Founder Series: Top Tips for Future Fund Conversions & Redemptions

9 minute read | July.03.2023

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 29 consecutive quarters (PitchBook, Q1 2023). You can view our previous series instalments here.

In April 2020, the UK Government announced a scheme to provide financing to UK startups and scaleups in the form of a convertible loan invested by the Government alongside the company’s existing investors. The Government invested an aggregate of £1.14bn through this scheme between April 2020 and January 2021. See here for our initial summary of its key terms and functionality.

As of 31 March 2023, 502 of these loans had converted into equity, many of which our London TCG team advised on and, as Q1 2023 drew to an end, roughly 42% of the loans remained outstanding with the three-year “maturity date” now fast approaching.

In the thirteenth instalment of Orrick's Founder Series, our Technology Companies Group offer key guidance for UK founders on what they should be considering during this turning-point in the timeline of the Future Fund loans.

1. What Happens at Maturity: On the third anniversary of the Future Fund convertible loan agreement, the default position is for the principal of the loans to be either (i) repaid (together with a 100% redemption premium) or (ii) converted (together with all outstanding interest which has accrued) into shares, at the election of the lenders.

Founders should therefore consider the economics of (i) repaying 2x the value of the loan on its third anniversary, (ii) raising additional funds in the interim period to tactically trigger a conversion of the loans, (iii) seeking an extension or (iv) converting the principal and interest at the company’s pre-Future Fund financing valuation.

2. Redemption Notices Generally: As the three-year maturity date approaches, we have seen that the Future Fund’s default position is to issue a redemption notice in respect of all loans which are due to reach their maturity date rather than to allow the loans to convert. Such redemption notices from the Future Fund have caused significant concern amongst companies receiving such loans.

This does not oblige the company’s existing investors (who invested alongside the Future Fund) to issue a redemption notice in respect of their loan amounts, and they may (acting by a majority of the loans held by those lenders) separately elect to convert their loan notwithstanding the Future Fund electing to redeem.

Therefore, Founders should consider seeking legal advice that can support them in opening those conversations with lenders (including the Future Fund) as early as possible.

3. Redemption Notices Where There is a Genuine Bona Fide Financing in Progress: Where the company has a genuine bona fide financing in progress, the Future Fund may be more inclined to consider taking a “reasonable” approach to allow such rounds to close for the purposes of conversion, rather than issuing a redemption notice for the repayment of the loan.

Therefore, where the maturity date of the loan is approaching, but the company is in the process of raising funds, it is worth engaging in a dialogue with the Future Fund to consider potential options.

4. Extending the Maturity Date: Anecdotally, we have learned that there is a potential opportunity to extend the maturity date by up to two years with the consent of the Future Fund and a majority of the other lenders if (amongst other things) the company has complied with the terms of its Future Fund loan agreement and the directors can produce a solvency statement.

However, we would stress that the Future Fund is under no legal obligation to do so and any extension is expected to come with an increase in the discount rate of between 5% and 10% (depending on the length of the extension).

Companies will need to submit an extension request within 20 business days of the Future Fund confirming whether they are eligible to submit a “maturity extension request” portal notification.

5. Conversion on Qualified and Non-Qualified Financings: The market has seen fewer priced financing rounds over the past year, with founders focusing more on convertible financing rounds (see our Deal Flow 3.0 Report for more on this). Companies may find some comfort in knowing that the Future Fund will treat funds raised via ASAs (and potentially SAFEs) as “newly committed capital” for the purposes of triggering a conversion of the loan in a Qualified Financing or Non-Qualified Financing.

We understand that the Future Fund are inclined to treat their portfolio companies equally. Absent a Qualified Financing or a Non-Qualified Financing and consent of the lenders holding a majority of the loans (other than those held by the Future Fund), the company will need to repay the loans. Therefore, although companies have sought to negotiate a voluntary conversion of an outstanding loan with Future Fund, such negotiations have not been successful.

As has always been the case, the Future Fund lenders require 20 business days’ notice of a Qualified Financing or Non-Qualified Financing. In our experience, companies should allow ample additional time (perhaps up to a few weeks) to further negotiate the terms and economics of a conversion, and to agree a conversion date with the Future Fund to avoid delays to their financing round.

6. Communication with the Future Fund: We strongly recommend an open dialogue with the Future Fund team at the earliest opportunity. We expect the Future Fund to be inundated with conversion / extension requests in the coming weeks and months. Whilst there is no guarantee the Future Fund will meet a company’s requests (or indeed an obligation on them to do so), the earlier a company begins the negotiation process, the more visibility it will have as to its options. Any communications with the Future Fund should be clear and reviewed by the company’s legal advisers to ensure that they set out the relevant background and request of the Future Fund are helpfully set out. A considered approach here could reduce unnecessary back and forth and ensure a more efficient process.

7. Practical Considerations at Conversion: At the time of conversion, the Future Fund will require the inclusion of certain provisions in the company’s articles of association and shareholders’ agreement, including a put option, the survival of certain terms of the Future Fund loan agreement and an extension to the “Permitted Transfer” regime. The Future Fund issue helpful guidance documentation at the time of conversion, setting out the required terms.

In addition, the Future Fund will require a company to give certain warranties in the subscription documents relating to the conversion shares and compliance with the Future Fund loan agreement. We have seen some deviation from these standard terms in specific circumstances but note that negotiating these terms with the Future Fund will likely incur additional costs and cause delays without a guarantee of success.

When carrying out conversion calculations, it is important to remember that the discount under the Future Fund loan agreement will apply to the principal of the loan amount only, and any accrued but unpaid interest will be converted at the full price of the round (or the company’s pre-Future Fund financing round valuation). Companies should also consider whether the discounted issue of shares at the discounted share price triggers existing anti-dilution “down-round” protections.

Given the high volume of conversions at present, we are seeing the Future Fund demand “fixed” conversion dates in advance, which are strictly enforced. We therefore recommend that financing documents are not open to broader negotiation with investors at this stage as the conversion date may need to be reset.

8. Pricing Considerations: To trigger a conversion via a Non-Qualified Financing, a company will need to raise “newly committed capital” exceeding 25% of the principal amount made available under the Future Fund loan agreement. In the event that a company has conducted a financing round during the lifespan of the loan whereby it raised 25% or less of the principal amount made available under the Future Fund loan agreement, the price of that round will not be applied as the conversion valuation.

Instead, the “last-round price” will be the price of the company’s pre-Future Fund financing round valuation. Given the three-year period which has passed in the case of many Future Fund loans, this price could represent a significantly lower valuation than a company’s current valuation.

9. Withholding Tax Considerations: A company may be required to withhold tax at a rate of 20% in respect of the interest element of a redemption or conversion. The company will need to consider this with reference to each lender on a case-by-case basis, noting that exemptions may also apply in certain circumstances.

On a redemption, if an exemption does not apply, the company must deduct a sum representing 20% of the accrued interest payable on redemption and account for such amount to HMRC.

On a conversion, if an exemption does not apply, the company must, in relation to the accrued interest, issue the relevant lenders with a number of shares which are equivalent to 80% (i.e. after withholding at a rate of 20%) of the value of the accrued interest. The company must then account to HMRC for the withheld amount, either in shares or cash. If a lender is looking to avail of a withholding exemption in a double tax treaty, a relevant treaty claim would need to be made to HMRC, which can take a number of months to be processed.

10. Future Fund as a Shareholder: In most cases, the Future Fund are comfortable with being a passive shareholder, and (regardless of the size of its shareholding) do not require board or observer seats.

Anecdotally, due to the combination of recent down-round valuations and the discount rate, conversions have occasionally resulted in the Future Fund controlling a material proportion of the cap table. In such cases the Future Fund have taken a more involved role in key shareholder decisions, which can result in delays.

Similar considerations are relevant in a sale process involving the Future Fund, where they are (i) converting immediately prior to such sale or (ii) an existing shareholder. To avoid delays, companies should aim to fix and communicate the target sale completion date as early as possible and, where relevant, consider addressing the conversion of the Future Fund loan outside of the main SPA to reduce the Future Fund’s review process.

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.

Disclaimer: this note been prepared without input from the British Business Bank or UK FF Nominees Limited.

If you would like more details on any of the issues above, please contact Jamie Moore.