For (S)EIS investors, are ASAs the Devil’s work?

When it comes to Angel investment, there are a number of different ways start-ups can get funded. And with options always comes confusion. Which one is right? What are the pros and cons?

Both the funder and the founder need to be aware of the different routes and options available and work out which is best for them. And of course, the risks and benefits are different depending on which side of the table you are sat.

That’s never truer than with ASAs. FounderCatalyst COO Sam Simpson looks at the pros, and the risks, and explains why for (S)EIS Angel investors an ASA might really just be the Devil’s work.

Angel investment: what are the options?

Before we explain ASAs in more detail, it’s worth us looking at the three main mechanisms by which Angels would typically invest in start-ups:

1. Via a ‘priced round’: This is the route most people would be familiar with - think Dragon’s Den. This a ‘normal’ funding round - one or more investors wish to invest at the same time. They would usually invest at the same valuation and under the same terms. A priced round has a clean ‘round closure’ process, where the key documents are signed by all parties.

2. Convertible Loan Note (CLN): Less common, these instruments are typically used before or between funding rounds. It is a form of short-term debt that may convert into equity, typically in conjunction with a future financing round; in effect, the investor would be loaning money to a start-up and, if things work out as intended, instead of a return in the form of principal plus interest, the investor would receive equity in the company. Crucially, whilst CLNs are popular in America, Angels use them less often in the UK - they aren’t compatible with the amazing (S)EIS schemes, so in practice they may be utilised by institutional investors or other investors that can’t make use of (S)EIS for whatever reason.

3. Advanced Subscription Agreement (ASA): The topic of today’s discussion, this final option in our list is also used either before any funding round has been undertaken or between funding rounds. An ASA is an investment in equity where the investor pays in advance for shares that they will receive at a later date. They allow a founder to defer the date at which they have to finalise the valuation of the company and allow them to take on funding before a priced round is undertaken.

There are quite a few differences between the ASA and CLN, with the key difference for Angels being that HMRC has kindly clarified that ASAs are, when used correctly, compliant with the SEIS and EIS schemes.

So, what is an ASA, what’s good about them, and importantly, what are the risks?

The positive:

There are some serious advantages to ASAs from a founder’s perspective:

• First, ASAs allow a founder to take on investment without having to fill a complete funding round.
• They also get to defer the point at which they need to decide a valuation.
• They are useful to get cash in quickly if the start-up is reaching the end of their runway.

In fact, for founders there are very few downsides to using ASAs. There’s a bit more paperwork flying around and you need to manage the conversion from ASAs into full equity in due course, but that’s not onerous.

For investors, there is a significant advantage: the ASAs will usually (though not always) offer a valuation cap and / or discount to the next priced round.

The big ‘but’ of ASA...

The big ‘but’ of an ASA comes for the investor. And in my opinion, the risks may well outweigh the benefits for investors. Let’s take a look at why.

Risk 1: The start-up crashes before the ASA converts

The SEIS / EIS tax incentives are great, as we all know, but the delay between investing via an ASA and the ASA converting to an equity investment in the company can create a risk.

To illustrate this, let’s look at two similar scenarios:

1. You invest £50k in a company via an SEIS-priced round. The round closes, you receive a share certificate and get issued your SEIS3 form but unfortunately a few months later the business collapses for whatever reason. Not great, but you can still claim £25k income tax relief and up to £11,250 in loss relief (depending upon your prevailing tax position), so you lose £13,750 out of the £50k. See this great calculator to model various scenarios: https://seiscalculator.co.uk/

2. You invest £50k via an ASA. The business collapses in the 6-month period between you being issued the ASA and this converting to equity in the business. As clarified by HMRC, “relief will only be available from the date of the share issue”. No shares have been issued at this point as the ASA hasn’t converted so you lose all of the reliefs you thought you would be getting under the (S)EIS schemes.

Ouch.

Whilst this may seem an unlikely scenario, I know a couple of investors that have been bitten by ASAs in this way.

Risk 2: No chance of ‘fill or kill’

A start-up is raising a £500k round in order to develop the first iteration of their product. In reality, £300k might do to get an MVP out of the door.

In a priced round scenario, you would usually invest on a ‘fill or kill’ basis. You pledge £50k to the round but only pay the money over when you are comfortable that the start-up has enough money to reach their goal. If they get all £500k committed, great! If they get £300k then you still may consider completing the investment. If your £50k is the only money being offered, then you may wish to reconsider your investment - it’s unlikely that the start-up will be able to achieve anything meaningful with 10% of the anticipated funding.

What happens with an ASA though? Imagine you are the first person to invest, you put your £50k in and nobody else invests. Ok, so you can just get your investment back right? In short, you don’t. HMRC rules clearly state that, to be compatible with the (S)EIS schemes, the ASA must “[...] not permit the subscription payment to be refunded under any circumstances”. So, no fill or kill for you.

It is unlikely that the business can do much useful with just £50k - they may try to get funded for the next few months, but may chuck in the towel before too long (see risk 1 above!).

Risk 3: Uncertain terms

Under an ASA, the price per share you are investing in is (usually) uncertain at the point you invest. This is a given, and you would usually have a valuation cap to provide an upper bound.

But imagine a start-up is doing a first round. They don’t have a shareholders’ agreement in place yet and they are just using (soon to be replaced) model articles of association. You invest £50k, 6 months pass, and your ASA converts to equity. You are given a Deed of Release and Adherence to sign and shown the proposed shareholders agreement (that you’ll be adhering to) and articles.

But hang on…When you review the shareholders’ agreement you find that your investor protections are weak, you have no information rights or consents, the undertaking to protect your SEIS status is weak, and since you’ve signed up to the ASA you’ve now got a VC joining the party and taking preference shares above you.

What can you do? Short answer, nothing. Remember, the (S)EIS rules do “[...] not permit the subscription payment to be refunded under any circumstances”. You could try negotiating with the company, of course, but you would be doing so from a weak position as the founders would know you’ve got no plan B - like it or not, your ASA will convert, and you’ll have no choice but to accept the terms offered.

Risk 4: Uncertain timings

The date at which your ASA converts to shares is, usually, uncertain. It could convert on the longstop date (6 months from the date of issue to be compliant with (S)EIS), or it could convert sooner - typically upon closing of a priced round.

This creates a couple of risks:

1. Companies are only eligible for SEIS within three years of ‘starting to trade’. It may be that the company is ‘within time’ for SEIS when the ASA is issued, but the date of conversion to equity is outside of the three-year limit, causing the investor to lose the ability to claim under this scheme.

2. Many investors fully utilise their tax bill each year and need to be careful with the timing of investments to ensure that investments occur in the right period - making an investment when you’ve already offset all your tax means that the investment won’t be eligible for the benefits of the SEIS or EIS schemes. Imagine you have used your tax allowance in 21/22, but invest in a further investment in January 22 on the basis that the ASA converts in the 22/23 tax year, and you’ll have further tax liability to claim against. If the priced round closes earlier than expected, then the ASA could convert in March 22, meaning that you won’t be able to use the SEIS / EIS schemes at all.

Risk 5: No Warranty / Disclosure process

A very standard protection for investors are warranties and the associated disclosure process.

This allows an investor to have an honest appreciation of a business before they invest. When an investor puts money into a business via an ASA, the warranty / disclosure process would only be undertaken at the point that the ASA converts to equity; too late to allow an investor to make an informed judgement on the implications of the disclosures.

Risk 6: Deferred customary protections

Most investors expect to be covered by some standard rights when they sign up to a shareholders agreement - undertakings, covenants, information rights, consent provisions, pre-emption protections, etc. These investor protections are all embedded in the shareholders’ agreement, but won’t kick in until the ASA converts and you become a party to the shareholders’ agreement.

You are therefore lacking these protections during the period between issue and conversion of the ASA.

Risk 7: ASA makes an already brittle SEIS/EIS even more so

Finally, and maybe a small point compared with the others, it’s a risk none the less. The SEIS / EIS is already brittle enough, something we’ve talked about before – so the additional complexities of an ASA just compound an already brittle situation.

So, what do you do?

In short, there’s definitely something about an ASA that makes me gulp. Why don't people build an ASA that solves some of these issues? Because HMRC specifically state "The ASA must not function as an investment instrument that offers other benefits, such as investor protection."

When it comes to investment, there are of course no guarantees. But you can often reduce, manage, mitigate or avoid risk with the right advice and support.

So, what do I think overall? If you’re an Angel investor, count an ASA as the Devil on your shoulder. Since you’ve read this article, if nothing else, you are consciously accepting the risks.