(This is a piece written originally for TechCrunch, and is reproduced here for exhibition purposes only. Please note, the information below is not current, although the comment may still be of interest)

Originally posted at: http://techcrunch.com/2011/09/25/for-better-or-worse-the-uk-plans-big-changes-for-startup-investment/

Sunday, September 25th, 2011
This is a joint guest post from security camera tech entrepreneur / startup finance blogger Nick Pelling and “sweat equity” investor/consultant Andrew Lockley. They report on The UK government’s ongoing consultation on to the Enterprise Investment Scheme (EIS), which could well reshape the UK startup investment landscape during 2012.

The UK government has spent most of 2011 whacking the same pro-enterprise rhetorical stake into the ground. It wants to turn the UK into ‘Venture Central’, “the best place in Europe to start, finance and grow a business”; and it claims that it will do pretty much whatever it takes to achieve this.

10/10 for ambition, but… what’s the plan? Aside from Tech City grandstanding (a bit shallow, but decent enough PR) and the whole Enterprise Zone fiasco-to-be (more offices? Why?), what the government wants to happen now is for business angels and VCs to start funding lots of high growth startups – fast.

Yet even though the March 2011 Budget increased the income tax relief available to angels via the Enterprise Investment Scheme (EIS) to 30%, that decent-hearted snowball failed to trigger the government’s hoped-for avalanche of UK tech investments (seen any on TechCrunch? Nope, neither have we). As a result, it started to wonder whether the problem might be with EIS itself. So in July, HM Treasury opened up a three month consultation period on radical updates to the EIS, to end on 28th September 2011.

However, the only ‘stakeholders’ likely to read (let alone submit detailed commentary on) its hefty document’s government-speak are the usual suspects: larger angel networks and trade bodies (e.g. the BBAA and the BVCA). This is not entirely unlike consulting solely with lions on your “Preferred Access to Wildebeest” scheme.

We (Andrew & Nick) wanted to know how this change will impact the UK’s startup finance landscape, so we both trawled carefully through its 62 pages. What follows is our joint summary of it, so that you don’t have to put yourself through that same ordeal…

Here’s what the consultation document says.
Essentially, HM Treasury wants to retain EIS while offering a new scheme called ‘BASIS’ (“Business Angel Seed Investment Scheme”) entirely in parallel. This will offer even more tax advantages, but only to hardcore angel investors, investing at high personal risk in high tech startups. Which begs the question: who / what should qualify for BASIS? Because if BASIS ends up significantly more tax advantageous than EIS, then stricter vetting will be needed to avoid abuse and manipulation.

As a result, most of the Treasury’s document is filled with a near-interminable sequence of open questions addressing what precise attributes of angels and startups should make them eligible / ineligible for this extra tax advantage. (Angel networks would probably like ‘membership of an accredited angel network’ to be the deciding factor for the former, for example.)

So, what’s the big difference with this new scheme? Well, whereas for EIS 100% of an angel’s investment has to be in ordinary shares in order to qualify, the intention here seems to be to make the new BASIS scheme as laissez faire liberalized as EU constraints will allow. Though the document airily claims that this ‘simplifies’ the legislation, in practice its details and implications are very far from straightforward. (Cue fat fees for lawyers, accountants, agencies, brokers and various other non-value-adding service providers.)

Let’s look at some of the funding options that may now become accessible:-

1. Preference shares
Preference shares give more rights than ordinary shares, though what those rights are varies considerably. For example, they can act rather like a bond, specifying a fixed dividend that has to be paid in full before any ordinary shareholders get anything at all: this would be a preferential right to dividends. As a result, having preference shareholders can be quite divisive, because the outcome of business decisions may affect each different class of shareholder differently, unsubtly shifting their view of what the company should do.

Even angel groups haven’t been openly campaigning for preference shares, because (for the most part) they genuinely want angels’ interests to align with entrepreneurs, something that EIS’ insistence on ordinary shares arguably achieves.

Andrew: …although many founders still end up loathing their backers, so it clearly isn’t that simple.

Despite these reservations, allowing preference shares is an avenue HM Treasury is keen to explore, though admittedly with only a very limited subset of the nothing-up-my-sleeves chicanery VCs like to put in place (e.g. not with any preferential rights on winding up, nor any future right to be redeemed, nor any preferential right to variable and/or cumulative dividends).

Despite the fact this is intended to help angels not be marginalized in later VC-led rounds, the Treasury’s EU-constrained version of preference shares is downright ‘soft’ compared to VC versions. Consequently, even if angels do end up with Treasury-friendly preference shares, the strong suspicion is that VCs will always find a way to make their own prefs more ‘senior’ (i.e. with far better rights on dividends, assets, liquidation, etc). Asking VCs not to do this would be rather like asking a dog not to bark: they can’t help it, that’s what they do.

2. Quasi-what?
HM Treasury additionally proposes that while up to 30% of an investment can be in the form of debt (more on that below), 70% of the investment must be in equity or quasi-equity, to bring it into line with its VCT legislation. Errm… quasi-what, exactly?


“Quasi-equity” is a fearsomely voguey word in the Charities sector, but almost never used in startups. One example of it is a Revenue Participation Right, whereby the investee sells the rights to a percentage of a company’s gross audited revenue (note: not its profit) or revenue above a certain agreed level. This loosely makes sense, insofar as the investors (or ‘revenue participators’, call them what you like) thereby start earning a return as soon as money starts coming in. It’s a bit like sales commission, but on your whole sales line, not just on that earned by a single individual.

In the context of charities, the total figures to be paid back are usually capped to prevent the actual IRR becoming accidentally stratospheric: but the HM Treasury document doesn’t even begin to cover to what degree any of this fits startups.

Andrew: I’ve used similar structures in the past, which usually end in something close to tears. I avoid them now.

3. Convertible notes
Reading between the lines, the main factor driving the whole exercise seems to be ‘bubble envy’. Looking across the Atlantic at the massive US startup finance bubble (crazy valuations, huge quick raises, early VC rounds – deals, deals, deals, baby), the Treasury must surely be wondering what it can do over here to engineer even 5% of the extraordinary startup dealflow happening over there. (But let’s put to one side the question of whether that’s actually a gargantuan vastly-oversold techy-startupy-social-Ponzi scheme. Even though it probably is.)

One of the key funding mechanisms widely believed to be driving the US startup bubble is convertible notes, an in-fashion form of debt finance that magically turns itself into equity in a subsequent (normally VC) round. Essentially, the parties pre-agree not a price, but a discount relative to whatever the later round’s pricing comes in at. It’s a neat way to ensure that investors can both have their cake and eat it.

Yet there is a world of difference between this and the (frankly rather vanilla) ordinary shares required by the present EIS. Can the debt-heavy convertible notes mechanism ever be shoe-horned into BASIS’ equity-heavy setup? Possibly, but it’s hard to see how to retain that same post-sale pricing flexibility without leaving the overall system open to abuse.

4. Debt
What does the Treasury team think can be achieved by allowing up to 30% of an qualifying angel investement to be debt? If that 30% is structured as actual (i.e. on the books) debt, this could very well go down badly with banks, whose lending debt is normally the most senior. Regardless, few startups have much collateral to borrow against except IP (and therein lies another set of problems completely), so the potential hazard of trading insolvently is never far away. And with 30% actual debt, you certainly don’t get the transaction savings of a full convertible note round, because a proper equity arrangement still needs to be negotiated and drawn up for the other 70%.

It’s more likely that HM Treasury’s finance wonks intend the 30% figure to be merely a weighting metric for hybrid debt/equity instruments, depending on how the debt and equity components should be divvied up. But what specific hybrids do they have in mind, apart from prefs and quasi-equity? Their intentions with all this are far from clear: much more transparency would be helpful. (NB: if you’re losing the will to live by now, you try reading the original document.)

OK, but… what does it mean?
At this point, it all gets somewhat subjective, so we’ve split the commentary out into our two different viewpoints. But be sure to let HM Treasury know your thoughts before 28th September 2011 – for if they don’t have a properly balanced range of viewpoints to weigh up, BASIS could work out very badly indeed.

The Entrepreneur view – Nick Pelling
What’s going on in the Treasury team’s minds here? I suspect the bottom line is that they want BASIS (a) to raise income tax relief to the magic number 50% (i.e. matched state-funding), while (b) allowing only a small subset of hardcore angels and (hopefully high growth) tech startups to be eligible, but (c) without falling foul of EU state aid constraints.

Yet the so-called “simplification” (actually, just plain liberalization) aspects of BASIS don’t quite add up. For example, the Treasury’s watered-down preference shares seem to divide angels and entrepreneurs, while still not actually protecting angels from VCs – no wall that strong has yet been built, nor perhaps could one ever be.

Similarly, quasi-equity is surely a financial minefield of epic proportions. For me, the casual mention of such exotic financial engineering instruments is perhaps a sign that open-mindedness to options has gone too far.

Finally, using even partly debt-based funding instruments might well give banks yet more reasons not to lend to startups: have banks been explicitly included in this consultation? I didn’t notice any evidence of this.

So as an entrepreneur, I don’t see any tangible benefit for BASIS over EIS beyond the increased tax relief aspect (and I suspect that what is in fact missing in the UK is an active culture of angel investing rather than improved governmental sweeteners). But as far as BASIS’ liberalization of eligible share structures goes, I really do wonder whether HM Treasury will ultimately take its cues from both lions and wildebeest… or just be led by the lions. If their ”advice” led to pure laissez faire hybrids being allowed, I would be highly unsurprised if it quickly proved to be a disaster for everyone involved (except the lawyers and accountants).

The Angel view – Andrew Lockley
The problem with all these tax relief schemes is that they are essentially meddling. Right now, the tech sector is awash with investment, particularly in the US. This has lead to the formation of a bubble – a classic inflationary scenario, with too much money chasing too few goods (the goods in this case being tech stocks). We’re ripe for a shakedown soon. Solid foundations in any industry are not founded on investment bubbles, for these are followed inevitably by busts. All this tax-system meddling smells just like the government’s interfering attempts to keep the UK’s heavy industry afloat in the 70s and 80s. Business needs genuine simplicity, not legislative knots.

Whilst the minutiae of this-or-that tax relief scheme might seem terribly important, it’s really not the demand side for investment which is broken right now – it’s the supply side. The global tech sector is swilling with money, but the ability of the UK to keep pace with these global opportunities is choked off – not by the lack of investment, but by the poor quality of much of the sector. Before you stone me to death, allow me to clarify – I’m not trying to say that your startup is rubbish. What I’m saying is that the sector isn’t principally held back by a lack of funding, but by a second-rate education system, where schoolkids think that computer studies is about Facebook and not about Linux.

However, much more pressing in the short-term is the woeful lack of entrepreneurship baked into the education system. If more tech graduates knew more about business, there’d be more businesses worth investing in – and even more which could succeed without an investment begging bowl. (Shock horror – successful companies can come from organic growth.)

With a few notable exceptions such as UCL, the hungry entrepreneurial graduates coming out of university today have been denied the most elementary introduction to real business skills. What little tuition is given is generally abstract to the point of uselessness. I know this first hand, as I went to business school.

Nick: so did I, and – financial accounting aside, which is a must-have skill – I’d basically agree.

I reckon you’d learn more about business selling fruit out of a barrow. Most graduates, especially techies, have not been taught the importance of the profit imperative, they lack management and delegation experience, and they don’t appreciate how to apply their know-how in a commercial startup – especially one where funding isn’t necessarily available or needed.

Sure, there are a load of exceptions, and that’s what makes hot spots like Silicon Roundabout so exciting. But the UK is a big place, and it needs a lot more energy in the startup scene. That starts with education, not quick fixes to tease artificially-cheap investment money into the community. The government should stop mucking about with meddlesome subsidies, tax breaks and other interfering nonsense, and instead get on with fixing our lacklustre education system and generally reducing the complexity of doing business.

As attractive as these relief schemes seem, they’re actually part of the problem. In general, good businesses will ultimately find backers – if and when these are needed. Tax incentives can sweeten the mix, but they’re the icing and not the cake, and it’s the cake we need to get right. A plethora of quality firms run by well-educated people is what this country needs; but right now we’re falling behind for the lack of decent business and technical education. Ever-more complex tax and subsidy fiddling won’t fix the real problem, they’ll just distort the market. It’s time we thought differently.