Orrick's Founder Series offers monthly top tips for UK startups on key considerations at each stage of their lifecycle, from incorporating a company through to possible exit strategies. The Series is written by members of our market-leading London Technology Companies Group (TCG), with contributions from other practice members. Our Band 1 ranked London TCG team closed over 320 growth financings and tech M&A deals totalling US$9.76bn in 2022 and has dominated the European venture capital tech market for 7 years in a row (PitchBook, FY 2022). In our previous instalments, we have guided founders through the process of incorporating a private limited company, building their team, how to use share options to attract and incentivise their employees, protect their ideas, identified key compliance considerations, what to consider when raising their round, and how to navigate the evolving cyber threat landscape, how to flip to a Delaware corporation and how to steer a company through financial difficulties.
Convertible securities such as simple agreements for future equity (SAFEs), advance subscription agreements (ASAs) and conventional convertible loan notes (CLNs) are increasingly used as agile and flexible funding instruments, as they can provide companies with short-term, quick-access capital that only converts into equity based on future events and/or valuations. Our Deal Flow 3.0 data shows a 47% increase in the number of convertible debt financings in 2022 as compared to 2021.
In the tenth instalment of Orrick's Founder Series, our Technology Companies Group offer key guidance for UK founders looking to this alternative financing option while they set up for their next equity round and explore some of the key terms found in these instruments.
- When conversion happens. The right to convert convertible securities is usually triggered on certain future events, such as a future financing round where at least a certain threshold of further funding is provided, an exit event, an initial public offering or on a set longstop / maturity date.
Conversion can either be automatic (i.e. immediately prior to one of the trigger events listed above), or at the election of the investor (i.e. where a financing has taken place, but where it does not meet the threshold specified for it to be an automatic conversion).
Automatic conversion can provide the company, existing investors and incoming investors with certainty that the company will be going into its next financing round or exit debt-free and removes any unnecessary friction from the conversion process.
- What the instrument converts into. The trigger event would normally influence the class of share the investment amount converts into.
As part of the incentivisation rubric of convertible instruments, it is usual for the investment amount to convert into the most senior class of shares issued on the company’s next financing round (usually at a discount as a sweetener, see below). It is worth noting that if you have Enterprise Investment Scheme (EIS) investors and are using an ASA (as EIS is not compatible with convertible debt), additional drafting will need to be added to ensure that the longstop date is no more than 6 months from the date of investment and that the investment amount converts into an ordinary class without certain preferences; so that the conversion shares can be EIS-eligible.
On the longstop date, an exit event, an initial public offering or an insolvency, the investment amount would normally convert into either the most senior class of share currently in issue, or into ordinary shares.
- Conversion price. There are a number of mechanisms which play into the price per share on a conversion event and which you can use to incentivise your investors to provide the bridge financing required to get your company to its next equity funding round, most commonly:
- Discount: as early-stage convertible investors will be investing in the company at a pivotal and riskier stage in its lifecycle without immediately receiving any of the benefits and investor protections enjoyed by investors on an equity financing round, one way to incentivise investors to invest is to offer them the ability to convert at a discount on the conversion price associated with certain trigger events. Our Deal Flow 3.0 report highlights that throughout 2022, we saw discounts ranging between 15% – 35%, with the upper end being a noticeable uplift from the upper end in 2021 (which was closer to 20%).
- Valuation cap: the valuation cap is designed to provide a ceiling on the conversion price. Where the next round valuation is higher than the valuation cap, the investment amount will convert at the cap, resulting in the investor receiving an increased number of shares to that which they would have otherwise received. This provides the investor with a significant benefit for taking the additional risk and investing early.
- Does the instrument carry interest? As a debt instrument, CLNs will usually accrue interest from the date that the funds are advanced until conversion or repayment. The applicable interest rate is a commercially negotiated term and will often be dictated by the circumstances of the bridge financing and the perceived level of risk being taken by the investors. Our Deal Flow 3.0 report highlights that interest rates throughout 2022 ranged between 6% and 10% per annum.
Unlike CLNs, SAFEs and ASAs are equity instruments and so do not typically accrue interest. Further, accruing interest rate would prohibit an ASA or SAFE from being EIS / SEIS eligible.
Notably, in the case of a CLN, accrued interest is rarely paid in cash whilst the instrument is outstanding, and more often gets “rolled up” and added to the principal amount to be repaid or converted on the applicable trigger event as if it was part of the original capital.
- Redemption. Unlike ASAs (and most SAFEs), which do not usually provide for redemption of the investment amounts, CLNs will often include a redemption provision. This allows the investor to demand repayment under certain circumstances (for example on an event of default, such as an order being made for the winding-up, liquidation, administration or dissolution of the company), or the company (sometimes with the prior approval of the investor or a majority of the investors) to seek to repay the debt prior to conversion on a trigger event.
Redemption can sometimes carry a premium to balance a high-risk profile of an investment. In such circumstances, the company is required to pay back the principal amount of the debt along with a redemption premium (most commonly 200% of the principal amount) as well as any accrued interest.
From the company’s perspective, although not unusual, this can result in the debt being expensive and should be resisted. We often see redemption premiums form a more important part of negotiations in distressed financing scenarios, where there is a risk that the company may not be able to deliver on its business plan, is under-performing, or is in danger of triggering an insolvency event.
- Security. Taking security is not market standard and is generally not viewed as appropriate in the context of convertible financing rounds of early-stage startups.
The limited occasions where you may see investors requesting security over the company’s assets are in distressed financing scenarios where investors invest money as a way to rescue the company from potential insolvency and therefore require the additional comfort given by obtaining security against the company’s assets.
- Tax considerations. One of the benefits of ASAs is that (if drafted appropriately) individual investors who are subject to tax in the UK may be able to benefit from certain tax reliefs in respect of the shares issued pursuant to ASAs, specifically the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS).
Although we won’t go into detail here about the EIS and SEIS regimes, one of the key requirements is that EIS / SEIS investors invest their money in exchange for equity in higher risk, early-stage companies, therefore the investment cannot resemble debt or carry investor protections that could otherwise protect that investor’s return.
Unlike CLNs, the features of which reflect a debt-like position (e.g. the ability / obligation to repay in certain circumstances, the duration of the loan, and the inclusion of interest), ASAs convert into equity in all circumstances and do not include these debt-like terms. As a result, ASAs are more likely to be eligible for EIS / SEIS relief.
This is a highly technical area requiring specific tax advice, so you should always seek specialist advice to ensure that the proposed investment would qualify for EIS / SEIS and your investors should seek their own tax advice regarding their personal tax position and eligibility for EIS / SEIS.
- What if you have US investors? If you have US investors coming in as part of your convertible round, they are likely to be most familiar with the form of SAFEs (rather than ASAs or CLNs), which were popularised and standardised by the US start-up accelerator, Y Combinator.
Although the Y Combinator SAFE is governed by Delaware law and is drafted specifically for investments into Delaware corporations, at Orrick we have created a SAFE template based on the Y Combinator SAFE, but which is subject to English law and includes amended terms appropriate for investments into companies incorporated in England and Wales. This gives US investors the comfort they require by investing on familiar terms, while also being appropriate from the company’s perspective.
- Warranties. More common in the context of a CLN rather than an ASA or SAFE, investors will sometimes seek additional protection through the inclusion of warranties provided by the company. Warranties are statements of fact given at the time of the agreement about the state of the company’s business, its assets, any potential liabilities etc., which give investors additional comfort around the value investment they are making.
We would not expect to see a full suite of warranties (in the same way as an equity investment round) in the context of a convertible financing, but certain title and capacity warranties, as well as very limited business warranties can sometimes be included.
To the extent the CLN includes warranties, you should consider whether your CLN investors should then also benefit from the warranties given at the time of an equity financing.
- Other terms. Convertible instruments are intended to be a quick and easy way to raise capital. In contrast to traditional equity rounds, convertible fundraising involves short-form documents and fewer terms to negotiate, as the investor is not actually receiving equity (to which many of these rights attach) at the time of the investment.
Some investors, however, want to secure their position in respect of certain key investor rights on conversion of their convertible instruments, and we do sometimes see more investor-friendly positions being negotiated in convertible financings, mostly in the form of side letters.
Some of the more common terms we see requested are:
- Information rights to allow investors to monitor their investment and comply with their own reporting duties to LPs.
- Consent rights for investors on key decisions relating to the company. Our Deal Flow 3.0 report highlights that 24% of convertible debt financings we advised on last year included consent rights for the investors. Convertible debt investors have traditionally not obtained consent rights on their convertible investment as they are not equity shareholders at the time of the investment.
- Pro rata entitlement to participate on the company’s next equity financing, with just over half of the convertible debt financings we saw in 2022 including pre-emption rights for convertible investors.
- Director or observer appointment right on the next equity financing, with 29% of the convertible debt financings we saw in 2022 including this right for investors; a sign that being able to accurately track and influence portfolio company performance was at the forefront of investors’ minds during choppier economic times.
- Most Favoured Nation provisions in essence allow investors to cherry pick “superior” terms from subsequent convertibles and absorb such terms within their own convertible. To the extent you do not intend to issue any more convertibles (on different terms e.g. with a bigger discount) ahead of your next equity round on which such convertibles will convert, this should not be a controversial request to accept. However, where you are likely to have additional convertible investors come in on more advantageous terms, you might want to consider pushing back on this request.
Our London TCG practice reflects London’s role as one of the world’s leading financial markets and a centre for international commerce. Nothing inspires us more than helping tech companies develop novel strategies and push boundaries. Through our extensive client portfolio, deal volume, and relationships in the tech ecosystem, we provide commercial and legal insight to each company’s strategy. We work with tech companies on all aspects of their business plans, financing strategies, protecting intellectual assets, retaining talent, securing and monetising data, and advocating for innovation-friendly public policy.
If you would like more details on any of the issues above, please contact Jamie Moore.