As discussed in The New World Order of Innovative Financing, investors are increasingly opting to invest into companies in advance of formal funding rounds (including seed rounds). In the UK, these investments are usually made through convertible loan notes or advanced subscription agreements (known as ASAs).
In this post, we’re look at the advantages and disadvantages of these instruments from the both the investor and company perspectives. We’ll also look at what situations make them ideal and what their the limitations are.
In broad terms, these instruments will grant an investor the present right to become a shareholder on a future investment round on the terms set out in the instrument. The document is often simple and contains minimal rights, but no shareholder rights because the investor is not yet a shareholder. Those rights follow on conversion at the next round. So, why would an investor look to invest in a company this way?
Three main reasons:
- To get in early. A full investment round requires the company to be valued. In most cases, the company isn’t at the stage where a valuation discussion can be meaningful and so the drafting of investment documents can be deferred until that point.
- To establish a relationship with the founder early on. Fostering this relationship, ahead of later investors, can give the investor a unique visibility over the company’s affairs that could prove more valuable than the rights they may hold under the investment documents as one of a number of shareholders. This could even continue after the company grows and other shareholders enter the picture.
- Money talks. Getting on board early and investing funds without customary shareholder protections can give investors a better chance of negotiating better terms in exchange. Better terms could include leveraging a favourable valuation cap or discount mechanism as a reward for coming in early. These preferential rights can be activated on a future investment round where the investor can become a shareholder at a lower subscription price to the round price.
It’s not just the investor that can benefit from this type of instrument. These instruments can also carry significant advantages from a company perspective.
The ability to welcome investment pre-round not only saves the company from having to carry out the valuation, but also lowers the risk of getting the valuation wrong and setting it too high which can scare off future investors.
For the company, an injection of cash at a pre-round stage could give the business the short-term boost it needs to grow and justify a higher valuation when it comes to investment round stage. The company also gets a chance to demonstrate to future investors that it has already attracted investment and can create a track record for managing its invested funds even before its first round arrives.
Additionally, taking investment outside of the formal investment round can give the company a degree of additional control over the investment during and after negotiations. Deals negotiated and closed on an individual basis with different instrument holders can be a more flexible process, bypassing the stand-off scenarios that can arise from having to try to agree a single set of documents with all investors before any funds can be received.
On the other hand, the company will have the ongoing administrative task of monitoring and managing a number of instruments and their unique terms.
This increased level of control by the company can also continue after the instruments have been concluded, as the instrument holder will rarely receive the right to have a board seat or observer to attend board meetings.
But there are also disadvantages for a company:
- Such an investment structure will inevitably grant the instrument holder a discount to the subscription price when it comes to a round in exchange for the investors handing over funds without customary protections. A company could end up giving away more shares and relinquishing more control at a shareholder level to investors than it would have under a straight equity round with a non-discounted subscription price.
- The company probably won’t be able to raise as much money as it would on a traditional round. This is because the investor will be more reticent to invest at its full capacity under a convertible loan note or an advanced subscription agreement, because they won’t immediately receive the normal suite of investor protections that come with the typical fully negotiated formal investment documents.
The Bottom Line
The increased popularity of advanced financing instruments is likely to increase as investors look to secure their place early at the investor’s table for a promising start-up.
At the same time, companies are happy to receive fast, flexible cash at the bootstrapping stage.
Looking at whether the deployment of such instruments is appropriate in a particular scenario, there are two fundamental questions to examine:
- The investor’s attitude towards risk: Is the investor willing hand over its cash without typical minority shareholder protections or an agreed set of long-form constitutional documents setting out their rights?
- The company’s financial position: Can the company support itself until a formal round is to be conducted, without needing to sell itself short by promising discounted shares in the interim?
Despite the fact that there may be particular circumstances where they may not be appropriate for a investor or a company, convertible loan notes and ASAs do, without question, increase the availability of capital in the market and the ability for investments to be made in a flexible, timely way. There’s now a range of accepted and increasingly recognised structures available to both investors and companies out there in the UK VC market and this definitely to be welcomed and celebrated.
This post was co-written by Imran Bhatia, Associate and Howard Watt, Partner, JAG Shaw Baker. The information in this blog post is provided for general informational purposes only, and may not reflect the current law in your jurisdiction. No information contained in this post should be construed as legal advice from JAG Shaw Baker or the individual author, nor is it intended to be a substitute for legal counsel on any subject matter.