At this time many businesses are desperate for cash, they may have furloughed staff and be considering taking up the government’s many funding options from the banks, but these may take too long for some.
Until now, entrepreneurs may not have needed to secure third party funding for their successful business and may not be aware of other options available. We have worked with many growing business who have been able to secure alternative funding routes, some of which we cover here with some of their key features.
Using loan notes
The lender makes a sum available and, at an agreed point in time, the principal is repaid with interest. Interest can be deferred or rolled up and the loan note is repayable on the occurrence of specified events, insolvency, an exit or at a fixed date. Loan notes can be secured or unsecured over the company’s assets or some of them.
Many people who have spare cash are looking for a decent return in a world of minimal interest rates, which is inevitably going to continue. They can be a quick and easy route to finance. The company can reserve the right to prepay loan notes or of course seek refinance from a bank when the economy has returned to a more normal state and the immediate crisis is over.
Convertible Loan Notes
Convertible loan notes are a different type of loan note – they are simpler, quicker, cheaper and offer more flexibility than shares. They allow pre-valuation investment and also allow the founders to keep control. Convertible loan notes are, initially, debt rather than equity. Upon insolvency debt is paid off before equity. This is the big attraction for investors. We have acted on many convertible loan notes that have provided flexibility to the investor and the business.
However, if the investor is hoping for EIS (see below), convertible loan notes are not possible. But for non-EIS investors, convertible loan notes are becoming more and more favoured over other methods of investment. This is because they offer an additional level of protection and choice as to whether to convert to equity. The price at which they convert to equity can be deferred to another day and be based on the value of the business at a later time.
As is the case in any commercial agreement, there are details to iron out; when do they get repaid, what is the interest rate, what is the consequence of not repaying when demanded? Depending on their terms, there is the obvious risk that when the loan is converted, the lender gets their loan plus interest converted into equity at a discounted rate.
Conversion can leave the shareholders giving away significantly more equity in the company than envisaged, depending on the agreed conversion and rates. This could affect future investors as the convertible loan note could be a disproportionately large portion of the investment round and leave the existing investor as potentially the largest shareholder in the company following conversion.
Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme
This is a well-established government backed scheme for investors into emerging companies. An investor subscribes for shares in your company at a fixed price and becomes a shareholder. There will be the inevitable discussion around what price is paid for any shares and what proportion of equity you give away. Consider what control an investor will have and whether you are happy to have another shareholder on board.
However, it has to be accepted that very few businesses are solely owned by the individual or individuals who founded it; dilution of their stake is inevitable. It is the old balancing act – own 100% of something or a smaller percentage of something which has grown larger and more valuable.
Any investment is risky for an investor as they can lose it all and it ranks behind debt. With this in mind, the EIS regime aims to de-risk investment by offering investors generous tax reliefs. Although tax-rates are rising, the Government appears keen to continue to promote EIS. The key benefits for an investor are income tax relief of 30%, up to a yearly investment amount of £1m, and a CGT exemption on disposal.
EIS can be secured from one investor or there are a number of platforms where you can secure investors, such as syndicate rooms. There are a number of technical issues to understand; not all businesses qualify and sometimes there is a gap between what the investor might want and the EIS requirements.
So if your successful business needs some funding, do look at the range of government loans which are available but do consider the other options to fund the business.