Seed and start-up businesses often need funds and funding advice early in their lifecycle in order to get a concept off the ground, develop their commercial offering or start trading.
Sometimes they raise finance through convertible loan notes (CLNs) that are convertible into shares in the future. Another way of funding early activity is via advanced subscription agreements (ASAs) under which subscription money for shares is provided up-front, with the company being valued and shares issued at the first formal funding round.
What is an advanced subscription agreement?
Under an Advanced Subscription Agreement (ASA), a funder agrees to purchase shares in a company and provide equity funding, but the shares are not issued immediately. Effectively, the investor is pre-paying for their shares, with the shares only be issued when a ‘trigger event’ takes place.
The advantage for the ASA investor is that when the trigger event happens (normally when the company enters its first equity funding round), the shares issued to the ASA investor will be at a discount from those issued to the initial equity round investors.
ASAs are advantageous for companies as, unlike CLNs, they don’t have to pay interest on the funds received. In addition, the funds don’t have to be repaid. From the investor’s perspective, they have the right to receive shares at a discount, and in addition they can often benefit from the tax advantages available under the Enterprise Investment Scheme and Seed Enterprise Investment Scheme.
How do ASAs work?
Under an ASA, the investor provides finance to a start-up in return for the right to purchase shares in the company at a later date, often when the company seeks its first round of equity funding.
Because the shares are not issued immediately, there’s no need to carry out a valuation of the company in order to calculate the share price. The terms of the ASA will allow the investor the right to receive shares at a discount from the price offered to later investors.
The terms of the ASA will usually provide that the funding converts into shares when either a ‘qualifying funding round’ takes place, the company is sold, or at a fixed long-stop date.
A qualifying funding round is one where the start-up achieves a certain target in terms of funds received. Provided the target is met, the ASA shares will be issued. When setting the target, it’s important to balance the needs of investors and founders.
Investors will want to ensure a high enough target so that the company has plenty of funds when their shares convert. Founders won’t want the target to be too high, because the investment won’t convert into shares even though the business has received substantial investment.
When the ASA converts the shares are normally issued at a discount of between 10 and 30% and will be ordinary shares.
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Pros and cons of advanced subscription agreements
The main advantage to a start-up of issuing an ASA is that they can get their hands on finance quickly. Although certain terms like a valuation cap and how a qualifying funding round will be defined do need to be negotiated, these negotiations are likely to be less protracted than formal equity funding rounds.
Furthermore, from the founders’ perspective, the company does not need to be valued until the first funding round. Valuation of seed and start-up businesses is notoriously difficult, and investors often seek low valuations causing the founders to give away too much equity early in the company’s lifecycle.
If issuing an ASA, founders should make sure that the agreement includes a valuation cap when the company is eventually valued, so that the existing shareholders know approximately how much their shares will be diluted when the ASA rights kick in.
For the ASA investors, funds advanced under an Advanced Subscription Agreement may be eligible for tax relief under the EIS and SEIS schemes unlike financing provided under a CLN. Because under a CLN, funds may need to be repaid to the investor, the capital is not deemed to be ‘at risk’ and therefore not qualify under EIS or SEIS. The investor also receives a discounted price for the shares once they are ultimately issued.
From the founders’ perspective, because they are giving away shares at a discount, their own shares will be further diluted when the ASA shares are issued, depending on the size of the discount. The ASA investors, although they have not paid as much for the shares issued as part of the equity funding round, will normally receive the same rights, covenants and liquidation rights as the new equity investors.
In addition, the existence of outstanding ASAs can deter future investors under subsequent funding rounds as the ASA holders will receive shares at a discount and thus a higher percentage of equity for the funds advanced than new investors.
From an investor’s perspective, ASAs are slightly less beneficial than CLNs on a liquidation, as the noteholders will rank higher than the shareholders. In addition, and unlike CLNs, funds advanced under an ASA will not bear interest.
What to consider when drafting an advanced subscription agreement
The first thing to consider when entering into an ASA is whether the directors have the right to issue shares, and whether there will be any rights of pre-emption (where existing shareholders have the right of first refusal when new shares are issued). The company’s articles of association should be inspected as the ASA investors will be subject to these when shares are ultimately issued.
In addition, there may be a shareholders’ agreement in existence, and investors will need to understand how its terms will apply to them. If there isn’t currently a shareholders’ agreement in place, investors will need to ensure they’re comfortable investing without knowing up-front what terms may apply once shares are eventually issued.
The terms of the ASA that will need to be considered and negotiated are:
- The long-stop date (often 12 months or less) by which time shares shall be issued, regardless of the outcome of a future funding round (however if the investor wishes to claim the tax benefits of an EIS or SEIS this will need to be shorter)
- The amount of the valuation cap so that the investor receives an adequate percentage of the shares issued
- The definition of the qualifying funding round that will trigger the conversion of funding into shares
- The trigger events that will lead to the ASA converting into shares
- Whether the shareholders will need to waive existing pre-emption rights
How to ensure EIS and SEIS compliance
While it isn’t possible to receive clearance from HMRC in terms of EIS or SEIS tax relief availability, this should be available if:
- The investment under the ASA cannot be refunded
- The shares issued are ordinary, fully paid-up shares and paid for in cash
- The investor is a third party to the company, i.e. that they don’t have any ‘connections’ with the company (meaning the right to acquire more than 30% of the company’s share capital) for two years prior to the investment date, or three years after the investment date
- There are no investor protections in place under the ASA
- The ASA can’t be varied, cancelled or assigned and does not bear interest
- The longstop date will normally be no more than six months from the date of the agreement
For more answers to commonly asked questions and advice on advanced subscription agreements, equity funding and EIS/SEIS schemes, consult our corporate solicitors. Get in touch on 0800 689 1700, email us at firstname.lastname@example.org, or fill out the short form below with your enquiry.