Most equity raises consist of what's known as a 'priced round', i.e. shares are issued at an agreed price per share at the point that the investment is made. Alternatively, the company or the investors may use a convertible loan note, under which the investment is initially made by way of debt, which later converts to shares when a future event takes place (for example, the next financing round or an exit).
The conversion price is usually set by that future event, for example a discount of 15-25% on the share price associated with that transaction. This has the advantage of postponing the difficult and contentious question of valuation. It also provides some downside protection for the investor, as the investment remains a debt that may become repayable, and ranks ahead of shareholders in the event of insolvency.
Tax Relief Implications
Whilst convertibles are used extensively in the U.S., they are not that common in the U.K., largely because they don't allow the investor to claim Seed Enterprise Investment Scheme (SEIS) or Enterprise Investment Scheme (EIS) relief on the investment.
An ‘advance subscription agreement’ seeks to address this. If structured correctly, it enables the investor to subscribe for shares, with funds being provided to the company at the date of the agreement, but with that investment converting to shares upon a future event (e.g. the next financing round).
However, the investor has no right to demand this money back. The investment has to convert to share capital at some point, which in the absence of another equity raise or exit, will be a specified date or an insolvency. This would mean that the investment no longer has the downside protection of a convertible loan, and may therefore be eligible for SEIS / EIS relief.
Key Features Of Advance Subscription Agreements
These arrangements can involve a variety of terms, although the core features to look out for are:
• Discount – the reduction in the share price for the advanced subscription investors when their shares convert into shares. We see 15% - 25% as being the market norm.
• Cap – the maximum value at which the investment will convert into shares, designed to ensure that the investor does not end up with an unexpectedly low equity percentage.
• Qualifying Threshold – a minimum size of the round that will trigger conversion (if the round is very small, the investor may prefer to wait until a more significant investment is made).
• Long Stop Conversion Price – the price per share that is used for the conversion if there is no funding or exit event to provide a third party valuation of the company.
Many early stage investors value the ability to agree specific terms governing their relationship with their investee company through a priced round. In particular, a warranty and disclosure process appeals, though of course these advantages could be delivered through a bespoke advanced subscription arrangement. It is an interesting tool for both investors and fast growing companies to be aware of.
If you'd like more information about any aspects of advance subscription agreements, please get in touch.
This publication is intended for general guidance and represents our understanding of the relevant law and practice as at February 2017.
Specific advice should be sought for specific cases. For more information see our terms & conditions.
Dan.Johnson@EquitableLaw.com
+44 (0) 333 390 3525 (U.K. Based / Worldwide Roaming e-Voicemail)
www.EquitableLaw.com
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