As lawyers, we cannot advise on how to fund your business but can share some insights that we have gained through completing myriad transactions for clients.
The choice between issuing equity or a convertible loan to raise funds depends on several factors, including your company’s specific circumstances and financial needs, as well as the current state of the market and the preferences of potential investors.
Equity financing involves selling ownership stakes in your company to raise capital. This type of financing is typically best for established companies with a proven track record, as investors are more likely to be willing to purchase equity in companies that have already demonstrated some level of success.
A convertible loan is a type of financing that allows a company to raise funds by issuing a loan that can be converted into equity at a later date (usually at the option of the investor, or if a certain milestone is reached, for example the company raising a certain sum). This type of financing can be attractive to early-stage startups that are not yet ready for a traditional equity round but need capital to grow.
The main advantage of a convertible loan is that it provides companies with the capital they need to grow without having to set the share price immediately. Investors like them as if the company fails (before conversion of the loan) the investor is more likely to receive some money back as a lender than it would as a shareholder. But if the company does well, the investor can convert the loan in to shares, and take advantage of the capital growth in the value of the shares.
However, there are also some disadvantages to consider. For example, convertible loans often come with high interest rates and short repayment periods, which can be challenging for companies with limited cash flow. A convertible loan will not qualify for S/EIS benefits, which can be a deal breaker for UK tax paying individuals investing in emerging UK companies. Additionally, the conversion process can be complex and can result in dilution for existing shareholders if the loan is converted into equity.
DOCUMENTATION
Under English law, the legal documentation required to issue shares or a convertible loan will depend on several factors, including the type and size of the offering, the stage of development of the company, and the preferences of the investors. The typical requirements are set out below.
For equity financing:
- A term sheet outlining the terms and conditions of the investment
- A subscription agreement between the company and the investor, where the investor agrees to subscribe for the shares
- A shareholders’ agreement that sets out the rights and obligations of the shareholders
- Articles of association that set out the internal governance rules for the company
- Board minutes approving everything and issuing the new shares
- A shareholders’ resolution authorising the issuance of new shares
- A share certificate for the new shares
- A Companies House Form SH01 to let them know that shares have been issued
For a convertible loan:
- A loan agreement outlining the terms and conditions of the loan, including the interest rate, repayment period, and conversion terms
- A security agreement providing the lender with a security interest in the company’s assets, if the convertible loan is secured
- Board minutes approving everything and issuing the new shares
- A shareholders’ resolution authorising the issuance of new shares
ADVANCED SUBSCRIPTION AGREEMENTS
Analysis of this topic would not be complete without reference to advanced subscription agreements (ASAs). These are increasingly common method of raising capital quickly and cheaply in the UK. An advance subscription agreement is a contract between an investor and a company, in which the investor agrees to invest a fixed sum to purchase shares, with the investment being paid immediately, and the shares being issued and the share price set later on. This agreement provides the company with immediate cash, while allowing the investor to secure the right to purchase the shares at a discount, usual of 20%, at the next fundraising. The terms of the agreement typically outline the amount of the investment, the rights and obligations of both parties, and the conditions under which the agreement may be terminated. With careful drafting an ASA can qualify for S/EIS benefits, but shares will always need to be issued within six months of the date of the ASA.
FURTHER INFORMATION
For further information, please contact Simon Halberstam, head of technology law at SMB – simon.halberstam@smb.london