Seed and start-up businesses often need funding to develop products, recruit employees or begin trading. Two common options for early investment are convertible loan notes and Advanced Subscription Agreements (ASAs).
A convertible loan note begins as debt and converts into equity later. An ASA allows an investor to pay for shares in advance, with those shares issued when a future event occurs, often at a discounted price.
This article explains how ASAs work, the terms they should include and how they compare with other investment documents. It also considers the rights and risks for investors, the approvals a company may need and the requirements that can affect SEIS (the Seed Enterprise Investment Scheme) and EIS (the Enterprise Investment Scheme) tax relief.
Thinking about raising early stage funding using an ASA? Our specialist funding round lawyers can help you draft and negotiate the agreement, assess its effect on your share capital and work with your tax advisers where SEIS or EIS relief is intended.
Jump to:
- How does an Advanced Subscription Agreement work?
- What terms should an Advanced Subscription Agreement include?
- How is an Advanced Subscription Agreement different from other investment documents?
- What rights does an investor have under an Advanced Subscription Agreement?
- Can an Advanced Subscription Agreement qualify for SEIS or EIS relief?
- What company approvals are needed for an Advanced Subscription Agreement?
- What happens when shares are issued under an Advanced Subscription Agreement?
- Can an Advanced Subscription Agreement be used in different investment situations?
- What are the risks of using an Advanced Subscription Agreement?
- When should I take legal advice on an Advanced Subscription Agreement?
How does an Advanced Subscription Agreement work?
Under an ASA, an investor pays an agreed amount to a company. Rather than receiving shares immediately, the investor receives a contractual right to be issued shares when a specified event takes place.
That event will often be the company’s next funding round. The agreement may also require shares to be issued when the company is sold, when an agreed final date is reached or when another event specified in the ASA occurs.
The number of shares issued is usually calculated by reference to the valuation used for the next funding round. The investor may benefit from a discount on the price paid by new investors, a maximum company valuation, known as a valuation cap, or both.
An ASA is intended to represent an advance payment for shares rather than a loan. The investor commits their money to the company and will not usually have the right to demand repayment or receive interest. A company may use an ASA when it needs funding quickly but is not ready to complete a full investment round. For example, it may need funds to develop a product, hire employees or support its operations while a larger round is being negotiated.
An ASA can also be useful where the company and investor cannot yet agree a valuation. Instead of delaying the investment, the parties can calculate the share price later, when more information about the business is available.
ASAs are generally most suitable where the company expects to complete a funding round within a reasonably short period. They may be less appropriate where there is no clear plan for a future round or where the investor expects interest, security or repayment.
Before entering into an ASA, the directors should consider the likely number of shares to be issued, the dilution of existing shareholders and the effect on future investment negotiations.
What terms should an Advanced Subscription Agreement include?
An ASA should clearly state the amount being invested, when the shares will be issued and how the number and price of those shares will be calculated.
It should identify the class of shares the investor will receive. In many cases, the investor receives the same class as investors participating in the next funding round. The ASA may exclude or adjust certain rights granted to those later investors.
One of the most important provisions is the longstop date. This is the final date by which shares must be issued if no earlier event has triggered the allotment. It prevents the investment from remaining outstanding indefinitely.
The agreement should explain how the share price will be calculated if the company has not completed a funding round by that date. The calculation may use a fixed valuation, a valuation cap or another agreed formula.
An ASA may also include a discount. This allows the investor to acquire shares at a lower price than investors in the next funding round, reflecting the earlier risk they have taken. For example, if investors in the next round pay £1 for each share and the ASA provides a 20 per cent discount, the ASA investor may receive shares at 80 pence each.
A valuation cap sets a maximum value for the company when calculating the ASA investor’s share price. If the company completes its next round at a valuation above the cap, the investor’s shares are calculated using the lower capped valuation.
This protects the investor from receiving a much smaller interest if the company’s value rises significantly. A low valuation cap can result in substantial dilution for founders and existing shareholders. Where both a discount and a valuation cap apply, the agreement should explain how they interact. The investor will often receive the benefit of whichever calculation results in the lower share price.
The ASA should also address what happens if the company is sold, becomes insolvent or fails to complete a funding round. It may contain warranties dealing with the company’s authority, share capital and compliance with the agreement.
How is an Advanced Subscription Agreement different from other investment documents?
An ASA differs from a convertible loan note because it is intended to be an equity investment from the outset. A convertible loan note begins as debt. It may carry interest and may become repayable if it does not convert into shares. An ASA should not usually provide for interest or repayment. This distinction is particularly important where SEIS or EIS relief is intended. Terms that make the arrangement look like debt may prevent the resulting shares from qualifying.
An ASA also differs from a conventional share subscription agreement. Under a share subscription agreement, the investor usually agrees to acquire a known number of shares at an agreed price. The shares are issued when the investment completes.
Under an ASA, the investor pays before the final number and price of the shares are known. Those details are calculated when the relevant future event occurs.
A full share subscription agreement will often contain detailed warranties, investor protections and completion conditions. An ASA may be shorter, but it still creates significant obligations and must be drafted carefully.
What rights does an investor have under an Advanced Subscription Agreement?
Before shares are issued, the investor has contractual rights under the ASA rather than shareholder rights arising from the investment. Unless the investor already holds shares, they will not usually have voting rights, dividend rights or the right to attend shareholder meetings. Their principal right is to require the company to issue shares in accordance with the agreement.
The ASA may provide limited information rights or include restrictions intended to protect the proposed investment. These rights are usually narrower than those contained in a full investment agreement or shareholders’ agreement.
The investor will not normally receive interest and will generally have no right to ask for their money back. They are accepting the risk that the company may fail and that the investment may be lost.
Shares are issued when a conversion event occurs. This is commonly the next qualifying funding round, a sale of the company or the longstop date. Once the shares are allotted, the investor acquires the voting, dividend and capital rights attached to the relevant share class.
Can an Advanced Subscription Agreement qualify for SEIS or EIS relief?
Shares issued under an ASA may qualify for SEIS or EIS relief, but qualification is not automatic.
The company, the investor, the shares and use of the funds must all satisfy the relevant statutory requirements. The ASA must also be drafted consistently with HMRC’s approach to advance subscriptions.
Where relief is intended, the agreement should generally provide that:
- the investment cannot be refunded;
- the ASA does not bear interest;
- the ASA cannot be varied, cancelled or assigned;
- the investor receives ordinary shares that are fully paid in cash;
- there are no protections that remove the investor’s ordinary investment risk; and
- the shares will be issued by an appropriate longstop date.
HMRC generally expects the longstop date to be no more than six months after the date of the ASA. Longer periods are sometimes accepted where the commercial rationale is clear, but this is not guaranteed. Companies intending to claim relief should seek advance assurance and take specialist tax advice.
The investor must also satisfy the relevant eligibility requirements. This includes the rules concerning connections with the company and the proportion of its share capital the investor controls.
Relief may be unavailable if:
- the company does not meet the qualifying company conditions;
- the funds are not used for a qualifying activity within the relevant times limits;
- the shares carry prohibited preferential rights; or
- arrangements exist that protect the investor from the normal commercial risks of equity investment.
The company can apply to HMRC for advance assurance before accepting the investment. This gives an indication of whether the proposed investment is likely to qualify, based on the information provided.
Advance assurance is not a guarantee. Relief may still be refused if the transaction is completed on different terms or if the company or investor fails to meet the requirements when the shares are issued.
The EIS and SEIS rules are detailed and can change. Companies and investors should take specialist tax advice where relief is an important part of the investment decision.
What company approvals are needed for an Advanced Subscription Agreement?
The board should approve the company entering into the ASA. The directors must consider whether the agreement is in the company’s interests and how the future share issue may affect existing shareholders. The company should review its articles of association, shareholders’ agreement and previous investment documents before accepting the funds.
These documents may require shareholder approval before the company enters into an ASA or issues shares. Existing investors may also have consent rights over fundraising, new share issues or changes to the company’s share capital. The directors must have authority to allot the shares when the ASA converts. The source of that authority will depend on the company’s share structure and articles.
Existing shareholders may also have pre emption rights, giving them the opportunity to subscribe for new shares before those shares are offered to another person.
Statutory pre-emption rights under section 561 of the Companies Act 2006 apply where equity securities are issued for cash. The analysis usually crystallises at the point of allotment rather than at the date of the ASA. The articles of association or any shareholders’ agreement may contain additional contractual pre-emption rights that apply earlier.”
The company may need a shareholder resolution disapplying those rights before it can issue shares to the ASA investor. The ASA itself is not normally filed at Companies House, although the company must notify Companies House when the shares are allotted.
What happens when shares are issued under an Advanced Subscription Agreement?
When a conversion event occurs, the company must calculate the number of shares due to the investor in accordance with the ASA. The directors should approve the allotment and record their decision in board minutes. Shareholder resolutions may also be required if the directors need additional authority or pre emption rights must be disapplied.
The company must enter the investor in its register of members, update its register of allotments and issue a share certificate. It should also update its capitalisation table to show the revised ownership position.
Form SH01 must be filed at Companies House within one month of the allotment. Where the investment involves a new class of shares, the company may also need to amend its articles or file documents describing the rights attached to that class.
An ASA does not usually provide a complete framework for the investor’s future relationship with the company. Once the shares are issued, the investor may be required to join an existing shareholders’ agreement.
The articles and shareholders’ agreement may also need to be amended to reflect information rights, consent rights or restrictions on transfers agreed with the investor.
The company should speak to its accountant about the treatment of the ASA funds before the shares are issued. The appropriate accounting treatment will depend on the agreement and the applicable accounting standards.
Can an Advanced Subscription Agreement be used in different investment situations?
A company can enter into ASAs with one or several investors. Where there are several agreements, the company should model their combined effect. Different valuation caps, discounts and longstop dates can make the capital structure difficult to understand.
This may cause complications during the next funding round. A lead investor will usually want to know how many shares will be issued under the outstanding ASAs and the resulting dilution.
The company should therefore maintain an accurate capitalisation table and ensure that its agreements operate consistently.
An overseas investor can use an ASA to invest in a UK company, although the parties should consider relevant tax, regulatory, sanctions and money laundering requirements.
SEIS and EIS are UK tax reliefs. An overseas investor may not benefit from them and should obtain advice on their own tax position.
ASAs will often prevent investors from transferring their rights. This allows the company to retain control over the identity of future shareholders and may also support the intended tax treatment.
What are the risks of using an Advanced Subscription Agreement?
ASAs can offer a quick and flexible way to raise funding, but they delay certainty about the company’s ownership.
For an investor, the main risk is paying money before acquiring shareholder rights. Until the shares as issued, the investor will usually have no voting rights, no dividend entitlement, no interest and no right to repayment.
The company may fail, the anticipated funding round may not take place or the shares ultimately issued may be worth less than expected (or worthless). The investor may also discover that anticipated SEIS or EIS relief is unavailable.
For the company, the main risk is unexpected dilution. A low valuation cap or a large discount can result in the investor receiving more shares than the founders anticipated.
This risk increases where the company has entered into several ASAs on different terms. The combined dilution may affect founder control, employee option arrangements and the willingness of future investors to invest.
ASAs may also conflict with existing articles, shareholders’ agreements or investor consent rights. A company could promise to issue shares without having the necessary authority or approvals in place.
When should I take legal advice on an Advanced Subscription Agreement?
For the company, a corporate solicitor can review the articles, shareholders’ agreement and existing investment documents. They can confirm what approvals are required, prepare the ASA and explain its potential effect on ownership and dilution.
For the investor, legal advice can clarify when the shares will be issued, how the price will be calculated and what rights the investor will have before and after the allotment.
The parties should also obtain specialist tax advice where SEIS or EIS relief is expected. Appropriate drafting is important, but the agreement alone cannot guarantee that relief will be available.
Taking advice at the outset can reduce the risk of disputes, unexpected dilution and problems during the company’s next funding round.
