Getting to "yes" in a world of "no"…

Liquidation prefs and EIS…

Here in 2011, the UK Government’s Enterprise Investment Scheme (‘EIS’) gives tax payers a number of good reasons to invest their money in eligible startups: there are direct tax incentives (for investing at all), plus other tax incentives covering the up-side (i.e. if the investee does well) and the down-side (i.e. if the investee does badly). Because the government is anxious to ensure that this is only used for fair share arrangements between entrepreneurs and investors, it only allows investors to buy startup equity as ordinary shares (i.e. with no special rights or preferences).

For 2012, the Treasury is preparing a new scheme called “BASIS” (intended to encourage really hardcore angels to invest in full-on high-growth startups), which I think it plans to run in parallel with the existing EIS. The BASIS consultation document (which I discussed here not so long ago) goes to great pains to explicitly allow certain watered-down types of preference shares within BASIS, which – reading between the lines – it seems to think marks a great liberalization of its policy attitude towards angels and entrepreneurs. My guess is that it was not angel trade bodies but VC trade bodies (and if so, probably the BVCA) who were lobbying for this change, though it beats me why the BVCA would want to influence this part of the market given that its UK members hardly ever fund startups that early in their lifecycle.

What is curious here is that it is apparently already possible to get the effect of liquidation prefs with EIS shares. The first time I picked up on alternative liquidation prefs was the mention of the Elderflower approach on TechCrunch in 2009, apparently first noted by well-known UK entrepreneur/angel William Reeve. Essentially, this changes the initial “subscription” (how the equity is bought) so that whereas entrepreneurs has their sweat equity shares initially valued at 0.01p per share, the angel investors have their shares valued at (say) £10. The investors might only end up with (say) 25% of the total number of shares (with the entrepreneur(s) with 75%), but in the [hopefully unlikely 😮 ] case of a liquidation event, the investor would get their subscription back at the £10 per share rate, whereas the entrepreneur would get his/her subscription back at the 0.01p per share rate.

This mechanism, if it still works as described and has not been disqualified by HMRC, should give the same net effect as ‘proper’ liquidation preference shares. According to Tom Allason’s comment on TechCrunch, Shutl used this: and having talked to various startup people around London, it seems that at least one startup may well be using this right now. All the same, Danvers Baillieu noted (also in a TechCrunch comment) there that “I would also be interested to know if any of [the] investments in question have progressed to a further round of funding and, if so, what has happened to the share rights at that point.” Hence, because it’s not as yet entirely clear how this ‘trick’ really works in practice that little bit further down the line, all I can say is “caveat investor / investee”.

Curiously, back in September 2010, Alliott Cole wrote an entry on the Octopus Ventures blog discussing liquidation preference shares:-

“4. Angels in the United Kingdom appear to dislike liquidation preferences too. A cynic may hold the view that this is because most business angels think that to subscribe to a class of share with a preference would prohibit the investor from obtaining Enterprise Investment Scheme (EIS) status (and the associated income tax relief and loss relief). This view is in fact erroneous: the Octopus Venture Partners, who require EIS qualifying investments, co-invest with Octopus on every investment we make – all of which include liquidation preferences. The trick is in how one defines a liquidity event.”

From this, it would seem that Octopus uses a yet different method for emulating liquidation preference shares. *sigh* Please leave a comment below if you happen to know how Octopus’s terms manage to achieve this end, I’m sure we could all do with a laugh. 🙂

OK… even though I understand there is always a ‘sport’ element to law as practised (how close to that line can you throw your legal javelin?), I’m struggling to see how emulating liquidation prefs in this sort of way amounts to anything more than a means for lawyers to make additional money out of angels and startups, at a time in their investment lifecycle when cash is at its greatest premium.

Personally, I’m with the spirit of the law here: just because you can game a system doesn’t mean that you should do so, and it doesn’t mean that the people running that system can’t retrospectively tighten the rules. Really, isn’t setting up a ‘vanilla’ share arrangement plenty expensive enough already?


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