Future Fund verdict: good for VC but not a panacea for startups

Applications for the UK Government’s hotly anticipated £250m Future Fund are open, following several weeks of speculation and lobbying since the publication of the term sheet in April. Applications for funding hit a reported £453m on the first day, prompting speculation that the capacity of the Fund – which is run by the British Business Bank (BBB) would need to be promptly doubled and confounding predictions that uptake would only be modest since this is a relatively niche product.

It will be interesting to see whether the Fund’s capacity will indeed be increased, how the BBB will cope with the demand and how quickly funding will actually flow to the businesses that need it – a 21-day turnaround time has been indicated..

In the meantime, now that full details are available, it is worth reflecting on what the Future Fund is, and what it is not.

As we explained in our initial briefing, the Future Fund is a pool of taxpayers’ money which has been made available to provide bridging loans to early stage companies that are in between fundraisings. It is not available on a standalone basis (since it requires at least an equal amount of matched funding from other investors), and it cannot be used as part of an equity fundraising, so it is not available to companies raising for the first time and cannot be used alongside EIS or SEIS-qualifying money.

The Fund is aimed at companies which have raised angel, seed or VC money in the (recent) past and are finding it difficult to raise again in the current economic climate without being obliged to conduct a dilutive down-round, since it provides funds to – hopefully – tide those companies over until economic conditions, investor appetite and their equity valuations have had a chance to recover.

This structure aligns well with the priorities of venture capitalists and other investors so far during the crisis – that is, to shore up their portfolio companies and help them to survive until the hoped-for economic recovery. The Future Fund helps these investors to do so at a reduced cost to themselves, allowing them to conserve capital to be deployed another day.

Targeting VC-backed companies as the most likely concentration of quality innovative businesses is certainly a logical approach: VCs have been incredibly successful in sifting out and selecting the very best ideas and management teams, and they conduct rigorous due diligence processes and negotiations which ensure that only the very best businesses make it through. Those businesses should, in theory, be best place to survive the crisis and lead the innovation of the future, and the Government’s support for them is naturally welcome.

However, since the Government’s PR hailed the Future Fund as world-leading support for early-stage businesses without going into many of the details of the funding terms or eligibility criteria, it is understandable that parts of the start-up community were disappointed to learn either that the Fund would not be accessible to them, or that it would only be available on what are perceived to be aggressively investor-friendly terms.

Since the Fund’s eligibility criteria require applicant companies to have previously raised at least £250k in equity investment from external investors during the past five years, scores of start-ups without previous backing are immediately excluded. And the fact that the application for funding needs to be made by the lead “matching” external investor – not by the company – confirms that this is a product that is designed to top-up funding from other investors, not to provide a capital pool accessible to by startups and founders who do not have a ready pool of other investors.

Among those companies and investors who do meet the eligibility criteria, there has been concern that the terms of the Fund are too aggressively investor-friendly, and a review of the prescribed form convertible loan agreement – which it has been made clear is not up for negotiation – does little to dispel such concerns. It has undoubtedly been drafted from the perspective of a quasi-venture capital investor, with a view to ensuring a decent return on the taxpayer’s investment and an acceptable level of downside protection for the Government.

Particular terms for applicants to be aware of are as follows:

• Interest will accrue at a minimum rate of 8% (but will not be payable until maturity or earlier conversion);
• Loans will convert into equity at a minimum discount of 20% to the equity valuation on a qualifying fundraising or exit, as follows:

• • automatic conversion on:
    • completion of a qualifying funding round (“qualifying” meaning that the company raises fresh equity finance at least equal to the total amount of the Government and matched funding); or
    • completion of a sale or IPO if this would provide a better cash return to the lenders than redemption, or if the lenders would receive any non-cash consideration ;
  • lender-only option to convert on:
    • completion of a smaller, non-qualifying fundraise, maturity of the loan; or
    • completion of a sale or IPO if conversion would result in the lenders receiving any non-cash consideration;
  • any conversion of principal to take place at a minimum discount of 20% to the valuation set by the most recent funding round (except where the most recent funding round took place prior to the loan advance date, in which case there is no discount);
  • conversion will be into the most senior-ranking class of shares then in issue, so the Government will benefit from any liquidation preference or other preferential terms that are agreed with other investors (there is also an option to upgrade into any more senior class of shares that is issued in the six months following conversion); and
  • no valuation cap to be set by Government, but Government will benefit from any valuation cap set by other lenders and generally from any improved terms offered to other lenders.
• If not previously converted, the loan will be redeemed with a 100% redemption premium (i.e. company to repay 200% of the borrowed amount) on:
  • maturity at the end of the 3-year term (if lenders elect to be repaid rather than convert);
  • completion of a sale or IPO if this would provide a better cash return for lenders than conversion (or if the lenders would receive any non-cash consideration and elect to be repaid) – there are concerns that this mechanism could turn into a “poison pill” which could affect the company’s ability to achieve an exit;
  • various insolvency-related events of default or unremedied material breaches of the loan agreement.
• If the lenders elect to convert on completion of a non-qualifying financing and there is an exit by way of sale or IPO in the next six months, the lenders will be entitled to receive by way of consideration on such exit an amount which is at least equal to the redemption value of their loan including the 100% redemption premium – it is unclear whether, in practice, this clause would conflict with the share rights set out in company’s articles of association, and there is a high risk that its inclusion could complicate or even impede such an exit.

Early indications are that the Future Fund is well placed to serve those companies for which it is designed – and which are confident enough in their growth prospects that they can stomach the risk of incurring the 100% redemption premium and the potential complications to their future exit plans. However, in order for the Government to truly be able to claim to be providing additional, targeted support for all innovative startups during the crisis, a separate fund will be required, and soon.

If you are a startup or investor considering applying for Future Fund investment and would like to discuss this further, please contact any of the following members of our dedicated Growth Capital team.

Jamie Hamilton

Graham Spitz

Anthony Shatz