Background

First it was the corporate lender of last resort with the launch of the CBILS scheme, next the employer of last resort with the introduction of the Coronavirus Job Retention Scheme, and now Rishi Sunak, Chancellor and architect of both the aforementioned schemes, has laid out his plans for the Government to assume the role of ‘investor of last resort’ to support the previously overlooked UK start-up community.

The move follows sustained lobbying from a who’s who collective of the early-stage investment community (unified under the banner of Save our Start-ups) as genuine concern was voiced that the Covid-induced freeze of the economy would drive many of the UK’s most cutting-edge enterprises out of business by this summer without emergency state intervention. £10.1bn was invested into UK tech companies alone last year with the UK third in the world for tech unicorns behind only the US and China (77) and the broad consensus has been that to protect the UK’s position as a global tech hub, the Chancellor needed to act quickly to get the companies of tomorrow across the river today.

The £1bn stimulus package has now arrived in the form of two separate pots of money, a £250m public-private investment fund initiative labelled the ‘Future Fund’ and also an expansion of the role of Innovate UK (the national innovation agency which provides grants and loans to small knowledge-intensive businesses) with £750m allocated to new deployment, the bulk of which is supposedly earmarked for existing recipients of Innovate UK support.

Both initiatives are major commitments by the government to try and sustain the growth and development of the start-up economy through this crisis. However it is the Future Fund in particular, as the newly-unveiled scheme, where the success of this state effort will be judged and, as ever, the devil will be in the detail of how the scheme shall work in practice when launched next month.

The Future Fund

The Future Fund is intended to operate on a ‘matching’ basis whereby the Government will commit £250m in total funding (with individual cheques written by the Government ranging from £125,000 to £5m) to those eligible start-ups alongside venture investors who agree to match the Government’s funding with their own private capital (or, if the private investors are inclined, they may provide further funds in excess of the £5m-matched government cheques). More of a ‘beef-up’ of investment capacity, rather than a pure bail-out of the sector (the latter an approach which critics of any interventionist support whatsoever for start-ups had been the most fervently opposed to).

To be eligible, investee companies must be UK-registered (and with a substantive economic presence in the UK), unlisted, and have already raised at least £250,000 in equity investment in the last five years. As yet, there has been no restriction applied as to the maximum age permitted for eligible companies.

The government’s portion of the total bridge funding extended will be provided in exchange for the issue of convertible loan notes by the investee companies. An initial term sheet which sets out the headline minimum terms of such notes has been published here (the “Term Sheet”). It is not yet clear what form the private investors’ matched funding should take or whether this will be subject to restriction at all. It is also proposed that any funds invested under the scheme are to be used solely for working capital purposes, with restrictions on leakage out of the structure that will be familiar to those familiar with VCT and EIS investments.

Term Sheet

Our summary of the Government’s conversion rights contained in the Term Sheet is as follows:

• Automatic Conversion –  if new money raised is of an amount equal to the bridge funding provided by the government and the matched investors (a “qualifying funding round”), the notes shall convert into equity at a discount rate of 20% to the price set by that qualifying funding round or more as may be agreed.

• Optional Conversion –  
A. if new money raised is of an amount less than the bridge funding provided by the government and the matched investors (a “non-qualifying funding round”), conversion to equity is only at the election of the holders of a majority of the principal amount of the bridge funding held by the matched investors (“the Matched Majority”) at a discount rate of 20% to the price set by that non-qualifying funding round, but at no discount if the most recent non-qualifying funding round took place before the bridge funding;
 
B. on a sale or IPO, the noteholders to receive whichever generates the higher amount from a:
 
(i) repayment of the bridge funding plus a redemption premium of 100%; or
(ii) conversion into equity at a discount of 20% to the price of the most recent non-qualifying funding round (since the bridge funding)

• on maturity of the bridge funding [three years from issue], at the option of the Matched Majority, the loan will:

A. be repaid with a redemption premium of 100%; or

B. convert in to equity at a discount of 20% to the price of the most recent [qualifying or non-qualifying] funding round (but at no discount if the most recent funding round took place before the bridge funding); AND the Government’s loan shall convert into equity unless it requests repayment.
 
On a conversion, any accrued interest always converts at no discount.

Our key takeaways from the Term Sheet

The following notes cover what we consider to be the most material points to be clarified by the Government ahead of the scheme’s launch next month and/or should be of interest to any investment manager considering how it might leverage the use of the Future Fund:

• Will participating investors’ portion of the bridging investment be required to be in the form of convertible loan notes or will other forms of investment be permitted (so long as the minimum quantum invested matches the Government’s investment)? Convertible loan instruments are not permissible under the existing EIS/SEIS scheme rules and consequently unless clarification is given that other forms of investment (i.e. by way of direct equity investment or via an advance subscription agreement) are permitted then the Future Fund will inadvertently exclude a large population of EIS/SEIS fund managers and individual angel investors.

• The Term Sheet is silent on whether the matched investor(s) constitute incumbent investors only, or whether they may also be joined by new participating round investors willing to match (again via what instrument, to be confirmed). Naturally, the wider the net of potential private investment in each investee company the better.

• Pricing of 8% simple interest charged per annum over three years (if held to maturity) and a 100% redemption premium right should the Government request repayment, rather than conversion, of its loan, equates to a 2.24x total return for the Government on its loan investment. This is arguably an appropriate commercial reward for the risk the Government is taking on by assuming such a large portfolio in such a short space of time, but from a company point of view (especially one that may still be struggling in three years’ time), being saddled with such a large repayment bill is unlikely to help in the circumstances. What is also not clear from the Term Sheet is whether the redemption premium right is calculated on simply the Government’s portion of the commitment or the full bridge funding amount (inclusive of the matching investor(s)’ portion), our expectation is that it will be clarified as the latter.

• The optional conversion right is drafted slightly oddly in that it appears to grant (a majority of the) matching investors a right to require the conversion of the notes on any non-qualifying round, at the 20% discount rate to the price set by that funding round. This provision in particular suggests that the Term Sheet anticipates that matching investors will indeed hold the same class of instrument as the Government (i.e. the notes), thereby ensuring that their valuation interests are aligned.

• The conversion equity held by the Government is to be the “most senior class of shares in that company”. This could be open to discussion where companies have attracted multiple rounds of equity investment and have complex share structures.

• At what point does the Government commit its funding on each particular investment round? We would expect that subscription mechanics would only allow for the Government’s funds to be transferred once the investee company has confirmed that it is holding the matching investors’ cash in its bank account.

• It is also not clear from the Term Sheet how and in what circumstances the Government might exercise its votes in respect of any converted shares held and whether those shares would be subject to existing provisions in favour of the existing investor group.

• Finally, the government has reserved the right to transfer its holding to ‘institutional investors’ in blocks of ten or more and may well want to shift these investments off its balance sheet as soon as it can post-crisis.  It will be interesting to note what further clarification the government provides on its eventual exit rights, as private investors will be keen to understand who their future co-investors may be (particularly since the Term Sheet does note that the Government will have ‘limited corporate governance rights’ which, if in fact wide, may be inherited by an incoming transferee).

In conclusion

The Future Fund, if deployed ably and on time by the Government over the coming months (the window for applications runs initially until end of September), could yet be the saviour of a generation of national start-ups that might not otherwise see out the storm.

Key questions following yesterday’s announcement must now be clarified over the coming days by the Chancellor, not least the investor universe to which the scheme is relevant to (in our view there should be no distinction between traditional VC investors and SEIS/EIS managers and angel investors), so that the industry can quickly react accordingly.

We also expect Mr Sunak to comment on whether the £250m committed at this stage is considered to be only a ‘pilot’ amount. As it stands, if those venture investors first in the queue next month each theoretically requested a £1m matched investment in their nominated start-up and were successful in their application, then a mere 250 start-up companies would be handed the lifeline of investment. In an ecosystem where approximately 15,000 start-ups have raised £250,000 or more in a single transaction in the last five years (and thus not even accounting for those which will have raised much more over time across multiple rounds), the £250m commitment by the Government may need to be revised significantly upwards.

RW Blears
21 April 2020