MJ Hudson’s View on the £250m Future Fund for UK Start-Ups
Our Snapshot: the Future Fund represents a positive and much needed move by the UK Government to support the VC ecosystem but its success will depend on fleshing out the finer details, with key structural and practical challenges needing to be addressed ahead of official launch.
Last week, the UK Government announced a new £250m Future Fund (Future Fund) to be administered in partnership with the British Business Bank (BBB) to support UK start-ups during these difficult times.
We welcome the Government’s new scheme. It is positive news for the start-up community – coming at a critical moment when the funding pressures and, indeed, very survival, of many dynamic early stage businesses in the UK, becomes increasingly challenging. While the scheme has been met with a mixed reception from the VC industry – in part, due to perceived investor friendly terms being required by the Government – it is important to contextualize what the Government is trying to achieve here, which is to address a critical funding gap which many start-ups are currently facing, while, at the same time, safeguarding the interests of the Government (and, by extension, the UK tax payer) but without dictating market terms – a fine line to tread.
Headline Terms document
To date, the Government has published a Headline Terms document (Headline Terms) (see link here), with comprehensive guidance we have been told will follow shortly. There has already been plenty written in the mainstream VC ecosystem about the pros and cons of the proposed draft Headline Terms. Our detailed analysis of the Headline Terms themselves can be found here.
While this initiative represents a positive step forward by the Government, it clearly remains a work in progress, the terms of which need fleshing out in some detail ahead of fund launch in May. To be fair to the Government, they have already said as much.
Our analysis here is therefore focused on three key aspects of the scheme which, in our opinion, require further clarification or design change to make the scheme more effective and accessible and, ultimately, more successful in achieving the Government’s end objective. These are structural and practical challenges which we believe will be important to address ahead of official launch of the scheme.
Key Observation 1: No need to restrict the pool of matched funding
(i) Why exclude equity financings and why not be S/EIS compatible?
While convertible debt is a commonly used instrument on early stage VC investments, it is, of course, just one of a variety of different instruments used on VC deals. Our reading of the Headline Terms is that it assumes the private sector matched funding will also need to take the form of convertible debt which strikes us as unnecessarily restrictive.
To make the Future Fund more effective, we would recommend building in greater flexibility by accommodating other forms of matched funding. In particular, there are two key forms of start-up funding which, in our view, are unnecessarily being locked out from being able to leverage the Future Fund support package: equity financings and S/EIS funding which, as many will no doubt be aware, must meet certain conditions to attract the favourable tax breaks which are a key incentive to encourage investment in start-ups. It should be possible, with a few refinements to the Headline Terms, for the Government’s convertible to sit alongside any matched investors who choose to invest via either a subscription for shares, an advanced subscription agreement (ASA) for S/EIS purposes or other such equity and/or convertible instruments.
In 2017/18, according to the published HMRC report, the overall funding put to work in UK start-ups through S/EIS funds totalled circa. £2bn, of which £1.9bn was EIS funding for 3,920 UK companies. This funding will have been deployed through equity rounds, as well as via ASAs, neither of which would be compatible with the current Headline Terms. The report also confirmed that more and more companies are raising money though EIS for the second or even third time.
This is all third-party investor money being injected into UK start-ups on arms’ length terms – the very thing the Future Fund should be looking to encourage and “piggy-back” off. Admittedly, there is a long-running debate in the VC market around the nature of EIS/non-EIS investor appetite and outlook, but to disregard this large capital pool seems folly in our opinion – unless there is a policy focus towards supporting later stage businesses which, arguably, are more likely to have an investor base where S/EIS relief is a less relevant factor. If that is the case, then the Future Fund remit should be clarified to avoid confusion in the market and perhaps a separate discussion is needed on specific support of a similar nature for start-ups with an S/EIS investor base should be put in place swiftly. Otherwise, the impact from the outset of the Future Fund will likely be limited and optics in the market will not be great, especially among those start-ups with strong fundamentals but an investor base who are looking for S/EIS relief and/or who are closing their rounds in the form of equity.
(ii) Why no look-back?
From our reading of the Headline Terms, we understand that recent funding received by a start-up during the start of the Covid-19 impact would not qualify as “matched funding” on the basis that the Future Fund scheme is only intended to support future funding requirements of start-ups. However, we believe this overlooks an important point that, for those start-ups which have recently closed funding rounds, it is highly likely that many of these businesses will need to go out to market again to raise further funds to stabilise their finances now that the economic impact of Covid-19 has begun, and will continue, to bite.
We therefore believe the Government should consider building in a certain look-back period for matched funding to apply to recently closed equity financings to address the fact that these start-ups may need additional financing support to sure up their working capital requirements and give them sufficient runway to weather the uncertain economic times ahead. At the very least, the look-back should cover fundraisings undertaken in March 2020 (much like the 1st March look-back under the Government’s furlough scheme).
The other practical consideration to keep in mind is that fundraising discussions will inevitably take longer to conclude than before in these unusual times of Zoom/virtual meetings only and general disruption caused by the ongoing lockdown policy. Therefore, allowing for some kind of look-back period in respect of those investors which start-ups may recently have brought on board, becomes all the more important in our view.
Key Observation 2: Don’t dictate to the market, let the market lead
It goes without saying that the success of the Future Fund will, in part, turn on whether the commercial terms of the note it is offering are broadly “market” and therefore acceptable to recipient companies, as well as their incumbent investor base who are likely to have some sort of consent right (or at least influence) over such funding arrangement.
While we appreciate the importance of the Government taking appropriate steps to protect its interests and, where possible, de-risk its funding strategy, it is equally important for the success of the scheme that the commercial terms are balanced – if certain terms are considered too investor friendly, it will likely put off well-advised start-ups from applying for the scheme. We have already seen concern being expressed in certain quarters of the industry regarding the perceived risk that the commercial terms set by the Government may simply establish a base line position from which certain third-party investors could look to negotiate more favourable investment terms for themselves, terms which they would not otherwise have been able to achieve.
Our hope is that the Government gives further thought as to the final commercial terms of its convertible loan note to ensure that those terms present a more balanced and market standard position between Government/investor and start-up. We expect that this is indeed part of the ongoing workstream that the Government is engaged on currently and, as such, we set out below those key terms which, in our view, are mis-aligned with market:
- the redemption premium which appears to lock in a minimum 2x return on capital for the Government (as well as those investors providing the matched funding). While the principle of the Future Fund loan being repayable on maturity of the loan is not unusual for a convertible note, it is rare in venture deals to lock in a redemption premium of this nature on maturity of the loan (or on a sale or IPO, being the other scenarios where the redemption premium may apply). The interest (set at 8% non-compounding) should effectively represent the repayment premium. In fact, where we might see a redemption premium is more in a private equity context where a PE investor might require this premium on loans it makes to a portfolio company, but even in that context, such redemption premiums are typically levied on early prepayments only – the perceived logic being to deliver the minimum forecast return the PE house has budgeted for.
- the Most Favoured Nation (MFN) provision which is unusual in the context of venture capital transactions. Those familiar with fund documentation will be aware of the concept in fund limited partnership agreements, but it is not – and, in our view, it should not become – a standard term in venture transactions. We think the exception here is that we are dealing, ultimately, with the tax payers’ money, so a right to be able to allow the tax payers’ money to be able to step up and benefit equally from a more favourable term which the recipient company is offering makes sense from a public policy point of view; having said that the current MFN wording in the Headline Terms can be construed as forward looking and that, in our view, should be clarified.
- no right to prepay – it would be sensible, in our view, to allow the start-ups to have a right of prepayment. Clearly, accrued interest would also be payable at the point of prepayment. If this was felt to be too generous, then, in these unique circumstances (i.e. emergency funding using tax payers’ money), the use of the redemption premium could be contemplated; however, if so, it should, arguably, be set at a lower threshold and be triggered only when pre-payment is made earlier in the life cycle of the loan.
Key Observation 3: Keep the investment process simple and fair
(i) Speed to market – how fast can the Future Fund be deployed?
The Government and the BBB have an ambitious target to deploy £250m in a very compressed timeline i.e. effectively just over four months based on a May to September investment window.
A legitimate question, therefore, that many will have is how quickly the Government will be able to deploy this State-capital into start-up businesses, particularly in light of other recently introduced Government initiatives, such as the Coronavirus Business Interruption Loan Scheme, where implementation of the loan programme has struggled to keep pace with the significant demand from borrower applicants. A key part of the answer to this will depend on the application process being developed by the Government/BBB.
In order to successfully deploy this scale of funding within this timetable, we believe that the more transparent, straight forward and streamlined the application process is, the better. This is no doubt the work currently being undertaken behind the scenes.
(ii) First past the post v. Pro rota allocation
Given that the overall size of the Future Fund is limited to £250m to be deployed between its launch date (May) and September 2020, a key issue for the Government to decide will be how they choose to allocate the money, i.e. should it be as and when valid applications are received (First Past the Post) or should they allocate on a pro rata basis by reference to all valid applications received by a fixed deadline (Pro Rata Allocation). In our view, this is an important distinction and it is vital that the Government clarify its position as soon as possible.
The current prevailing market assumption is that the Government may adopt the First Past the Post approach. Based on what we are hearing from the market, there are well resourced start-ups – especially those in the process of raising late stage scale up/growth funding – which have already positioned themselves to take advantage of the maximum £5m funding limit as quickly as possible when the Future Fund launches. Therefore, there is a risk that the majority of the Future Fund may well be concentrated into the later stage and/or better resourced start-ups. Alternatively, the Government could consider adopting the Pro Rata Allocation approach, which would be a more equitable means of allocating its funds as it would ensure that all eligible start-ups who have made a valid application by a pre-announced deadline would get a pro rata tranche of the government funding. If the demand outstrips the Future Fund £250m funding limit, the benefit of the Pro Rata Allocation model is that the Government could consider increasing the funding limit and allocate to all eligible start-ups quickly and fairly. A potential issue with the Pro Rata Allocation approach is that certain start-ups may not receive the funding as quickly as they need to. However, if designed appropriately, the scheme should be able to either fast track funding on an exceptional basis or on a tranched basis.
Having to secure funding from investors is already challenging for many businesses in the current environment and seeing as this is a matched funding initiative, the Government’s imperative here should be to support and match any private funding a qualifying start-up receives, provided it is made on bona fide arms’ length terms. In our view, therefore, the current proposed Headline Terms need finessing to ensure that this happens, in two main ways:
- by allowing more flex in the design to enable the Government loan to sit alongside and match any arms’ length private funding arrangement (irrespective of what form that equity financing takes); absent this flex, the scope of the Government scheme is unduly restrictive in our opinion and will likely exclude many start-ups who would otherwise be interested in applying for the scheme, particularly those who have an S/EIS investor base or where extensive negotiations have already been concluded resulting in an equity financing at a pre-agreed valuation and structure.
- by making the terms of the Government loan more market in certain respects so that start-ups, including their incumbent investors who will likely have consent rights (or at least influence) over such funding, see the Government loan as a fair and affordable source of interim funding for their businesses.
Last but not least, from a practical perspective, it is also worth highlighting that any start-ups out there who may be gearing up to take in money from the Future Fund will need to accelerate (or, indeed, decelerate), where possible, any ongoing or prospective funding discussions they are having with investors if they want to align themselves for when the Future Fund goes live. Other more procedural steps should also be considered in this context – for example, ensuring there is sufficient headroom/authority to allot the relevant equity securities and, where possible, securing pre-approval and dis-application of pre-emption rights from existing investors/shareholders.
If you have any questions on this article or other feedback on the Government’s initiative, please feel free to contact us and we would be happy to discuss further.
We also plan to host a webinar in the next two weeks on this important subject for the VC community, which we intend to use as an open forum to address any initial questions or comments you may have and to keep you informed of any further developments as and when further guidance is released. We intend to invite a select panel for this webinar to ensure we get a wide range of views and thoughts to make the session meaningful. More details to follow; in the meantime, if you would like to attend, you can register your interest here.