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INSIGHT: The U.K. Future Fund

June 26, 2020, 7:00 AM

The Covid-19 pandemic represents one of the greatest challenges to businesses in the U.K. since the Second World War. The impact of Covid-19 is a particular threat to the U.K.’s thriving start-up scene, given that many early-stage businesses, so important to building a strong economy for the future, are now faced with a potentially critical lack of financing. In an attempt to counter this, the U.K. government has introduced (among other measures mentioned below), the Future Fund matched-lending scheme.

This scheme has initially proved popular and appears to be oversubscribed already, but how does it operate in practice and will it be enough to avoid a generation of talent being lost to the pandemic?

The Funding Gap

In response to the crisis, the U.K. government has introduced various schemes to try to ease cash flow issues for businesses and ensure that they can continue to access funding in the economic downturn. These include the Coronavirus Business Interruption Loan Scheme (CBILS), whereby the government guarantees 80% of the value of loans of up to 5 million pounds ($6.2 million) made to borrowers that are approved by British Business Bank “accredited lenders,” and 100% government-backed loans of up to 50,000 pounds from similarly accredited lenders under the Bounce Back Loan Scheme (BBLS), which require no repayment of capital or interest for 12 months and are targeted at businesses requiring smaller fast-track loans.

Initially, however, the government was criticized for leaving a funding gap in respect of those early-stage companies which do not have the cash flow and profitability to satisfy lenders under the CBILS and require funds in excess of the 50,000 pounds offered by the BBLS. This applies particularly to high-growth technology businesses, so prevalent in the U.K.’s much lauded start-up environment, which, even in “boom” times, are typically not profitable for years and burn cash at high rates, meaning that traditional banks will not lend to them and they are often reliant on equity financing from high net worth “angel” investors and/or venture capital funds for survival.

Enter the Future Fund

To support these early-stage companies, the U.K. government, in partnership with the British Business Bank, announced the 250-million-pound Future Fund, whereby qualifying unlisted companies that have previously raised at least 250,000 pounds from third-party investors may apply for a convertible loan from the government ranging from 125,000 to 5 million pounds, provided that the amount of the loan is matched by private investors (who can be from the U.K. or overseas).

The intention is that the loans convert to shares at the time of the company’s next bona fide equity financing, or on certain other trigger events, at a minimum discount of 20% to the price of the round. The loans bear interest, which can be paid in cash or through conversion to equity, at a minimum rate of 8% per annum. The convertible loan agreement itself is similar in many ways to the type of instrument often used by early-stage companies to raise “bridge” financing between equity rounds and is structured to avoid the need to agree a company valuation at the date of the agreement. It is also largely non-negotiable, meaning that the loans can be entered into quickly.

It is worth noting, however, that the loans attract a punitive redemption premium of 100% of the principal amount in the event that there has been no conversion trigger within the 36-month term of the loan and the lenders then elect to require repayment in cash on maturity. This is an aggressive pro-lender term, although proponents of the scheme may argue that it is justifiable in order to dissuade those companies which are not genuinely reliant on equity financing in the short to medium term from applying, as the preferred and intended outcome is that the loans convert to shares on a fundraising well before maturity.

Initial Response

The Future Fund opened on May 20, 2020 and has proved popular, with applications reportedly oversubscribed after the first day. The scheme is available on a “first come, first served basis,” unlike the CBILS and BBLS where the lenders—commercial banks—undertake a more critical review of each borrower’s underlying business. The British Business Bank, on the other hand, which administers the Future Fund, is reliant on third-party validation of the investee companies and will not carry out any material due diligence of its own prior to investing. The corollary of this is that those businesses with their “ducks in a row” when the scheme opened are more likely to be approved for lending. It is not, however, clear if this means that new applications are futile unless the scheme is extended; albeit the Chancellor, Rishi Sunak, previously intimated that an extension was likely, and applications continue to flow in.

EIS and Diversity

The program has been criticized for not being compatible with the Enterprise Investment Scheme (EIS), which offers attractive tax breaks to U.K taxpayers investing in qualifying early-stage companies. This means that businesses that do not have access to venture capital funds or other institutional investors will be less likely to access the loans. The prior third-party funding requirement has also been criticized for favoring companies that have spent other people’s money over companies whose own founders have put blood, sweat, tears and, moreover, their own cash, into the business. This approach does, though, align with the government’s desire to try to protect taxpayers’ money by only investing in companies that have gained traction and validation in the market. This should ensure that the scheme is not a “blank check” for all start-ups, many of which may have failed regardless of the impact of Covid-19.

Also, research has shown that a greater proportion of EIS investment goes to under-represented founders than venture capital funding, meaning that the Future Fund could have an unwanted knock-on effect on diversity. In response, the government has expressly stated that the Future Fund will become a signatory of the government’s “Investing in Women Code,” which aims to increase female representation across innovative sectors, and is encouraging matched lenders under the Future Fund to do the same. Further, there are concerns that the 250,000-pound prior funding criterion puts founders from outside of the south-east of England at a disadvantage and the scheme might primarily benefit a relatively narrow group of predominantly male-dominated London businesses.

Alternatives

Smaller companies, or businesses that otherwise do not qualify or successfully apply for the Future Fund, may instead need to seek investment from “angels” investing under EIS or the Seed Enterprise Investment Scheme (SEIS), or perhaps look towards the 750 million pounds being made available in grants and loans for small and medium-sized enterprises focused on research and development, which was announced by the U.K. government at the same time as the Future Fund. Under these latter arrangements, Innovate UK, the national innovation agency, is purportedly to accelerate up to 200 million pounds of grant and loan payments for its existing customers (if they opt in). The balance will be made available to increase support for existing customers and around 1,200 firms who do not currently receive funding from the agency.

Other Specific Tax Issues

Borrowing companies and their existing investors should be aware of the various potential tax consequences of participation in the Future Fund. For example, the SEIS and EIS schemes require that, during the qualifying three-year period, the investee company is not under the control of another company, which could be the inadvertent consequence of conversion of a loan held by a corporate entity (such as the general partner of a venture capital fund) which owns a material stake in the business. Also, a matched lender will be unlikely to qualify for the EIS in respect of future equity investments in the same company, whilst founders and other material employee or director shareholders should be aware of potential dilution and the risk of their equity dropping below the 5% threshold currently required to claim Business Asset Disposal Relief (the successor to Entrepreneur’s Relief). Further, due to the convertible nature of the loans, borrowers may be prevented from claiming tax relief on the interest, and investors should be aware of the complex tax scenarios that can sometimes arise from making convertible loans (albeit this does not seem to be disincentivizing lenders, given the popularity of the scheme to date).

European Response

In comparison to other key European jurisdictions, some commentators have argued that the Future Fund and related arrangements do not go far enough. The German government, for example, has announced a 2-billion-euro ($2.24 billion) aid package for start-ups whereby public venture capital fund investors will be provided with additional public funds which can be used to co-invest with private investors, along with measures to make it easier for early-stage companies without venture capital shareholders to use venture capital financing. The German government is also continuing to work on the planned establishment of its own 10-billion-euro “Future Fund” for start-ups. France, meanwhile, has allocated 4 billion euros in support for early-stage businesses through a combination of bridge funding, loan guarantees and tax breaks. Perhaps the most innovative of these is a French government-backed loan specifically tailored to start-ups which do not generate any meaningful revenue, allowing them to borrow up to two years of payroll for employees based in France, rather than linking the amount available under the facility to the company’s turnover.

Will it be Enough?

The U.K. is an outstanding environment for start-ups for a number of reasons, including the wealth of talent, tax breaks, time zone, close links to the City of London and, in more salubrious times, access to finance. The Future Fund scheme has been generally well received and is a positive step towards supporting start-ups through the crisis. Whilst it is disappointing that the scheme is not compatible with the EIS, ruling out many businesses without access to institutional money, the investment criteria and third-party validation requirement should mitigate the risk of taxpayers’ money being spent recklessly.

However, given the predicted severity of the economic downturn, it is likely that the scheme will need to be significantly extended and continue to be supported by the other emergency measures that the government has introduced to avoid an array of innovative early-stage businesses being lost to Covid-19.

Gary Ashford is a Tax Partner at Harbottle & Lewis LLP and a Council Member of the Chartered Institute of Taxation (CIOT); Tom Macleod is a Senior Corporate Associate at Harbottle & Lewis LLP.

The authors may be contacted at: gary.ashford@harbottle.com; tom.macleod@harbottle.com

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.