EIS-y Money?

A primer for founders raising EIS and SEIS rounds

What are EIS and SEIS?

In a nutshell they (the Enterprise Investment Scheme and Seed Enterprise Investment Scheme) provide tax incentives for investors to invest in early stage companies. There is a lot of money flowing into startups structured this way. EIS investments in 2014–15 (the last time HMRC published data, see here for the full report) accounted for a total of £1,816 million with SEIS accounting for £175m. By sector, tech companies accounted for the largest proportion.

Generally speaking, EIS and SEIS relief is only available for investors who receive ordinary shares. The theory behind this is such a tax incentive should apply to the earliest and riskiest form of financings. As such, preference shares that carry favourable terms such as liquidation preferences etc. (see this post for more on this) don’t qualify. Due to the requirement for ordinary shares, convertible structures (see this post for more on convertible notes) will also usually not qualify under EIS or SEIS. I say usually because certain forms of advanced subscription agreements (a form of of convertible – see here for more on these) can qualify for EIS and/or SEIS but the discussion of that is beyond the scope of this post.

What are the benefits for Investors?

As mentioned above, the key benefit for investors is the potential tax relief. If they qualify, the tax benefits broadly cover:

1. Income tax:

For EIS investments — 30% of the amount invested (on an annual limit of £1,000,000 investment) can be used as an income tax reduction.
For SEIS investments— 50% of the amount invested (on an annual limit of £100,0000 investment) can be used as an income tax reduction.

So, for example, if an individual invested £10,000 in an SEIS eligible investment (see below for eligibility) they would get income tax relief of £5,000 (50%). Thus, the net cost of the investment to them can be thought of as £5,000. Although the limit is £100k per year it’s also possible to carry back. Therefore, if an investor made zero SEIS investments the year before they can make up to £200k in a year. Income tax relief is offset in the appropriate year of claim, up to a maximum of the income tax liability. In other words, initial income tax relief could reduce an investors tax bill to nil.

2. Capital gains tax:When the investors sell their shares they won’t pay capital gains tax on the gain. SEIS Investors can also get CGT reinvestment relief meaning that if an asset is sold (and a potential CGT is payable) and all or part of the amount of the gain is reinvested in SEIS qualifying shares, half of the amount reinvested may be exempted from CGT (see here for a worked example). EIS Investors can potentially defer payment of CGT meaning gains realised on different assets can be deferred if they invest such gain into EIS qualifying shares (see here for a worked example).

3. Loss relief: If the company fails and the investor loses all of their investment, they can reduce their taxable income by the loss.

4. Inheritance tax: Generally, there’s no inheritance tax to pay on shares under EIS.

The upshot of all this for investors is that they effectively get a discount on the investment (income tax reduction), they don’t pay any tax on gains if the company sells (zero cap gains tax) and they also have a nice downside protection (reduce taxable income by the loss). All in, It’s a pretty good deal for investors.

In addition to the Company requirements discussed below, there are a couple of investor requirements that are also worth noting. The investor can’t be employed by the start-up they are investing in or own more than 30% equity in total. Plus, they need to hold the shares for at least 3 years.

For more examples of how the various tax reliefs work check out the handy Enterprise Investment Scheme Association site.

Is my Company eligible?

Not all companies are eligible for EIS and/or SEIS. Firstly founders should consider the type of share they are issuing (as discussed above) to make sure the structure of the financing qualifies. After that there are some simple company requirements (note the below is a summary: for the full list please check out the gov.uk site).

To qualify for either EIS or SEIS:

The company must have a UK permanent establishment (this does not mean that the Company has to be incorporated in the UK, see here for HMRC guidance on what constitutes permanent establishment);
Companies carrying on certain excluded activities, including (amongst others) dealing in land, property development and banking are not eligible for the scheme; and
The company can’t be a public listed company.

To qualify for SEIS:

The company must not have had any investment under EIS before any shares are issued under SEIS;
The company’s gross assets must not exceed £200,000 immediately before the investment;
The company must have fewer than 25 full time employees; and
Any trade being carried on by the company at the date of issue of the relevant shares, must be less than 2 years old at that date. That condition applies whether the trade was first begun by the company, or whether it was first begun by another person who then transferred it to the company (Note: the company need not have started trading when it issues the shares).

To qualify for EIS:

The company must have gross assets of no more than £15 million before the investment and £16 million immediately after the investment;
The company must have fewer than 250 full time employees; and
The same trade rule as for SEIS but must be less than 7 years.

How much can you raise?

Up to a maximum of £150,000 under SEIS and the money must be usedwithin three years. So companies can raise their first £150k under SEIS before moving on to EIS.
Up to a maximum of £5 million under EIS and the money must be used within 2 years.

Sounds good…What are the next steps?

It’s possible to apply to HMRC for advanced assurance that a company will qualify for SEIS and/or EIS. This is a good tactic for founders to check they meet the necessary requirements (see here for a link to the form to apply). Last I heard it takes around 4–6 weeks to receive advanced assurance. Also, whilst advanced assurance isn’t a 100% guarantee that the company will qualify it will can provide an additional level of comfort to EIS or SEIS investors considering investing at the round.

Is this just relevant for Angel investors and small rounds?

Yes and no, EIS and in particular SEIS are usually relevant for individual investors. However, there are also a number of EIS funds that are actively investing utilising the schemes. Also, for most early stage financing rounds I’ve been involved with there is often some SEIS and/or EIS money as part of a larger round. It’s possible with careful drafting (experienced VC lawyers will be familiar with this) to structure equity rounds that bring in SEIS, EIS and institutional money (i.e. VC funds) all into the same round. Therefore it’s good for founders to research and consider these schemes so that they can potentially unlock further investment for their round.

The above points are by no means exhaustive (and, to flag, do not constitute any form of professional advice) but hopefully they provide some useful background for founders considering SEIS or EIS. As with anything technical like this, I’d also recommend founders seek advice from their lawyer and accountant.

Useful links:

Enterprise Investment Scheme association: http://www.eisa.org.uk/
Overview of the Seed enterprise investment scheme: http://www.seis.co.uk/
UK government information site : https://www.gov.uk/topic/business-tax/investment-schemes

Thanks to Will Neale and Harry Glasstone for reading drafts of this post.

Originally posted on Medium.

Hitting the right note

A primer for founders raising using convertible notes

Convertible notes are one of the most common ways of raising financing for a startup. Particularly the first round of financing. We currently use a form of convertible for all of our pre-seed deals at Seedcamp. Having reviewed and issued many convertible notes over the past few years, I wanted to distill this knowledge down into some key questions for founders to consider and why I think they’re important.

Before we get to the questions, some background..

What is a convertible note?

Broadly speaking, a convertible note is a financing instrument that can be used to provide funds to companies in advance of issuing shares. It is often used on early stage financings because it avoids the need to establish an explicit valuation. Convertible notes can provide a faster and simpler way to document a funding round than a priced equity round.

I’m using the term “convertible note” in this post but many of the below points will also apply to other convertible financing agreements such as: Simple Agreement for Future Equity (SAFE), Advanced Subscription Agreement (ASA) etc. The reason for choosing one variant over the other is often driven by potential tax preferences for investors (i.e. ASA for EIS / SEIS investors) or familiarity (i.e. SAFE for US investors).

For an example of a convertible note and advanced subscription agreement and some of the main differences between the two check out the Seedsummit site here.

8 questions to consider when reviewing a convertible note

(1) What constitutes a Qualifying Financing?

As mentioned above, the primary intention of convertible notes is for them to convert into shares (the clue’s in the name) and the majority of such conversions happens at the next financing round of the company that constitutes a “Qualifying Financing”.

The Qualifying Financing is usually the trigger for an automatic conversion of the note which is then calculated using either the valuation cap (see below), discount (also, see below) or price per share paid at the round -whichever results in the greatest number of shares to the note holder.

The amount (i.e. size of the next financing round) that constitutes a Qualifying Financing can vary depending on the stage of the company and how much the company is raising in total under the convertible note. A reason behind having a qualifying amount is that it protects the investor from having their investment converted to equity in a company that is under funded. Before it is converted the convertible note will technically class as debt and therefore rank higher in the event the company becomes insolvent. This can also ensure that the Qualifying Financing is a true financing for a meaningful amount. However, this lower bound amount should not be set too high so that the Company risks having the money not convert at a true financing round.

(2) Is there a Valuation Cap?

This is often one of the most negotiated elements of a convertible note. The level the Valuation Cap is set at can have a major impact on the number of conversion shares issued. Understanding how it works is of crucial importance. Simply put, it is the maximum value at which the convertible note would convert in a Qualifying Financing (see above), regardless of the price set at such Qualifying Financing. This mechanic prevents the shareholding on conversion from being reduced to a very small % in the event that the company raises at a high valuation for its next round. To illustrate how this would play out in practice let’s look at an example..

Valuation Cap — Example scenario:

Company X is raising a £1m priced equity round (i.e. they are issuing £1m worth of shares to the new investors investing at this round) at a £3m pre-money valuation (for the purposes of the two examples in this post, we’ll call this the “Seed Round”).

Previous to the Seed Round, Company X had raised £50,000 on a convertible note with a valuation cap of £1m (this is the only note they have raised to date).

Assuming that the £1m round is a Qualifying Financing (see above), the convertible note would automatically convert at the valuation cap of £1m because this will result in a greater number of shares than if the convertible note converted at the terms of the round (i.e. £3m pre > £1m cap). Broadly speaking, the convertible note investor would get an effective~3x lower price per share than that paid by the new investors investing at the round by taking the Valuation Cap as the basis for calculation rather than the pre-money of the round.

I always recommend founders model the impact that the notes they enter into will likely have on their cap table when they convert. As the above example shows, the Valuation Cap can have a significant impact on the dilution incurred by the company. However, it’s worth bearing in mind that the convertible note investor has likely invested at an earlier point in time and therefore should probably be entitled to better economics to reflect the increased risk they took.

(3) Has a Discount been specified?

Like the Valuation Cap, the Discount placed on a note is another variable that can have a significant impact when calculating the number of shares that the note converts into. Hence, it is also usually front and centre in any negotiation. Generally, where included, the discount it is drafted as a % of the price paid by investors investing at the round often ranging from 0–30%. Again, taking an example scenario to help illustrate..

Discount — Example scenario:

Using the Seed Round metrics from above (£1m at a £3m pre).

In this example, assume that Company X had raised £50,000 on a convertible note with no valuation cap but a discount of 20% (this is the only note they have raised to date).

Assuming that the £1m round is a Qualifying Financing (see above), the convertible note would automatically convert by taking the price paid per share and discounting by 20% because this will result in a greater number of shares than if the convertible note converted at the terms of the round (i.e. Seed Round price per share> 0.80*Seed Round price per share). Broadly speaking, the convertible note investor would get an effective 20% lower price per share than that paid by the new investors investing at the round.

Note: Convertible notes can also be drafted to include a Valuation Cap and a Discount (and, in rare cases, they could include neither). If they include both, the convertible note holder would choose to either convert into shares using the Valuation Cap or the Discount (whichever would result in them receiving the most shares).

Overall, both the Valuation Cap and Discount are very important terms and care should be taken in particular when determining the effect they can have on the ownership position following conversion.

(4) Is there an Interest Rate?

To flag, not every convertible note will carry an Interest Rate (i.e. the note we use as the basis for our pre-seed investments at Seedcamp does not carry an interest rate). If it is included, the Interest Rate will usually start accruing from the day the convertible note is signed and issued until the day the note becomes due and payable or converts. The interest rate is important to consider because, on a conversion, the accrued interest can be thought of as acting like an additional discount. Overall, the Interest Rate is an additional factor that impacts the investor’s return and therefore can form part of a negotiation.

(5) What happens if the next round is not a Qualifying Round?

Usually the convertible note holder would have the option of whether to convert or not if the next round does not constitute a Qualifying Round. The Valuation Cap or Discount may be set at different levels compared with how the note would convert on a Qualifying Financing (if different it would be common for the valuation cap and/or discount to be more favourable for the investor). This provision may also give the convertible note holder the option to convert the note to shares in the event there is no financing round prior to the maturity date (see below) based on an agreed pre-money valuation. This clause can have an impact in the event things don’t go to plan and the company has to raise a smaller than planned round (i.e. a bridge financing or similar).

(6) What happens if the company is acquired before conversion?

There will usually be a specific clause that addresses the situation in which the company is acquired before the convertible note has had a chance to convert into equity in the company. This situation is common in “acquihires,” or the acquisition of a company at a very early stage, and in which the amount being paid for the company is based on the recruitment of its employees rather than the company’s intrinsic value (i.e., the company’s intellectual property, revenue, etc.). The three most common possible scenarios for the treatment of the note are: (1) the convertible note converts into ordinary shares of the company, and then proceeds from the acquisition are distributed to the common stockholders on a pro rata basis; (2) the convertible note converts into preferred shares, which provides protection of liquidation preference, among others; (3) the convertible note holder is entitled to a return of a certain amount, based on then balance of the note (i.e. the amount they invested under the convertible note). In (3), the return entitlement can be 1x, 2x or higher. This clause is important for founders to consider particularly if aquihires are common in their industry or they believe the company may be acquired prior to a conversion.

(7) What’s the Maturity Date and what does it mean?

The Maturity Date is the date that the convertible note technically would need to be repaid if it is still outstanding (i.e. it has not converted or been repaid in some way). In practice, if the Maturity Date comes to pass it is often agreed by the convertible note holder that it can be extended (particularly common for VC investors, experienced Angels etc.). Look out for wording explicitly stating that the Maturity Date can be extended. However, investors may enforce the repayment which could have dire consequences for the company (i.e. if they have insufficient funds or if such a call on funds would lead to insolvency). Most sophisticated investors would appreciate that extending is likely the best route because, in practice, it is very unlikely that the company would have sufficient disposable funds to repay the note. However, the same may not be true of all investors. Be careful in picking your investors – particularly if they have not invested using a convertible note before and don’t fully understand the risks and what the situation would likely be in the event the company does not succeed.

(8) What type of shares will the note convert into?

Generally, this will be either ordinary shares or the same class of shares that are issued to other investors at the round. It’s favourable for the investor to receive the same class of shares as those issued at the round because they will generally be preferred shares and carry such rights (i.e. protection of liquidation preference etc.). It’s important for founders to understand this clause because they are potentially increasing the size of any liquidation preference (see this post) they create on a future round.

The above points are by no means exhaustive but hopefully they provide a useful primer. I’d recommend founders run any detailed points past a lawyer and get legal advice before entering into any agreements.

Originally posted on Medium.

Bulletproof Vest – How vesting can save your startups life

Startups rarely (if ever) go perfectly to plan; things often go wrong and life throws up all sorts of scenarios that can have an impact. Sometimes things get so bad that founding teams split up. The chances of this are often increased where you have large founding teams formed in a short period of time (i.e. when the team haven’t really worked together before). Regardless of the size of your team and the likelihood of a founder fallout, how big an impact such a split has on your startup can make or break it. This is where vesting comes in.

One of the primary drivers behind the idea of vesting is to help reduce the impact of a co-founder leaving by ensuring they don’t leave with a disproportionate amount of equity. How this often works is that founder shares vest over time. So, as a founder you are 100% vested when you “own” 100% of the shares that have been allocated to you. For example (very simplified):

if you have a straight-line (meaning you vest daily a proportion of shares) vesting schedule in place over 4 years and you started vesting 2 years ago you will have vested 50% of the shares allocated to you.

Vesting is important to ensure that, should a co-founder leave during the vesting period, there is enough equity left in the company to adequately incentivise the remaining founders and team. This is even more important when you think that the company will likely have to hire someone to replace the departing co-founder and they will likely want a chunk of equity. Often vesting is thought of as solely an investor protection provision requested at the time of a fundraising round. I always advise founders not to think of it purely this way because, as described above, it helps protect against a potentially catastrophic impact of a founder fallout situation for all stakeholders (founders and investors).

Personally, I’m always impressed with founders who think about vesting early on and appreciate the theory behind it. It’s not necessary to worry about the detailed mechanics, your lawyer will incorporate this into the long-form legals when it is required (usually at a fundraising round). Often vesting schedules are set over 3–4 years with some form of a cliff after one year. This means that an amount (often 25%) is deemed to be vested only after one year of continued work (the “cliff”), with the remainder vesting incrementally on a straight line basis over the following 2–3 years. For example (assuming 4 years):

0–12 months = 0% vested
12 months = 25% vested
12–48 months = straight line vesting (i.e. you vest a small amount each day)
48 months = 100% vested

All sophisticated investors will request some form of vesting schedule should you raise a round of financing from them so it’s worth giving some thought to this when you are staring out.

I haven’t really dived into the nitty gritty of specific terms in this post (in particular I haven’t looked at the circumstances around founders leaving (i.e. Good Leaver, Bad Leaver, Acceleration on Exit etc.)). It goes without saying how important it is to fully understand any legal documents and the implication of the terms contained therein.

Originally posted on Medium.

Yet to incorporate your startup? Read this!

Often startups begin life as a project, hobby, hackathon submission etc. way before anyone thought about incorporating a company to formalise it. This is perfectly normal and it’s very likely that there will be some period of collaboration and figuring stuff out prior to incorporation. However, I’ve been involved in a couple of situations where individuals crop up further down the line (i.e. once a startup has received some press attention after having raised a round etc.) and stake a claim for a share in a company.

Often the claim goes something like:

“I was there that time in the coffee shop when we (current founders and them) were discussing the idea and I made X suggestion therefore I’m a co-founder and I’m entitled to Y% of the company”

Whilst it may be very difficult for someone to provide enough evidence to actually bring a successful claim like this, even having it potentially hanging over the company can be problematic (particularly around fundraising when investors are doing due diligence).

So, what can you do to protect against this?

At the point you start collaborating you should set out who you are collaborating with on your idea and who is going to own what in terms of % should you go on to set up a company. This doesn’t require a long-winded shareholders agreement or an expensive lawyer to draft it. You can probably get away with something on the back of a napkin at a push. However, I’d recommend something a bit more robust – for a free example of a simple template checkout the Seedsummit website here.

Unfortunately, nothing can stop someone bringing an entirely fictional and unfounded claim against your startup. I hate seeing such claims stress out founders and take up their valuable time. Having a clear paper trail in the early days, however basic, is a great way of hopefully mitigating against any effect and allows you to get on with building your business!