Here’s something pretty much every UK entrepreneur and business angel needs to be thinking about right now!
In July 2011, HM Treasury put out a request for consultation on proposals to change the way EIS (“Enterprise Investment Scheme”) works (download the 679K PDF linked about a page down from the top). Even though the government upgraded EIS relief in its April 2011 budget, it’s hard not to notice that TechCrunch Europe has still not been swamped by anything approaching an avalanche of angel backed UK tech startups. Hence HM Treasury’s diligent search has moved on to find other ways to, let’s say, ‘modernize’ the way the whole EIS system works.
Simplifying very slightly, the existing EIS works like this. If an individual business angel puts more than £500 into an eligible startup’s funding round solely as ordinary shares (but not more than 30% in a single company, and not more than £1m of EIS investments in a single year), then:-
- He/she can reduce their income tax bill by 30% of the amount they’ve invested
- If he/she then holds onto those shares for 36 months or more, they can be sold at a profit without incurring Capital Gains Tax
- If they are sold at a loss at any time, then the loss can be set off against other capital gains
This is all very sensible in a shiny-black-shoe kind of way, insofar as it uses the tax regime to encourage business angels to do The Right Thing – i.e. to invest in startups for the reasonably long term (3 years). Specifically, this doesn’t cover investments made using the kind of liquidity-preferential share equity clauses VCs like to put in place to multiply cover their investments, or in the kind of tricksy hybrid (part-debt, part-equity) security instruments that have infested the City since Moody’s opened the door to them back in February 2005.
So… what’s the problem? Well, I suspect HM Treasury is looking enviously over at the (frankly unbelievable) US startup bubble, where quite literally biiiillions of angel dollars routinely get poured into frothy startups at unsupportable valuations. Really, for all the (quite different) problems that entails, it makes for a stark comparison with the near-moribund state of angel investing back in Blighty.
It has been argued by some UK angel group representatives (who I suspect are the “stakeholders” mentioned in the consultation paper) that one of the key differences is that many US startup investment rounds use a hybrid instrument known as convertible notes, which (according to this page) started to gain popularity around 2004. A convertible note is a debt instrument (basically, a loan to the startup) that gets priced in terms of a discount relative to the next funding round, even though that has yet to even begin to happen (and there’s no agreed idea of when it would happen). The paperwork is cheap (because it’s not a ‘proper’ round as such, just a precursor to a later proper round), and so using convertible notes incurs – proponents argue – less negotiation hassle and lower legal costs. One key variant of this structure is “capped convertible notes”, which have a little recent controversy of their own.
Circa 2011, however, the big problem with using convertible notes in the UK is that Euro VCs are simply not doing anything like the number of early-ish deals they were. For all the talk of the upswing in Euro VCs’ funds as an asset class, the deals being done are getting ever bigger and ever later. This is the second equity gap – between £2m and £10m – mentioned in the consultation paper, and there’s no obvious evidence that it is reducing. So rather than having to hold onto your convertible notes for a paltry 12-18 months before the fabled big VC round happens, UK angels are instead facing the prospect of a 3-6 year wait, if it ever happens at all. How on earth are they supposed to price in that kind of wait?
Other people (mainly Basil Peters) have suggested exchangeable shares, which are equity instruments priced as normal but which automatically upgrade with whatever arcane conditions get imposed by VCs for their shareholding in a subsequent round. This is designed to prevent angel investors getting their shareholding turned to dust by VCs (which, sad as it is, does happen). But unless I’ve misunderstood the descriptions, this seems to be a double disaster for entrepreneurs, in that whatever bad-ass terms the VCs negotiate immediately get propagated to everyone else bar the entrepreneurs.
Back in the UK, other variants of this class of hybrid instruments have been proposed. Brad Rosser’s “magical pitch” (chapter 5 of his book “Better Stronger Faster”) revolves around taking a loan (debt) from an angel investor in tranches but giving a chunk of equity with each draw-down. The example he gives (pp.123-124) is a £200K loan delivered as 4 x £50K tranches, each one tied to delivery of milestones, and giving 10%, 7%, 5% and 3% equity with each respective draw-down. It’s a pretty neat arrangement… apart from the fact that it probably wouldn’t currently qualify for the EIS, making it tax inefficient if you’re an angel paying higher rate taxes (and no downside protection beyond the fact that the company needs to be hitting its milestones to get the next tranche). It also runs the risk of the startup trading insolvently (because of the loans on the books from Day One). All the same, might this kind of scheme be able to qualify for the new-look EIS being discussed?
Alternatively, one angel investor I’ve had many conversations with argues quite persuasively that what angel investors most want to avoid is losing their stake: and so what they would like most of all is some arrangement whereby they get their original stake (but no more) back as early as possible, leaving a certain amount of equity in place (at zero effective downside risk to themselves), allowing them to go off and invest it in something else. One way of doing this might be to allow the entrepreneur to buy back shares from the angel up to the principal amount, perhaps on a sliding scale. For example: a £200K investment for 25% of the company, but where the entrepreneur can buy back 12.5% for £200K in Y1, or 10% for £200K in Y2, or 8% for £200K in Y3 (or perhaps up to those amounts pro rata). This tries to align the benefits of a mini-MBO and an early repayment loan all at the same time. But could such an arrangement be shoehorned into the new-look EIS?
The key problem is that we’ve only scratched the surface and already we’re lodged headfirst in the quicksand of financial engineering – securitization, SWORD-financing, SPEs / SPVs, etc – which is what the original EIS expressly set out to avoid. It seems we will have to all become experts in differentiating the nuances of equity and quasi-equity in order to proceed: and that if EIS becomes too loosely inclusive, doubtless an entire (under)class of specialist financial advisors will spring up to offer us all custom-built clever-as-you-like angel-friendly EIS vehicles.
Ultimately, should “BASIS” (HM Treasury’s term for the next revision of EIS) be laissez-faire (e.g. as long as 70% of an investment is equity or quasi-equity, you can make up the rest as you like) to try to let the tier of financial engineers make it angel-friendly; or should it it largely retain its shape to protect entrepreneurs from being exploited by unfair contractual shenanigans? You have until 28th September 2011 to give the Treasury your comments – basically, what should the future of UK angel investment look like? You can help decide!
Funding Startups (& other impossibilities) 