The Government’s Future Fund Is Not Fit for Purpose

The coronavirus pandemic has devastated lives, jobs and economies worldwide. SMEs comprise 98% of private sector businesses in the UK, employing around 16 million people, and contributing £1.9 trillion per year to the economy. There is no doubt that start-ups and small businesses are crucial to the UK’s economic recovery following COVID-19, with recent Government support reflecting an understanding of their vital role in preserving jobs, livelihoods and economic growth in the country going forward.

Despite the Government introducing several financial schemes over recent months in a bid to support and protect British businesses, nearly a quarter of UK small business owners do not believe the Government support schemes available are enough to help them survive. Michael Buckworth, managing director at Buckworths, analyses the issues inherent with the Government’s response and they could be solved.

The Government’s Future Fund, launched in May, aims to match private sector investment with public money to help start-ups impacted by the pandemic. However, individual investors providing matched funding under the scheme cannot claim Enterprise Investment Scheme (EIS)—a tax relief to encourage investment into early-stage businesses—on their investment due to the scheme being structured as convertible loans. Moreover, angel investors wishing to make equity investments in start-ups under EIS will likely be unable to claim EIS where the investment monies are used to pay off existing debt (including Coronavirus Business Interruption Loans Scheme (CBILS) and Bounce Back loans) and for working capital purposes. EIS monies are to be used for growth and not for working capital. As such, many start-ups could be forced to re-enter the economy without sufficient financial backing.

Nearly a quarter of UK small business owners do not believe the Government support schemes available are enough to help them survive.

It is clear that an alternative scheme is required to support start-ups and SMEs unable to raise money via the Future Fund and/or using EIS. Now more than ever, the legal industry needs to engage with Government to ensure that tailored support packages are put in place to help sectors that are struggling.

The state of play for UK start-ups

Businesses can borrow money from high street and challenger banks under Government-backed loan schemes. However, where businesses need to borrow larger sums, banks may require personal guarantees from directors (which makes directors personally liable for the loan if the borrower goes bust), and may apply inflexible qualification criteria. CBILS also contains restrictions on “business in difficulty” from borrowing using the scheme. This concept includes high growth start-ups whose accumulated losses exceed 50% of their paid-up share capital. Whilst such businesses can in theory qualify for a Bounce Back loan, many are excluded due to the operation of State Aid rules. In short, Government-backed loans are not accessible for all, and in any event add to the repayable debt for businesses.

Nonetheless, British companies have so far borrowed £38.4bn under the Government’s emergency credit programmes since the coronavirus pandemic struck, demonstrating the urgent need for finance so that businesses can fund cashflow. For SMEs that have so far survived, the next 12 months will prove critical. Upon reopening, businesses will face significant re-launch costs; the employer contribution to the furlough scheme is increasing and suppliers may want arrears paid before they supply further goods and services.

Many businesses will look to raise investment to fund their working capital requirements and to ensure that they can afford CBILS and Bounce Back repayments once they kick in next year. Yet, as referenced above, existing schemes, most notably Enterprise Investment Scheme (EIS), do not allow tax relief on investments used to repay historic debt and to fund working capital: monies must be used for growth. As it stands, start-ups may struggle to raise investment.

Why the Future Fund is not fit for purpose

The Government’s latest funding involves a programme that will pump a further £250 million into innovative start-ups via a ‘Future Fund’ administered by the British Business Bank. The initiative aims to encourage private sector investors to take on some of the risk involved in rebooting the British economy. However, by structuring the scheme using convertible debt which does not qualify for EIS relief, UK based angel investors are not incentivised to provide matched funding as part of a Future Fund round, and this significantly weakens the impact of the scheme.

Most UK angel investors are reliant on EIS to reduce their risk and reward them for making high-risk investments in early-stage businesses. An investment under EIS can benefit from an upfront 30% income tax relief and 100% capital gains tax relief on sale. EIS only applies to equity investments meaning that convertible loans do not qualify. Consequently, whilst many SMEs have been able to secure matched funding from foreign angels (who would not qualify for EIS in any event) and VCs, many more have been unable to access the scheme. To make matters worse, many start-ups unable to access the Future Fund have also been locked out of CBILS and Bounce Back Loans due to the State Aid restrictions in respect of those schemes.

Businesses who wish to access the Future Fund must have raised at least £250,000 from investors within the last five years. This penalises early-stage start-ups and SMEs that have boot-strapped or grown organically. Many SMEs have been blocked from accessing the Future Fund as a result of this restriction.

Meanwhile, the options available to aid the economic survival and success of small businesses will need careful consideration. The ability to qualify for the Future Fund, the need to obtain matched private investment without access to EIS, the relatively high rate of interest on the loan, a 100% redemption premium in the event of repayment, and the favoured nation clause that ensures that the Government always get the best terms of any subsequent investment, are all key considerations that are likely to have long-lasting implications for start-ups.

Businesses who wish to access the Future Fund must have raised at least £250,000 from investors within the last five years.

The convertible loan agreement (CLA) is complex and non-negotiable with a number of terms that are more onerous than the UK market standard. Whilst the involvement of solicitors is hard-wired into the application process in that a solicitor must be appointed to hold investment monies, many start-ups are skipping the important step of taking detailed advice on the commercials and long-term implications of a Future Fund round. That aside, legal advisors will have to be acutely aware of the terms of the CLA when advising on future fundraisings.

Strategies for the future

For many smaller start-ups, an alternative option to the Future Fund is needed which better shifts the risk from the Government to private investors. We believe that this could be achieved through creating a temporary tax relief scheme similar in nature to EIS to encourage angel investors to invest in start-ups.

Monies raised using such a scheme would provide working capital to SMEs and could be used to repay COVID-19 debts including CBILS and Bounce Back loans. Investors tend to want to invest for growth, not for working capital purposes. Consequently, it is our view that a higher upfront rate of income tax relief is required to compensate for the additional risks of providing working capital to an SME. We also believe that the age restrictions applicable to EIS should be lifted for any temporary new scheme.

The legal industry will be looked upon to advise small businesses at this difficult time, while champions of start-ups must continue to lobby the Government to ensure that all of our SMEs can access the right support. We believe that a new temporary scheme as outlined above is needed to help SMEs re-launch; others believe that changes to the current EIS scheme are required; whilst still, others advocate a further Government bail-out via debt forgiveness scheme. It is our job as lawyers to engage with our peers, clients and the Government to ensure that the voices of our clients are heard. Failure to act now could threaten the businesses that make up the bedrock of our economy, resulting in numerous SMEs entering insolvency, and contributing to rising unemployment and the threat of a recession worse than that predicted by the OECD.