue to trade until an equity round can be completed. It therefore takes the form of a convertible instrument, i.e. a loan that will convert at a discount to the price of the next round, similar to the commonly used Advanced Subscription Agreement (or "ASA"). A discount of 20% is typical, although if the match investors require a higher rate, then the Future Fund will follow suit.
A loan is also quicker to administer than equity - for a start, relying on a discount to the next round removes any need to establish or negotiate valuation. As a result, cash gets to these companies faster and can serve as a genuine bridge. The trade-off is that there remains uncertainty around the next funding round. Only a small proportion of companies that attempt to raise equity funding actually manage to do so, so it remains a distinct possibility that the loan will not convert at the discount and will instead revert to its usual terms - a minimum of 8% accrued interest and a 100% redemption premium. A company that raises £1m, will have to repay £2m, plus interest, on maturity.
Kicking the valuation can down the road also has its downsides - it may be that a subsequent round can be achieved, but with the volatility in the public markets, the pricing might not be where founders had hoped. A lower valuation, compounded by a portion of this new investment being at a further 20% discount, may be onerously dilutive to the existing shareholders.
On the flip side, the cost of funding between issuance and conversion is "only" 8% plus the additional dilution from the discount. For an investment into an early-stage, loss making business facing financial difficulty - that's not an unreasonable ask. From then on, the Government shares in the return made by the company’s most senior investors.
One particular challenge for companies accessing this scheme will be securing the match funding. Little detail has been provided on which investors will qualify as match funders. This type of convertible is relatively common among angels, syndicates and high net worth individuals, and they can, subject to certain conditions, be eligible for SEIS and EIS. However, the latest guidance issued by HMRC in January 2020 stated that loans should have a conversion long-stop date of no more than 6 months, which means the next funding round needs to be "just around the corner" to attract these types of investors.
For those investors a little higher up the food chain, such as seed funds and VC funds, equity and preferred equity are more commonly used instruments. For these funds to invest alongside the Future Fund, they will need to consider if they are comfortable aligning with the Government's terms. Ultimately, the Government will be relying upon the more established firms to be the conversion catalyst, so for the scheme to be effective, it is important that these funds remain active and continue to price risk and invest in equity.
Subject to a few clarifications from the Government, this scheme could have the potential to provide the boost that our startup ecosystem desperately needs. Let’s hope the devil isn’t in the detail.
