Funding Options: Standing out from the Crowd

This article was produced by Olswang LLP, which joined with CMS on 1 May 2017.

This article was originally published in May's edition of the M&C Report.

As well as advising on our fair share of the high profile M&A transactions the sector has seen in the past 18 months, Olswang has also experienced a significant increase in activity involving our advising on a variety of funding deals and investments into food and beverage concepts, both for early stage businesses and those that are more mature. This article looks at features of a few commonly seen funding/investment models we see for the more early stage concepts and highlights certain aspects of these for business to be aware of.

Early stage investment: the 'friendly' investor

Perhaps the most common deal we encounter is where we are approached by the founders of a concept who are seeking their first external investment into their business. The investors range from friends and family on the one hand to sector veterans on the other. Sometimes the investors have seen it and done it and understand the need for a sense of proportionality in their approach i.e. to keep it simple. The secret here, in my view, is to balance the deal (its complexity, size and scale) against the stage where the business is and any budgetary constraints. My mantra of "keep it simple" is all the more relevant advice to caution against a complicated investment model (perhaps more suited to private equity or venture capital investments) where the sums being advanced are very modest.

More often than not time is of the essence and the founders need cash in order to get the concept up and running. If there is not the time to put in place even a simple investment or shareholders' agreement (assuming the investor is seeking equity) then it is possible to establish simple short form loan arrangements between the business and the investor which in due course can be capitalised subsequently into the appropriate equity structure originally intended.

I often have to explain to my clients that there is no 'standard' agreement for an investment of this type and that each deal is largely bespoke depending on the personalities involved and the particular dynamics of each transaction. The best way forward, I find, is to have a checklist of items to cover off, dealing with fundamentals such as how the business will be managed (any veto rights for minority or passive investors), what are the rules about raising more funds (both debt and equity) and on transfers of shares (rights of first refusal, drag and tag rights). Some items are more relevant to certain deals then they are to others but all are worth considering.

Crowdfunding

An increasingly popular source of funding for start-ups and early stage concepts is crowdfunding. There are various different forms of crowdfunding but at its essence (and the way we will most commonly think of it) it is a way of raising funds by appealing to a large group of people (the 'crowd') for contributions to fund a business or project. It is actually not a totally new phenomenon but there has been an increasing focus on it since 2012 and the rise of online crowdfunding platforms like Kickstarter, Crowdcube and Seedrs.

The two most common forms of crowdfunding we encounter are known as equity or investment-based crowdfunding and peer to peer lending. Both forms have come under scrutiny from the UK regulator, the Financial Conduct Authority (FCA) which has introduced new rules that must be followed from April 2014, rules which have been criticised by entrepreneurs for "taking the crowd out of crowdfunding". The main grievance concerns a rule which will require investors to self-certify their level of investment sophistication before participating in an investment with inexperienced investors having to certify that they will not invest more than 10% of their portfolio in unlisted businesses. On the other hand crowdfunding investors can, going forward, expect consistent, safe systems to be operated by the platforms all overseen by the FCA.

The new rules are, however, unlikely to perturb the concepts themselves who should instead focus on their pitch and business plan which they will need to sell to their chosen platform. They will want to ensure that the platform is authorised by the FCA and to have checked the platform's terms of business - particularly the percentage of funds raised that it will typically have to pay to the platform by way of fees.

The way this model works most of the time is that the platform will market the business on its website and investors will participate on the basis of the platform's standard form documents. There will be little room for negotiation over the legals but that will keep advisory costs to a minimum.

SEIS/EIS

Almost every individual investor will be interested to ensure that his/her investment qualifies for tax relief under either or both of the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS). These schemes are designed to encourage entrepreneurship and assist small and medium sized unquoted trading companies (EIS) and smaller/early stage unquoted companies (SEIS) to raise finance.

The tax reliefs for investors are highly attractive. With EIS an investor can benefit from income tax relief of 30% of the amount invested for shares in a qualifying company (subject to a maximum annual investment limit of £1m) provided the shares are held for at least three years. For SEIS the income tax relief is increased to 50% but the annual investment limit for investors is £100,000 and the relevant company cannot raise more than £150,000 via SEIS investments. In addition, under both schemes, any gains on sales of the shares can qualify for an exemption from capital gains tax provided the shares have been held for at least three years.

To benefit from the reliefs under the schemes, the company receiving the investment must satisfy certain conditions e.g. the shares have to be new ordinary shares, the company must carry out a qualifying activity and for SEIS the company must be a genuine new venture. There are also rules in terms of what sorts of investors can qualify with outside investors finding it easier to satisfy the requirements than someone working in the business.

Such is the attractiveness of this model, various EIS and SEIS funds have been established on behalf of investors who collective funds are aggregated to make investments into attractive business ventures. Good examples of these are Calculus Capital and IMBIBA.

Funding for Lending

The funding models looked at so far are all equity based but there has also been increased amount of interest from lenders, particularly since the introduction of Funding for Lending (FLS).

FLS is the Bank of England and Treasury scheme designed to boost bank lending to households and companies. It kicked off in August 2012 and the aim was to increase bank lending by up to £70bn. The scheme has been extended until the end of January 2015 so, unless further extended, there are only a few more months for companies to benefit from it.

The essence of the scheme is the Bank of England letting commercial banks borrow from funds from it more cheaply than previously and then those banks pass the benefit of those low rates onto their customers. This ought to be very attractive but indications to date are that the up-take has not been as high as expected both from the banks or from their customers.

Part of the issue is that, perhaps quite sensibly, banks remain fussy about whom to lend to and new businesses, even in our sector, are considered high risk. New incentives announced in April 2013 to encourage banks to lend to SMEs mean that the banks are out there looking for business and offering attractive deals on paper but, and I speak from recent experience, when getting into negotiations with their borrower, are unable to operate unshackled from traditional banking concerns about security and serviceability. So on the one hand banks are being encouraged to lend but when push comes to shove the handbrake comes back on in the diligence and credit committee stage and the loans are not being written to the extent we perhaps expected.

Conclusion

The demand for funding is there; we are quite vividly experiencing it at the moment. And the supply of capital can be found also from a variety of sources. For early stage businesses it is critical that they choose wisely from where to get that funding. Get the relationships with investors right, make sure the investment model helps drive your business forward and does not impose roadblocks to its growth. Keep things simple and be strict about executing the funding deal in a timely manner so that you can get back to doing what you set out to do; deliver a quality experience to customers that keeps them coming back for more.