Convertible loan notes – top tips for founders of startups
If you are involved in investing, either as a startup or an investor, you are likely to come across an advanced subscription agreement. So what is an advanced subscription agreement and what do you need to consider when entering into one?
An advanced subscription agreement is an investment for equity where the investor pays in advance for shares that will be allocated at a later date. The shares will usually be issued at a discount to the price per share in the next funding round, subject to the startup achieving an agreed funding target for that round (generally known as a “qualifying funding round”). If such targets are not achieved then there is a long stop date (which should not be more than one year) by which time the investment will automatically convert and the shares will be issued.
Similar to a convertible loan note, an advanced subscription agreement is a way for a startup to get a quick injection of cash because it tends to be a relatively short agreement which is quicker to negotiate. However, an advanced subscription agreement can be preferable for a startup because, unlike a convertible loan note, it is generally the case that interest is not charged and an investor cannot ask for their money back.
In addition, an advanced subscription agreement can be preferable for an investor because the shares issued in accordance with an advanced subscription agreement are usually issued at a discount. However, unlike a convertible loan note, provided the advanced subscription agreement is structured properly the investor can still benefit from SEIS/EIS, when the shares are issued.
Some points which both startups and investors need to consider when negotiating an advanced subscription agreement are:
Under an advanced subscription agreement the question of valuation is delayed until closer to the date of the next funding round. However the startup should ensure that a valuation cap is included so the existing shareholders have some certainty as to the level to which their shareholding will be diluted on conversion.
Care should be taken as to the target to be set for a qualifying investment round. An investor will not want the target to be too low because it will mean their investment will convert when the startup is underfunded. On the other hand the startup will not want the target to be too high because it will mean the investment will not convert even though the startup may have received substantial investment.
The parties should consider if there are any other circumstances, in addition to a qualifying funding round or long stop date, in which the shares should automatically convert under the advanced subscription agreement, for example in the event of a sale of the startup.
The startup needs to remember that by entering into an advanced subscription agreement, a startup is giving the investor a right to subscribe for shares therefore, as with any other issue of shares, do the directors have authority to allot the shares and do any pre-emption rights apply? Pre-emption rights are where existing shareholders in a company are given a right of first refusal when a company is issuing shares, meaning the shares have to be offered to existing shareholders before they are offered to new investors. Therefore it is important for a startup to be aware if pre-emption rights do apply and to factor that into any timeframe for entering into the advanced subscription agreement.
The investor should be aware of the terms of any shareholders’ agreement and articles of association to which they will be subject, once the investment converts and shares in the startup are issued.
Emer Hughes is an Associate in the Corporate and Commercial team. She works on a broad range of corporate and commercial transactions including advising on commercial contracts and shareholder agreements, corporate governance, company restructuring, asset and share acquisitions, VC investments and listings on junior stock markets.
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