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VC Insights: Loans in early-stage businesses – why equity makes more sense

… and why you won’t get your loan back (probably).

Venture-stage companies are fundamentally risky. It’s tempting for the investor, looking for ways to reduce their risk and improve their returns, to invest a loan rather than share capital. This post explores how that approach can lead to both commercial and tax problems further down the line.

VC Insights: Loans in early-stage businesses

How a loan structure might increase your portfolio return

A quick note upfront: we’re not talking here about ASAs (Advanced Subscription Agreements) which are essentially equity instruments and, crucially, treated as such for tax purposes – see our earlier post.

The basic idea of using loan instruments to make a venture investment is a simple one and makes good sense. The idea is that, instead of 100% of the investor’s cash going into the company as equity, the bulk is invested as a repayable loan, and only a sliver as equity. Much like a private equity structure. That way the investor gets to have their cake and eat it – the risk capital comes back out and they get to share in the upside as well.

Take our usual example of SaaSco funding offer of £1m for 20% of the company. Wouldn’t it be better for the investor to have put in, say, £900k as a loan, and just £100k of equity for their 20% stake? These are the positives:

  • Bigger returns: the obvious advantage is getting an extra £900k on a successful exit, in addition to the value of the equity stake (although note: the investor’s gain is pound-for-pound a cost to the founders and other shareholders – a chunk of prior capital accruing at 12% in a start-up is real disincentive to management if things aren’t going to plan);
  • Quicker returns: if SaaSco manages to redeem the loan before the company as a whole exits (which might be years into the future) then the investor gets most of their monies back early and can either recycle their capital into new ventures or simply enjoy being de-risked. Either way, their portfolio returns are enhanced;
  • Downside protection: if SaaSco hits hard times, the loan ranks ahead of share capital. The investor therefore has more chance of recovering some of their investment if they hold a loan rather than pure equity.
  • Negotiating position: alternatively, if SaaSco struggles, the investor has the option to negotiate to convert the loan into equity, increasing their stake to mitigate SaaSco’s diminished value.

Let’s examine what the enhanced return might look like for SaaSco. Remember, we were planning to invest £1m, and in our previous posts we’ve assumed that after five years the equity stake might be worth £13m. In the leveraged scenario, let’s assume that the investor manages to get their £900k loan repaid out of a series A round after a year, and then gets that £13m equity pay-day in year five.

return calculations - VC Insights

What a difference it makes not only to get your stake monies back, but also get them back early: a 67% annual compound return is boosted to nearly 90%.

Of course, this analysis assumes that the investor managed to negotiate a loan structure without any give-up on equity percentage. We’ll come back to that point later.

So, what’s not to like about loan structures?

Getting your loan repaid when the company fails

First off: when SaaSco struggles, you’re unlikely to see your loan repaid. It depends on the circumstances but most venture stage businesses’ only assets of note are goodwill and intellectual property. Both assets are notoriously worth nothing if the company fails. Maybe you could take security over the IP but, realistically, if the founders couldn’t make it work, will the investor fare any better?

The best the investor can reasonably hope for is to get a better deal on converting the loan to equity in any recapitalisation but, even then, new monies will always trump existing securities in that scenario. New investors will also be cognisant of not wanting the founders to be diluted out of sight, so there’s a constraint on just how much equity the loan could convert into.

Getting your money repaid from future rounds

The investor might hope that their loan can be repaid in the short term in some subsequent, larger funding round.

There’s an assumption here that future investors will line up respectfully to finance SaaSco to honour its obligations to its prior investors. Sometimes that happens. More usually, expect any sophisticated venture investor to challenge the capital stack. Venture investors hate monies leaving the company, both on practical grounds and as a matter of principle. Just as importantly, they hate having an investor loan remaining in place and standing between them and the value of the business which they just backed. Why should the new investor support an existing investor getting their monies back first?

So, founders need to expect some pushback: “sure we’ll invest £5m, but you need to fix that £900k loan. It needs to disappear.”

That creates a tense situation: an early deal needs to be unpicked – either the loan gets waived, or converted to equity, or possibly converted to some junior instrument if the new VCs are happy. The negotiation can affect trust between founders and the initial investor. It’s a distraction, and possibly racks up legal fees. Maybe the investor won’t budge, and the new round gets derailed.

Consequently, if early stage investors chose to invest using a loan structure, they may end up having to be their own follow-on investors.

So just when might you get your loan back?

This structure works well when SaaSco scales using the first-round monies without needing further funding. The company either repays the loan from cashflows or on an exit.

Loans and EIS

For a private investor, the major drawback of loan investing is that it earns no EIS relief. Not when the cheque is written, nor when the loan is converted to equity. So, even if the investor ends up with only shares that would otherwise be EIS-qualifying, they’ve lost that relief if the investment was initially constituted as a loan note. This can’t be unpicked unless the loan can somehow be refinanced and genuinely new monies invested as fresh equity.

Losing some of the upside

The bullish illustration above assumed that the investor was able to negotiate a loan structure without giving up any of their equity share. In practice, with any savvy founder team, there’s going to be a negotiation in which there are trade-offs. Loans are sometimes used to solve an impasse over valuation, so that the investor accepts a sub-standard equity share in return for getting the apparent security and return-enhancement of a loan instrument.

It’s possible that the investor may be deceiving themselves about the logic of this trade-off. The issue is the relatively low chance of recovery of the loan compared with the potentially huge give-up on a successful exit.

Back to SaaSco: the founders agree to the loan structure above, but the 20% equity stake has been cut to 10% in negotiations. Seems fair. After all, £900k of the investor’s monies are loan, so only a fraction is really at risk. Right?

In our previous valuations case study, we assumed that the investor’s 20% opening stake was due to earn them £13m in year five but, this being a risky world, that happened only 15% of the time. If the investor accepts the loan structure, their equity stake on a successful exit is halved to £6.5m. Let’s keep the analysis fairly simple and assume that, another 20% of the time, SaaSco limps to an exit sufficient just to pay off the loan. The rest of the bets fail entirely with no recovery for any investor, whether loan or equity.

Here’s the returns analysis under both scenarios:

return calculations - VC Insights

So, the trade off – half the equity stake in return for getting first dibs on the proceeds – leaves the investor substantially worse off. In a nutshell, venture-stage companies’ habit is to fail and return nothing – even to lenders. VC portfolios make their return from the clear winners. That’s why the size of the equity stake counts for everything.

Round-up

Loans have their place – leverageable businesses generating cash to service debt, private equity and other specific later-stage types of investors – but they fit early-stage deals poorly. Using loans to protect on the downside may limit the upside and almost certainly will cause an issue for later-stage venture funders. If the investor wants EIS relief in particular, loans are just a bad idea.

 

David Smith

David Smith

Partner, DSW Angels

VC Insights: Loans in early-stage businesses – why equity makes more sense

By DSW Angels01 Oct 2020