One of the essential ingredients for a new company is funding. It may be that this is in place or covered by personal monies or informal arrangements. However, if you are looking to inject new funding into the company, there are two broad ways of achieving it: debt and equity (you can also look at grand funding options).
Related: A guide to business angels
1. Debt
1.1 Debt finance is the money a company raises by borrowing and comes in a variety of different forms. For example, it may be secured or unsecured, require that a specific asset or the assets of the company more generally are charged, be of a specific amount repayable on a specific date, or be a pool of funds which the company can use as and when it wishes. It is worth noting that if an asset has been charged, the company may be restricted in the way in which it can deal with that asset.
1.2 Due to the number of different forms it can come in, and the flexibility in approach due to a lack of prescriptive Companies Act regulation, debt is a useful way to raise investment in your company without diluting our ownership of it. However, despite the fact the market currently favours debt as it is cheaper than equity, debt can be difficult to obtain when forming a company, as banks and other institutions are reluctant to lend money to companies with little or no trading history, property or assets. As such, new companies may need to seek out equity investment.
2. Equity
2.1 Equity finance is a method of raising finance, whereby, in contrast to debt, the equity holder obtains an ownership stake in the business. In a start-up scenario, it may mean reducing your anticipated shareholding to accommodate the investor.
2.2 For new companies, this may be an easier way to raise funds, especially in light of many banks’ reluctance to lend. Also, new companies should be encouraged by the introduction of new schemes to incentivise equity investment from individuals and other companies in early stage companies, such as the Seed Enterprise Investment Scheme.
2.3 Caution should be exercised when attempting to raise funds from third parties, as strict ‘financial promotions’ rules may apply. In general, however, seeking out investment from venture capitalists and other certain other investors is allowed.
2.4 It should be noted that if you are seeking to attract investment in a young company from an investor, the investor will often require:
(a) the insertion of specific provisions governing the terms of their investment in the Articles of Association, such as preferential ranking in relation to dividend payments and the right to compel other shareholders to sell their shares in certain specified circumstances; and
(b) that additional documents be entered, such as an investment agreement
2.5 The investment agreement will set out details of the investment and the rights of the investor, which will often include the right for the investor to be required to give approval before the directors take certain decisions, to be able to take control of the company if certain conditions are met, and to be able to effectively force a sale of the company in certain circumstances.
2.6 The investment agreement may also require you to give warranties about the business, and impose restrictive covenants in case a director or shareholder leaves the business. These can, however, through negotiation, often be limited to specific time periods and be capped financially.
2.7 The key terms of the Articles of Association adopted on an investment and the investment agreement itself are as follows:
Investment agreement (also known as a subscription and shareholders agreement)
Subscription: this sets out who is subscribing for what shares, including details of the number and class of shares.
- Warranties: these are the investors’ main form of protection and are the statements on which the investors’ have relied when investing in the business. If one of the statements made by the company and/or its existing shareholders is incorrect, the investors may have a claim for financial compensation.
- Limitations: these set out the limits of the liability of the persons giving the warranties in the event that the investors bring a claim.
- Information Rights: this sets out the regular information updates the investors will require during the lifetime of the investment.
- Matters requiring investor consent: these are exactly as they sound: things that cannot be done by the company or the directors without the consent of the investors (or a proportion of them).
- Restrictive Covenants: these provisions often appear in both the investment agreement and service agreement of the managers of the company to ensure that the managers cannot leave and set up a competing business, destroying the value in the current business. Generally, the restrictions will include an obligation not to compete with the company and an obligation not to solicit employees, clients or suppliers from the business after a manager leaves.
Articles of association
Dividends: this article will deal with the important matter of when dividends are paid, in what proportion and to whom. Different types of shares may carry different rights to dividends.
- Exit/ Liquidation: these articles dictate how the proceeds from the sale of the company or its liquidation are divided up among the shareholders.
- Voting rights: this article details the voting rights attached to each class of shares.
- Anti-dilution protection: this article may be included by the investor to protect it against future investments that occur at a lower price per share than the price paid by the initial investor. This article can provide that the initial investor received additional ‘bonus’ shares if a lower priced investment occurs in the future.
- Allotment of shares: this article dictates whether new shares must be offered to existing shareholders before any third party (to prevent dilution of shareholdings).
- Transfers of Shares: these articles dictate whether shares can be transferred by any of the shareholders and to whom. There is likely to be a list of transfers that are ‘permitted’. If a transfer is not permitted or otherwise approved by the company, the shareholder may be required to first offer its shares to the existing shareholders before selling them to a third party.
- Compulsory transfers: these articles set out the situations in which a shareholder is forced to transfer their shares to the company or the existing shareholders and will set out the price to be paid on that transfer. Situations include death or insolvency of a shareholder, the change of control of a corporate shareholder, or a shareholder leaving the company. In the case of a leaver, a distinction will be made between ‘good leavers’ and ‘bad leavers’ with a higher price paid to a good leaver.
- Drag-along and tag-along: A drag-along article requires all the shareholders to sell their shares to a third party on the same terms if that third party has offered to acquire the company and a majority of the shareholders have accepted the offer. A tag-along provision is less common and, where a third party has offered to buy the majority of the company, gives the minority shareholders the right to insist that their shares are also purchased on the same terms.
3. Loan notes
3.1 An alternative funding option which many companies are increasingly using as a source of investment are loan notes. Loan notes record a third party lending money to a company, and will often bear a prescribed rate of interest. Loan notes can be a mix of both debt and equity, as there may be an option during the lifetime of the loan notes to convert them into shares. Loan notes are often used as a funding option by investors alongside straight forward equity investment.
4. Tax reliefs
4.1 Valuable tax reliefs are available to UK investors subscribing for new ordinary shares in small unquoted trading companies under the Enterprise Investment Scheme (‘EIS’) and the Seed Enterprise Investment Scheme (‘SEIS’).
4.2 Investors can obtain an income tax reduction (30% under EIS and 50% under SEIS) and a complete exemption from capital gains tax, provided the relevant shares are held for at least three years.
4.3 The money raised must be used for the purposes of a ‘qualifying business activity’ within certain time limits.
4.4 The relief is subject to many strict conditions. In particular, companies must be below a certain size (below £15,000,000 gross assets and fewer than 250 employees for EIS, and below £200,000 and fewer than 25 employees for SEIS).
5. Process
5.1 Fundraising can be a daunting process. As a general guide, the main stages are as follows:
- Put together a term sheet detailing the key terms you are seeking and start talking to investors.
- Choose your investor(s) and agree on a final term sheet, taking into account their requirements.
- Provide as much information about the company to the investor as possible to allow the investor to value the business. The investigations of the investor are known as conducting ‘due diligence’.
- Prepare and negotiate the legal documentation (i.e. the articles of association, investment agreement and any related documents specific to your deal such as service agreements, loan notes, share scheme documents).
- Review the warranties in the investment agreement and disclose any matters that may be considered a breach of these warranties. Any information that contradicts the warranties is set out in the ‘disclosure letter’, which is addressed to the investor(s). The investor(s) cannot subsequently bring a claim against the company/ management for matters detailed in the disclosure letter.
- Sign the document, issue the shares and start using that investment wisely!
Related: A guide to venture capital funding