Future Fund – 10 things you should know about convertible debt | Deloitte UK has been saved
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On 20 April the Chancellor announced the Future Fund scheme, to be delivered by the British Business Bank (BBB). Exactly a month later and the Future Fund is open for applications.
The Future Fund operates in the form of convertible loans alongside other investors and comprises £250m from the government to be matched by another £250m from private investors.
By its nature, convertible debt is complex, so we thought helpful to set out 10 key things we think high growth companies should know about the Future Fund:
1. Check and double check you meet the criteria
Whilst there aren’t reams of eligibility conditions for the company raising the money, there are a few to check carefully. For example, rules have been included regarding applicant companies having majority UK-based employees and UK sales. Additionally, groups with non-UK incorporated parent companies won’t be eligible (this remains the case unless and until the government relax any of the criteria).
2. Think carefully about the timetable
The Future Fund will put money in alongside other investors, so it will be vital to have that investor lined up, ready to go. Timetables for fundraising will vary. For many this will depend on their relationship with current investors and whether or not they need to seek new investors. What is clear is that deployment may take some time.
Businesses need to carefully consider when funds will be required. The BBB expects applications to take at least three weeks before Future Fund cash is released, but plan for longer.
3. Seek legal advice
The scheme requires the Future Fund, the other investors and the investee company to sign up to a prescribed form of convertible debt agreement. Both investors and investee companies need to seek legal advice to understand what it is they are being asked to sign up to. The agreement contains a number of warranties, covenants and conversion/repayment terms – the legal impact of which needs to be understood by all parties before signing on the dotted line.
4. Understand the purpose and use of funds
The convertible loan agreement (CLA) specifically restricts the use of the funds for certain purposes, such as repayment of shareholder loans or payment of dividends. It’s important for companies to carefully consider the intended purpose of the funds and put some processes / controls in place to monitor their use. This could include ring-fencing them in a separate bank account or accounting ledger.
5. Think about the interaction with regulatory capital
For certain regulated businesses, the Future Fund is unlikely to meet the relevant provisions to be considered eligible as regulatory capital. Given the three-year term nature of the loan, it is unlikely to meet the requirement of being perpetual in nature (Common Equity Tier 1 and Additional Tier 1) or having a maturity of at least five years (Tier 2) which most banks, payment services and e-money firms need to adhere to.
6. Consider the accounting for convertible debt
The accounting for convertible debt is more complex than a simple bank loan and its treatment will also be influenced by accounting policy choices made by the company.
The instrument has hallmarks of debt, but also of an equity instrument or derivative contract given the debt may be converted into shares. This could lead to the instrument being split into separate parts, with both a debt element and an equity element or derivative element (for which a fair value may need to be calculated periodically), or the instrument being fair valued as a whole.
7. Tax treatment of the resulting debits and credits
Where the instrument is accounted for in a bifurcated way (i.e. split between a loan element and an equity or derivative element), businesses need to think carefully about the tax treatment of the profit and loss account debits and credits arising on these parts as well as the tax treatment of the fundraising expenses.
It may be that some of these movements will be taxed according to the UK’s tax provisions governing loans, but other movements may be capital in nature and taxed under the UK Capital Gains Tax regime.
The tax deductibility of financing expenses may also need consideration against the raft of UK tax legislation in this area – for example, the Distributions and Corporate Interest Restriction rules.
8. Tax treatment of interest payments
While the Future Fund allows companies to defer the payment of interest until certain events occur, at some point accrued interest will be paid or converted into shares. On such events, businesses need to give careful consideration about whether any UK withholding tax (WHT) may arise, especially where the holders are individuals or non-UK entities.
The Government has left the door open to allow the Future Fund to transfer their portion of the investment and so the holders at the time of interest payment or conversion may not be known, adding further complexity to the withholding tax analysis. HMRC WHT clearances may be required.
9. Will other investors be able to take advantage of EIS on their matching investment?
Due to the structure of the convertible debt instrument, investments made alongside the Future Fund won’t qualify for SEIS or EIS.
10. What does a Future Fund investment mean for existing shareholders?
All parties involved may need to consider how a Future Fund Investment could affect them. This includes the company’s existing investors, especially those who hold tax advantaged investments like SEIS or EIS.
At its core, a Future Fund investment may in some cases result in a change of control of the company either through conversion mechanics or by representing an arrangement, which may otherwise confer a change of control. This is important as it could change the qualifying status of a company for EIS, VCT and EMI purposes.
The BBB FAQs note that previous SEIS or EIS investments “will not be affected where the convertible loan converts into shares” and further that the Government intends to make changes to the rules to clarify that where the loan is redeemed this is also compatible with such previous investments.
While these comments may be helpful, the position needs to be carefully thought through. At present, the legislation remains as drafted and the ramifications around change of control may have material consequences for other shareholders including employees holding options.
So what next? The Future Fund should be greeted with significant optimism by the UK high growth sector, but do remember to consider our 10 key points above before signing on the dotted line.
The UK Deloitte Private High Growth team is running regular webinars, for Founders and CxOs of fast growing businesses, on a variety of topics to offer practical considerations during this crisis. Please drop me a line to register for our next webcast.
Finally, Deloitte has pulled together a useful framework on resilient leadership and provides practical and specific steps that can help blunt the crisis’s impact—and enable organizations to emerge stronger, you can access the guide in full here.
The information contained in this article is intended to provide general information only and is not an exhaustive treatment of the subjects. Accordingly, the information in this publication does not constitute accounting, tax, legal, investment, consulting or other professional advice or services. Before making any decision or taking any action based on the information contained in the publication, you should consult a qualified professional adviser.
Dan is a Director in our Private Markets Tax practice working with High Growth Companies. Dan advises his clients as they move through all phases of the High Growth lifecycle, from starting out, through fundraising rounds, international expansion, incentivisation and acquisitions. He also works with businesses and their shareholders in relation to significant transactions such as trade sales, private equity transactions and IPOs on both the UK and US markets.
Megan is an Associate Director in our Private Markets Tax practice. Megan focuses on advising High Growth Companies on UK and overseas corporation taxes as well as UK shareholder taxes. Many of her conversations with clients tend to cover IP management, international expansion, employee reward, funding, M&A and corporate reorganisations.