Fuelling growth: funding your venture

Posted: 28/11/2024

A distressingly large part of a start-up CEO’s time is spent in the funding process – seeking the investment needed to get to the next stage on the journey. Penningtons Manches Cooper’s corporate team advises businesses on all stages of the funding cycle – from pre-seed and seed, through larger series A rounds and beyond to IPO. It’s an almost endless topic, but this article covers some of the issues most relevant to early stage companies.

Which investors?

In the earliest stages, companies will usually be looking to high net worth business angel investors and specialist pre-seed and seed venture capital funds (many VC funds will be focused on later-stage companies). Most will be looking for SEIS (Seed Enterprise Investment Scheme) or EIS (Enterprise Investment Scheme) relief (see below). For some businesses, especially with a more consumer focus, crowdfunding may be an option.

Sourcing and selecting investors is always a challenging process – it is important to think beyond the immediate fundraising need and consider long-term fit – eg how the investor base will change as the company grows, and how these early investors will fit in as it raises funds later on.

Fundamentally, you want to be working with investors who understand the business, who understand the risks of early stage investing, and will work with the company on a long-term basis. Being aware of the financial services restrictions that apply to seeking investment, and tailoring communications and approaches accordingly, is also necessary.

Ordinary/preferred shares

Founders, especially at the pre-seed/seed stage, will generally want to offer investors the same class of ordinary shares as founders – it’s simpler and means founder and investor interests are reasonably aligned. However, some investors will want preferred shares, which carry enhanced rights and priority returns over the ordinary shares. Those terms are not always something to be frightened of, but it can be hard to navigate the details of the legal language and some terms – for example, anti-dilution protections or liquidation preferences which go beyond the ‘standard’ 1x non-participating preference – can be particularly painful if things don’t go exactly as planned. Care also needs to be taken to ensure preferred share rights don’t prejudice the availability of EIS relief.

Convertible investments

Often at a pre-seed or seed stage, companies will look at convertible investments as an interim funding measure – investors provide their funds up front, but the shares are only issued at a later date, usually at a price which is a discount to the price on a later, larger funding round (often with a cap on the conversion valuation).

These can take the form of advance subscription agreements/SAFEs (agreements to issue shares at a later date but where the funds don’t represent debt and are not refundable) or convertible loans/notes (where strictly the investment is a repayable debt even if the expectation is that it will convert).

Convertibles have advantages in potentially parking difficult discussions about valuation until the company has made progress (and hopefully justified a higher valuation) and involving simpler documentation – in that detailed agreements with the investors about shareholding rights may not be required until the investments convert. But they are often not as simple as they may seem – particular care has to be taken about the conversion/valuation mechanics (especially where there is more than one round of convertible investment before the conversion); and there needs to be hard thinking about what happens if the expected conversion events don’t happen and what default protections need to be in place both for the company and investors. With convertible loans, these can raise the prospect of insolvency if they do not convert – how are they to be repaid in those circumstances?

Convertible loans/notes are not eligible for S/EIS so investors seeking those reliefs will usually prefer advance subscription agreements.

Non-dilutive funding

Many early stage companies may be able to take advantage of non-dilutive grant funding from bodies like Innovate UK – this is highly attractive since it doesn’t involve giving away any equity, and so doesn’t dilute existing shareholders. But it’s crucial to understand clearly the terms on which the funding is given, what conditions the company must meet and, in particular, any implications for the ownership or publication of resulting IP. Sometimes the grant funding (or a proportion of it) will need to be matched by separate equity funding obtained by the company.

SEIS/EIS reliefs

Most UK individual investors (including through crowdfunding and many early stage VC funds) will want to be able to obtain SEIS or EIS reliefs on their investments. These are very favourable tax reliefs for individuals which mean they can claim income tax relief on the amounts invested and the gains on sale of the shares can be tax free.

The good news is that most early-stage companies are going to be eligible for the SEIS and EIS reliefs – they are just the sort of investments that they are aimed at. You can get advance assurance from HMRC to confirm that investments should qualify for the reliefs and some, though not all, investors will want to see that before they invest.

The bad news is that some of the SEIS/EIS rules are hideously complicated and almost designed to trip you up! So, among other things, care needs to be taken to ensure investors’ rights don’t disqualify them from the reliefs and in the timing and documenting of the key investment steps.

Given the value of the reliefs to investors, it is important to take proper advice on this – the Penningtons Manches Cooper corporate and tax teams are very experienced with dealing with SEIS and EIS investments, or accountants may be able to help with some of the process.

This article is an edited summary from Penningtons Manches Cooper’s guide on ‘Navigating the journey of growth: key legal considerations for scaling up’, which focuses on the challenges facing start-ups or spin-outs on a growth trajectory, and how to solve them. For a copy of our guide, please click the banner below or get in touch with your usual contact.