The founders of most early stage companies will need to raise initial "seed" funding from external investors in order to meet the costs of initial development and testing to establish whether they can turn their idea or product into a viable business.
However the process of negotiating detailed investment documentation for the issue of new shares (equity) can often be time consuming and the potential costs involved for both the company and investors may not yet be justified.
Furthermore, issuing shares involves setting a valuation for the company, which may be something neither the founders nor investors want to commit to at the time.
Traditionally in the UK these problems have been addressed through the use of short form convertible loan agreements which are a form of debt that convert into shares if the company does subsequently carry out an equity funding round which meets certain criteria agreed by the parties. Whilst a subscription price may not be set the investors will typically seek a percentage discount to the subscription price that is ultimately agreed on the subsequent funding round. Investors may also seek to protect their position by requiring a cap on the valuation agreed for that round for the purpose of calculating the number of shares they receive.
Convertible loans do however have a significant disadvantage for some investors in that they do not meet the requirements of the UK HM Revenue & Custom's seed enterprise investment scheme or enterprise investment scheme rules. These schemes offer significant tax reliefs and exemptions to investors designed to encourage investment in eligible companies.
This issue has prompted the increase in use of an alternative arrangement often referred to as an "advance" subscription agreement.
An advance subscription agreement involves the investee company agreeing to issue shares to investors when a future investment round takes place in return for a payment at the point of signing, but unlike a convertible loan the amount paid by the investor is not repayable in any circumstances.
A number of venture capital funds have published their own template advance subscription agreements which are freely available on the internet. The funds involved tend to originate from the United States where similar agreements such as Y Combinator's "Simple Agreement for Future Equity" have proven a popular basis for raising start-up funding as they are not subject to the same regulatory regime as loan financing.
The template agreements may or may not have been drafted with the requirements of EIS/SEIS rules in mind, therefore it is important that companies and investors take specific advice on their own circumstances. Companies would be well advised to make use of the ability to seek advance assurance from HM Revenue & Customs to ensure that the proposed investment meets the relevant requirements and afterwards need to monitor their continued compliance with the conditions.
If you are a founder or investor considering an advanced subscription arrangement and would like more information please get in touch with your usual Brodies contact.