Wednesday 20 May 2020 12:01 am

£500m Future Fund launch mired by fears startups will miss out

Save our SMEs

Future Fund, the government’s £500m answer to startups’ need for cash to survive coronavirus, is set to launch today – but risks freezing out a swathe of British firms, entrepreneurs and investors have warned.

That many startups cannot yet demonstrate a turnover, and that they typically rely on equity investment for cash flow, excludes most from the Coronavirus Business Interruption Loans Scheme (CBILS).

After an open letter from British startups including Darktrace and Deliveroo demanding support during lockdown, the government announced the Future Fund.

It was designed to provide support to startups through government loans ranging from £125,000 to £5m, subject to match-funding from private investors. 

UK startups can then repay these loans or convert them into equity at the next funding round, or after three years. 

Read more: Startups’ coronavirus Future Fund is a ‘bad deal’ for founders

But while take-up is expected to be high, critics fear the terms favour investment from venture capital funds and freeze out private investors who play a crucial role within the investment landscape.

The fund is also incompatible with the Enterprise Investment Scheme (EIS) and the Seed Enterprise Investment Scheme (SEIS), which offer tax breaks to early-stage investors.

As such, a large number of British startups may receive little to no help from the government during the coronavirus pandemic, sources told City A.M

Venture capitalists will be ‘over the moon’

The Future Fund was launched to support the UK’s startups sector. However, critics of the Future Fund have said it only caters to venture capital funds, only one part of the overall investment landscape. 

Read more: Coronavirus loans hit £22bn, but just 50 per cent of CBILS lending approved

The headline terms are structured along the lines of a normal VC-type term sheet, Glafkos Tombolis, partner at tech law firm Kemp Little, tells City A.M. “The government has obviously taken the advice of City law firms that focus on VCs.” 

Unlike CBILS and other government support schemes that resemble state aid, Tombolis thinks it has been structured more like a commercial arrangement. This, he said, “is not the right approach”. 

Investor confidence has been dented by the outbreak of coronavirus. That means venture capitalists are turning their back on new investments and prioritising their own portfolio companies.

And, given VC funds tend to have more cash at their disposal than the average early stage investor, the Future Fund merely reduces VCs’ risk.

“The Future Fund is going to probably be used by a core number of VCs that will most likely invest into their existing companies,” Stephen Page, co-founder and chief executive of seed investor Startup Funding Club, tells City A.M. “It means they can reduce their risk. The VCs are over the moon.”

Additionally critics worry that VCs who do use the fund to support new investments will push startups to accept onerous terms. Page says the VCs will have the power to implement the terms because startups will be desperate.

Adam Dodds, founder and chief executive of stock investing app Freetrade, said: “The programme seems designed to support venture capitalists and will give them ample opportunity to take advantage of startups in desperate need of funding.”

Future Fund will not be EIS-compliant

The convertible loan note structure of the fund means it is not (S)EIS eligible.

EIS is a form of tax relief to encourage investment into startups and early-stage businesses. It allows startups to raise up to £5m a year, capped at £12m overall, through private investors who receive tax breaks. SEIS, being seed funding, has a lower ceiling of £150,000.

Therefore the majority of startups, which are powered by EIS funding, will not be successful in securing matched funding from investors or venture capital trusts (VCTs). 

Most startup funding in the UK comes from angels, private investors and family offices. But the reluctance to make the fund EIS-compliant means VCs are better-placed to co-invest. 

“EIS relief is critical for angel investors,” Tombolis says. “Angel investors take a measured approach in that they know a large proportion of investments will fail, and they’re banking on 10 per cent becoming successful.” 

Without the tax relief, investors will be unlikely to put money in alongside the government, risking the future of British startups particularly badly hit by the coronavirus crisis. 

While overlooking the role of EIS, the government has also not announced any additional support for the scheme, says Bruce Macfarlane, managing partner of VC fund MMC Ventures.

“Understandably, high levels of uncertainty have meant flows of capital into EIS have fallen sharply and as a result, investment for the UK’s early stage companies,” he adds. 

Read more: British startups call on Treasury to change terms of Future Fund

British startups with US backers will be ineligible for the Future Fund

Some of Britain’s brightest startups also face being locked out of the Future Fund because they do not have UK parent companies.

All UK startups that participated in US accelerator programmes, and therefore have a US parent company, will be excluded from the fund. 

A requirement of such accelerator programmes is that the startup creates a US parent company. It has usually not been an issue, with companies using a UK subsidiary to support employees. However, the Future Fund’s terms state a company must have a UK parent company to be eligible for government support. 

These startups have returned to the UK from the US, having secured funding and expertise in their fields, but are now excluded from both governments’ support packages. 

Read more: British startups call on Treasury to change terms of Future Fund

Last week, a group of more than 30 chief executives wrote to the Treasury asking for a revision of the terms. Kieran O’Neill, a signatory and chief executive of men’s styling service Thread, tells City A.M. that the Future Fund, as it stands, “will be missing out some of the most innovative and fastest-growing startups”.

“Many of them are biotech and artificial intelligence startups, which this government has said they will be working hard specifically to support,” he adds. 

More tax relief for investors could help startups

So what next for British startups unable to access CBILS and the Future Fund? 

There have been calls to introduce a temporary increase in the tax relief available through EIS. Macfarlane suggests an increase from 30 to 50 per cent could “help overcome investor caution and restore capital flows”.

Rather than relying on debt, “startups would be gaining equity investment”, says Macfarlane. “If we want to ensure the innovative UK technology sector continues to thrive after the crisis, it is more equity-based solutions that we need.” 

Page echoes this temporary relief, but also calls on an increase on the SEIS relief to 70 per cent. Otherwise, he argues, it risks a similar situation with the Future Fund where those being scaled up benefit. 

Page, whose company Startup Funding Club provides early investment for British startups, has also suggested a second Future Fund to support startups.

He explains there is a distinct difference between startups and scale-ups, which is what VCs focus on. As such, a second Future Fund “should be tax relief-centric so it is matching people like us and other funds and angels”. 

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