What follows is an edit of a post to the Open Coffee mailing list on the subject of the Seed Enterprise Investment Scheme and the fact that it only applies to straight equity investments, to the exclusion of convertible notes.
The Purpose of SEIS
Taking a step back… what is SEIS looking to achieve? If I’m right, then it is to encourage an increase in early stage funding for companies that have the potential to benefit the UK tax payer.
To a degree, I buy the argument that convertible notes are less risky than straight equity. They are, after all, senior in the capital structure.
Having said that, when it boils down to it, pre-seed / seed investment in any capacity can, inherently, only be classed as risk capital. If a startup company with no / limited assets is wound up, then you lose your investment no matter where you sit in the capital structure.
With this in mind, early stage investors should, in my opinion, be supported full stop, no matter the form of consideration their investment takes.
However, let’s assume that this is not the case and that the SEIS legislation as it stands receives Royal Assent, as it is expected to in July 2012.
The Negative Impact of SEIS as it Stands
An inability to agree on valuation, whilst not necessarily top of the list when it comes to a deal falling through, is certainly up there. If the investor and startup cannot agree on a valuation, then the deal simply won’t happen. So, highly incentivising investors to invest in straight equity, and therefore forcing a debate on valuation, will potentially negatively impact the number of deals getting done.
A premature debate on valuation for an early stage startup will not necessarily hurt a sophisticated investor; he or she will simply not invest at an inappropriate / inflated valuation.
Even if a valuation is agreed upon, in the case of a lower valuation (in favour of the investor) this will hurt the company and its existing shareholders (likely to be the founders), who may find themselves with less of the equity than would be the case had the valuation debate been delayed until a more appropriate time.
If an inflated valuation is agreed upon (e.g. where a less sophisticated investor simply wants to receive tax relief), then the startup may benefit from having received more money, but this will be ‘dumb’ money. Some may argue that this is not necessarily an issue (and I have certainly argued that in the past!).
However, what is undeniable is that inflated valuations at seed stage will have an impact higher up the chain. Either valuations at future funding rounds will, in turn, be inflated (creating the beginnings of an unsustainable ‘bubble’), or seed investors will get burnt by future down rounds and/or achieving limited returns… with the result that the whole purpose of the SEIS scheme, i.e. to encourage seed investment, will likely fail in the mid-to-long term.
A Potential Workaround
Assuming that the SEIS legislation does not encompass convertible notes, I have a potential workaround.
One of the companies I am in the process of investing in has a situation whereby some friends and family investors lent money to the company, but now want to convert that debt into equity.
In this case, they are simply being repaid the loan by the company, and they are then free to use these funds to participate in the current funding round and to receive the (in this case) applicable EIS reliefs.
So, I wonder… is a possible workaround to inject debt capital into a startup, potentially at a zero coupon (perhaps at a discount to par), or at a nominal interest rate, or with a non-cash interest element that simply rolls up on to the principal.
The limited or lack of cash interest payments means that the company is not burdened with the full interest cost of the loan, which it would be unlikely to be in a position to afford.
This debt (hopefully) allows the company to develop to the stage where assigning a valuation does make sense.
When that stage is reached (as judged by one or more pre-agreed triggers), the debt and any rolled up interest is repaid to the investor. The investor can then choose (or, perhaps, is obliged) to reinvest that capital as straight equity.
At this stage, the appropriate SEIS or EIS reliefs can be applied for.
Some Implications of this Approach
Mitigating downside risk
Sure, downside risk still exists for the debt investor, i.e. they are not protected by SEIS loss relief until they invest in straight equity.
However, you could potentially mitigate this risk, to a degree at least, with the equivalent of a multiple of the liquidation preference that the debt would receive over any equity instrument (e.g. at liquidation, the debt holders get 2x, or 10x, or Yx their money, including the rolled up interest, before equity holders get paid).
Of course, this is less helpful if you are investing in a startup with limited assets in the first place, but I am sure that minds far brighter than mine can think of other ways to mitigate downside risk.
Feel free to record any thoughts in the comments.
Facilitating upside rewards
This can be done in two ways.
Firstly, any rolled up interest could incorporate some upside reward, e.g. I invest £100k at an inflated 10% interest. After 3 years, this is now worth c.£133k.
So I have ‘made’ £33k over those three years (less any tax liability as, whilst when I am repaid my loan principal I don’t pay any tax on this, there will be a tax liability on the £33k interest).
As an investor, I can now invest an additional £33k (less tax) into the company as straight equity. In terms of the actual cash flow the company would only need to pay me the tax on that £33k, assuming that the net proceeds are reinvested as equity.
Secondly, there could be an agreement whereby the debt holders are allowed to take part in a separate funding round, before the next round involving external investors takes place.
This round could be at a pre-agreed ‘max’ pre money valuation, or at a pre-agreed discount to the valuation of the next round (whichever is lower).
This ‘early’ funding round would also have the upside of giving investors first dibs on the £150k SEIS limit, with investors in the following round getting EIS benefit (assuming that this doesn’t fall foul of the ‘you must have spent 70% of your SEIS funding before you can apply for EIS’…)
If HMRC or any other relevant body could be lobbied to include a form of convertible note in the SEIS legislation, this would, without doubt, be the cleanest way of supporting early stage investors without penalising investors and startups who want to delay the valuation debate for the reasons outlined above.
Failing this, however, I am interested in thoughts on the workaround I have outlined above.
Is it practically possible? In my mind it certainly falls within the spirit of SEIS (i.e. encouraging early stage investment in UK startups), but does it fall foul of the letter of the legislation, as it currently stands?
Or am I simply overthinking things (as I’m prone to do)…
Any thoughts welcome.
Do Investors Actually Prefer Convertible Notes?
To conclude, why would investors prefer convertible debt to equity? Or vice versa?
See the this blog post by Mark Suster for a reasoned debate.