New practices emerging with each Future Fund conversion should lead to more flexibility.
Companies need to act early in 2023 to ensure conversions run smoothly.
Complexities
The government-owned British Business Bank responded swiftly to the challenges posed by the pandemic by establishing the GBP 500m (later extended to GBP 1.14bn) Future Fund to invest in high-growth businesses through convertible loan agreements (CLAs) matching third party investments. The scheme was a crucial lifeline for some of the most promising early-stage companies in the UK and served a vital purpose, but a scheme designed in a time of crisis inevitably comes with some kinks.
Companies that applied to the Future Fund were issued a three-year convertible loan agreement (CLA). The loans secured the UK government’s right to shares in those companies either when they raised further investment or were acquired. The government did not undertake any material due diligence before committing to an investment.
It relied on independent third-party investors willing to invest alongside the Future Fund through the CLA.
Future Fund investments
Post-pandemic VC activity has led to conversions of Future Fund CLAs to equity through various routes. The latest statistics say that 515 CLAs (out of 1,191) have converted into equity shares in respect of which the Future Fund continues to hold an equity interest, and 43 companies achieved a full exit. It is also reported that approximately 83 companies went into administration or were restructured without the loans converting to equity. It is estimated that 550 CLAs still remain outstanding. These statistics prove that almost half of the companies into which investment was made, have converted. As the CLAs approach maturity in late 2023 / early 2024 investees companies are increasingly approaching the time in which conversion is no longer an aim but is becoming a necessity. With each conversion, the finer nuances in the CLA terms of conversion and the Future Fund practice terms are emerging.
Conversions gathering pace
One size fits all
A funding round for an early-stage business is a dynamic, fast-paced and rarely formulaic process, and can be exhausting for a founder. Add the complication of a Future Fund conversion, with its mix of written-only correspondence, rigid administration and reluctance to reconsider terms, the process becomes complex, delays are common, and founders (and their lawyers) grow a few more grey hairs.
One size fits all
The Future Fund has delivered on its aim to keep a large number of UK start-ups afloat through the pandemic. Regardless of the challenges the Future Fund scheme presents, the majority of investee companies will likely convert their CLAs before the 3-year repayment term and will be thankful for the support the Future Fund has provided.
Investee companies must stay alive to the administrative limitations of the Future Fund and build in sufficient lead times to cope with rudimentary correspondence channels, rigid timings and so on. Equally as the number of conversions continues to grow, we hope and have certainly seen recent evidence that the Future Fund process improves and becomes more streamlined. We also hope that it increases
its capacity for flexibility in its approach to businesses
where new investment does not fit naturally with an immediate conversion event, but is ultimately likely to
deliver the greatest opportunity for a conversion further down the line.
The CLA terms are intended to be a ‘one-size-fits-all’ structure and were not open for negotiation, bar some small commercial variations related to interest rates and valuation caps. The CLA terms are understandably ‘investor’ friendly and it is likely that in different circumstances, investee companies may have resisted some of the terms. Given their cash needs and pandemic uncertainty, many accepted them, often with the firm expectation that the CLAs would convert to equity swiftly once traditional funding routes returned to normality. In reality, the conversion options for companies that did not deliver strong growth over the last year remain limited. Access to traditional funding remains difficult, especially in the current economic turmoil and the terms of some funding options that are still available are not natural bedfellows for the CLA provisions. As a result, founders are having to navigate cash needs and CLA terms with little room for renegotiation with a market where investors are able to offer investment, but not necessarily in a structure that results in a straightforward CLA conversion.
Navigating rigidity
Acting early to avoid delays
We have now reached the “tipping point”, where as many loans have converted as remain outstanding, with the remaining loans soon reaching the point where they have to convert. In recent months, various complexities of the scheme have bubbled to the surface. Unless addressed, legal and practical issues associated with the Future Fund can hinder investee companies seeking to secure future investment. Companies need to act early to ensure conversions run smoothly and the Future Fund must take a more flexible approach to businesses where additional investment would make successful conversion at a later date, more likely.
Similarly, the terms and timings of conversion events are often a moving target. It is precisely in these circumstances that the idiosyncrasies of the CLA and the Future Fund scheme administration must be taken into consideration, lest they become an obstacle to a successful conversion event. For example, the CLA anticipates conversions to be a precise event for the purposes of calculating the number of shares to be issued, because the loan interest accrues until the completion date of the conversion event. In practice, conversion is often very different.
Closing a funding round can (and has) become a very difficult task unless sufficient time is built-in to the process to navigate such obstacles.
Funding rounds frequently face last minute complexities, documents are rarely finalised until very shortly before a company has an immediate cash requirement, and proposed conversion dates are often accelerated or postponed at short notice. This is fine where a small number of investors are involved, and the Future Fund team is fully engaged in the process. But with a growing pool of parties and a potential crutch coming on the number of conversions occupying the Future Fund team’s resources, closing a funding round can (and has) become a very difficult task unless sufficient time is built-in to the process to navigate such obstacles. You can find further details on Future Fund conversions in this paper.
Flexibility is crucial
Investee companies must stay alive to the administrative limitations of the Future Fund and build in sufficient lead times to cope with rudimentary correspondence channels, rigid timings and so on.
The next horizon will be how the Future Fund acts as a shareholder in the vast number of start-ups it has supported. The vast majority of the companies having achieved exit to date have done so simultaneously with conversion. Holding an equity interest and being involved in future fundraising and future exit processes as a shareholder will be a new challenge and will again test its flexibility to ensure the UK start-up ecosystem continues to thrive.
Most favoured nation
A provision that creates particular difficulties is the most favoured nation wording in the CLA. At its simplest, if a company raises further monies on terms more favourable than those in the CLA then it must apply those enhanced terms to the CLA. These clauses are not uncommon in convertible debt documents, however their application by traditional investors is often flexible to reflect the reality of any future funding round and in particular, the differing risk profiles which may exist at the time of a future funding round.
An investor will generally set the terms of a new funding round and particularly where any bridge financing is required the terms are generally more favourable to the investor than existing terms to reflect an increased risk profile. Not wholly unsurprisingly given the nature of the Future Fund, it is not easily able to flexibly consider and adapt to these key principles in the same way a traditional investor might.
The net effect is that some investee companies have been unable to successfully execute funding opportunities, impacting both their growth and ultimately the value of the companies the Future Fund has invested in.
Acting early to avoid delays
A funding round for an early-stage business is a dynamic, fast-paced and rarely formulaic process, and can be exhausting for a founder. Add the complication of a Future Fund conversion, with its mix of written-only correspondence, rigid administration and reluctance to reconsider terms, the process becomes complex, delays are common, and founders (and their lawyers) grow a few more grey hairs.
Similarly, the terms and timings of conversion events are often a moving target. It is precisely in these circumstances that the idiosyncrasies of the CLA and the Future Fund scheme administration must be taken into consideration, lest they become an obstacle to a successful conversion event. For example, the CLA anticipates conversions to be a precise event for the purposes of calculating the number of shares to be issued, because the loan interest accrues until the completion date of the conversion event. In practice, conversion is often very different.
Funding rounds frequently face last minute complexities, documents are rarely finalised until very shortly before a company has an immediate cash requirement, and proposed conversion dates are often accelerated or postponed at short notice. This is fine where
a small number of investors are involved,
and the Future Fund team is fully engaged in the process. But with a growing pool of
parties and a potential crutch coming on the number of conversions occupying the Future Fund team’s resources, closing a funding round can (and has) become a very difficult task unless sufficient time is built-in to the process to navigate such obstacles. You can find further details on Future Fund conversions in this paper.
Closing a funding round can (and has) become a very difficult task unless sufficient time is built-in to the process to navigate such obstacles.
Flexibility is crucial
The Future Fund has delivered on its aim to keep a large number of UK start-ups afloat through the pandemic. Regardless of the challenges the Future Fund scheme presents, the majority of investee companies will likely convert their CLAs before the 3-year repayment term and will be thankful for the support the Future Fund has provided.
Investee companies must stay alive to the administrative limitations of the Future Fund and build in sufficient lead times to cope with rudimentary correspondence channels, rigid timings and so on. Equally as the number of conversions continues to grow, we hope and have certainly seen recent evidence that the Future Fund process improves and becomes more streamlined. We also hope that it increases its capacity for flexibility in its approach to businesses where new investment does not fit naturally with an immediate conversion event, but is ultimately likely to deliver the greatest opportunity for a conversion further down the line.
Investee companies must stay alive to the administrative limitations of the Future Fund and build in sufficient lead times to cope with rudimentary correspondence channels, rigid timings and so on.
The next horizon will be how the Future Fund acts as a shareholder in the vast number of start-ups it has supported. The vast majority of the companies having achieved exit to date have done so simultaneously with conversion. Holding an equity interest and being involved in future fundraising and future exit processes as a shareholder will be a new challenge and will again test its flexibility to ensure the UK start-up ecosystem continues to thrive.
Most favoured nation
A provision that creates particular difficulties is the most favoured nation wording in the CLA. At its simplest, if a company raises further monies on terms more favourable than those in the CLA then it must apply those enhanced terms to the CLA. These clauses are not uncommon in convertible debt documents, however their application by traditional investors is often flexible to reflect the reality of any future funding round and in particular, the differing risk profiles which may exist at the time of a future funding round.
An investor will generally set the terms of a new funding round and particularly where any bridge financing is required the terms are generally more favourable to the investor than existing terms to reflect an increased risk profile. Not wholly unsurprisingly given the nature of the Future Fund, it is not easily able to flexibly consider and adapt to these key principles in the same way a traditional investor might.
The net effect is that some investee companies have been unable to successfully execute funding opportunities, impacting both their growth and ultimately the value of the companies the Future Fund has invested in.
We have now reached the “tipping point”, where as many loans have converted as remain outstanding, with the remaining loans soon reaching the point where they have to convert. In recent months, various complexities of the scheme have bubbled to the surface. Unless addressed, legal and practical issues associated with the Future Fund can hinder investee companies seeking to secure future investment. Companies need to act early to ensure conversions run smoothly and the Future Fund must take a more flexible approach to businesses where additional investment would make successful conversion at a later date, more likely.
With the continued scrutiny that comes with the government’s Covid support schemes and any losses which arise as a result of Future Fund companies failing to thrive, it is a timely reminder for course correction for the Future Fund conversions to ensure irrecoverable debt to the treasury is minimised. What has now become clear is that for any proposed funding round that is ‘non-standard’, the terms need to be considered very carefully and the Future Fund needs to be involved with discussions as early as possible in an effort to try to find pragmatic solutions. We are also hopeful that the new practices emerging with each Future Fund conversion will lead to more flexibility in the method with all parties acting cohesively prior to the looming maturity dates later this year.
Conclusion
Conclusion
With the continued scrutiny that comes with the government’s Covid support schemes and any losses which arise as a result of Future Fund companies failing to thrive, it is a timely reminder for course correction for the Future Fund conversions to ensure irrecoverable debt to the treasury is minimised. What has now become clear is that for any proposed funding round that is ‘non-standard’, the terms need to be considered very carefully and the Future Fund needs to be involved with discussions as early as possible in an effort to try to find pragmatic solutions. We are also hopeful that the new practices emerging with each Future Fund conversion will lead to more flexibility in the method with all parties acting cohesively prior to the looming maturity dates later this year.