The Government's Future Fund Isn't Fit for Purpose
The Government's Future Fund, launched in May, aims to match private sector investment with public money to help start-ups influenced by the pandemic. However, individual investors providing matched funding underneath the scheme cannot claim Enterprise Investment Scheme -a tax relief to encourage investment into early-stage businesses-on their investment due to the scheme being structured as convertible loans. Moreover, angel investors wishing to make equity investments in start-ups under EIS will probably be not able to claim EIS in which the investment monies are utilized to repay existing debt and Recover loans) as well as for working capital purposes. EIS monies are to be used for growth and never for capital. As a result, many start-ups might be forced to re-enter the economy without sufficient financial resources.
It is apparent that an alternative scheme is needed to support start-ups and SMEs not able to raise money via the Future Fund and/or using EIS. Now more than ever before, the legal industry must build relationships Government to make sure that tailored support packages they fit in position to assist sectors which are struggling.
The state of play for UK start-ups
Businesses can take a loan from high street and challenger banks under Government-backed loan schemes. However, where businesses have to borrow larger sums, banks may need personal guarantees from directors , and may apply inflexible qualification criteria. CBILS also includes restrictions on “business in difficulty” from borrowing using the scheme. This idea includes high growth start-ups whose accumulated losses exceed 50% of the paid-up share capital. Whilst such businesses can theoretically qualify for a Recover loan, most are excluded because of the operation of State Aid rules. In short, Government-backed loans aren't accessible for all, and in any event add to the repayable debt for businesses.
Nonetheless, British companies have to date borrowed lb38.4bn underneath the Government's emergency credit programmes since the coronavirus pandemic struck, demonstrating the urgent requirement for finance to ensure that businesses can fund cashflow. For SMEs which have so far survived, the next Twelve months will prove critical. Upon reopening, businesses will face significant re-launch costs; the employer contribution towards the furlough scheme is increasing and suppliers might want arrears paid before they provide further goods and services.
Many businesses will appear to boost investment to fund their capital requirements and to ensure that they are able to afford CBILS and Recover repayments once they kick in next year. Yet, as referenced above, existing schemes, especially Enterprise Investment Scheme , do not allow tax relief on investments accustomed to repay historic debt and to fund working capital: monies must be used for growth. As it stands, start-ups may struggle to raise investment.
Why the near future Fund is not fit for purpose
The Government's latest funding involves a programme that will pump an additional lb250 million into innovative start-ups using a 'Future Fund' administered by the British Business Bank. The initiative aims to inspire private sector investors to take on a few of the risk involved with rebooting the British economy. However, by structuring the scheme using convertible debt which doesn't be eligible for a EIS relief, UK based angel investors aren't incentivised to supply matched funding as part of the next Fund round, which significantly weakens the outcome from the scheme.
Most UK private investors are reliant on EIS to lower their risk and reward them to make high-risk investments in early-stage businesses. An investment under EIS can usually benefit from an upfront 30% income tax relief and 100% capital gains tax relief on sale. EIS only applies to equity investments and therefore convertible loans do not qualify. Consequently, whilst many SMEs happen to be able to secure matched funding from foreign angels and VCs, a lot more have been unable to access the scheme. To make matters worse, many start-ups unable to connect to the Future Fund are also locked out of CBILS and Bounce Back Loans due to the State Aid restrictions in respect of those schemes.
Businesses who would like to access the Future Fund should have raised a minimum of lb250,000 from investors in the last 5 years. This penalises early-stage start-ups and SMEs that have boot-strapped or grown organically. Many SMEs have been blocked from accessing the near future Fund as a result of this restriction.
Meanwhile, the options open to aid the economical survival and success of smaller businesses will need consideration. The opportunity to entitled to the Future Fund, the need to obtain matched private investment without access to EIS, the relatively high interest rate on the loan, a 100% redemption premium in case of repayment, and the favoured nation clause that ensures that the Government always get the best terms of any subsequent investment, are all key considerations which are prone to have long-lasting implications for start-ups.
The convertible loan agreement is complex and non-negotiable having a number of terms that are more onerous compared to UK market standard. Whilst the involvement of solicitors is hard-wired in to the application process in that a lawyer must be appointed to carry investment monies, many start-ups are skipping the key step of taking detailed suggestions about the commercials and long-term implications of a Future Fund round. That aside, legal advisors will have to be aware of the the CLA when advising on future fundraisings.
Strategies for the future
For many smaller start-ups, an alternative option to the Future Fund is required which better shifts the risk from the Government to personal investors. We believe that this might be achieved through creating a temporary tax relief scheme similar anyway to EIS to encourage angel investors to purchase start-ups.
Monies raised using this type of scheme would provide capital to SMEs and could be used to repay COVID-19 debts including CBILS and Bounce Back loans. Investors have a tendency to want to invest for growth, not for working capital purposes. Consequently, it's our view that a higher upfront rate of revenue tax relief is required to compensate for the additional risks of providing capital to an SME. We think that the age restrictions applicable to EIS should be lifted for any temporary new scheme.
The legal industry is going to be looked upon to advise smaller businesses only at that hard time, while champions of start-ups must still lobby the Government to ensure that our SMEs can connect to the right support. We feel that a new temporary scheme as outlined above is required to help SMEs re-launch; others believe that changes to the current EIS scheme are needed; whilst still, others advocate a further Government bail-out via debt forgiveness scheme. It is our job as lawyers to interact with our peers, clients and the Government to ensure that the voices of our clients are heard. Failure to act now could threaten the firms that make up the bedrock of our economy, resulting in numerous SMEs entering insolvency, and contributing to rising unemployment and the threat of a recession worse than that predicted by the OECD.
