What do I need to know about an advance subscription agreement?

What is an advance subscription agreement?

An advance subscription agreement is, in essence, a prepayment by an investor for ordinary shares in your company. The agreement states that an investor provides funds on the date of the agreement, which convert into ordinary shares in the company if an ‘exit event’ occurs in the future.

How do ASAs work?

An ASA is a unique funding mechanism for startups. Investors provide capital to a startup and, in exchange, secure the right to acquire shares at a later date. However, ASAs are more complex than a simple capital-for-shares transaction. They involve a multitude of elements specifically designed to cater to the needs of both startups and investors.

In an ASA, the investor finances a nascent company with the understanding that they'll receive shares at a later stage, often during the company's inaugural equity funding round. Shares via an ASA usually aren't allocated immediately.

One of the benefits of ASAs is how they protect the investor's right to future shares. Essentially, the investor is guaranteed to acquire these shares at a reduced price compared to what later investors might pay. This can entice early-stage investors who can often take on greater risk by backing a startup in its early stages.

A pivotal point in an ASA is the occurrence of a 'qualifying funding round', a company sale or when a predetermined long-stop date is reached. During a qualifying funding round, the startup strives to attain a specific fundraising target. Once this target is met, the shares under the ASA can be released. Carefully determining this target is vital for both investors and founders.

Investors need to ensure the target is high enough so that when their shares convert, the company is well-capitalised, enhancing their potential return. Conversely, founders must avoid setting the target too high as it could result in substantial investment not converting into shares even if received.

Upon conversion of the ASA, shares are usually allocated at a discount rate between 10 and 30% and are typically ordinary shares. Therefore, the ASA model not only assists startups in procuring much-needed early-stage funding, but also offers investors an exciting chance to support a burgeoning company while securing a beneficial position for future returns.

What are the key provisions of the agreement?

The agreement usually has the following key provisions:

  • The conversion is typically triggered by a next funding round, a sale or a listing.
  • The investor’s funds are converted into ordinary shares at a price per share which is at a discount to the then share valuation, usually the discount is between 15% and 25%.
  • There may be an upper limit on the number of shares that the investor can receive.
  • There is a longstop date if an exit event does not occur, which is currently set by SEIS/EIS rules at a maximum of 6 months from the investment date. On the longstop date, the conversion occurs typically at 15% to 25% discount to the current share valuation.

The investment is not a loan - the investor has no right to receive interest nor to repayment under the advance subscription agreement.

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Balancing the Needs of Investors and Founders

ASAs involve the careful balancing of the interests of investors and founders. This balance becomes especially important when determining a 'qualifying funding round', a crucial component that can significantly influence the manner in which an ASA functions and eventually transforms into shares.

A 'qualifying funding round' is a critical juncture in an ASA's lifecycle. It's the point where the startup strives to reach a predetermined fundraising goal, and once this objective is met, the shares under the ASA are distributed to the investors. However, setting this goal requires thoughtful deliberation, with the aim to harmonise the needs of both the investors and the founders.

From the investor's perspective, the goal needs to be lofty enough to guarantee that the startup is adequately capitalised by the time their monetary contribution transforms into shares. This is vital because it directly impacts the potential yield on their investment. If the goal is set too low, the company may exhaust its funds prematurely, thereby endangering the investor's expected return.

Conversely, founders need to be wary about setting the goal too high. The danger here is that even if a significant amount of investment is procured but falls short of an overly ambitious goal, the funds won't translate into shares. This could lead to a scenario where the startup has substantial financial backing, but the investor hasn't received any shares as compensation.

It's important to strike an optimal balance when defining a 'qualifying funding round' within an ASA framework. The needs of both parties must be taken into account to ensure the agreement is mutually beneficial, fulfilling the investors' desire for a favorable return and the founders' requirement for sufficient funding to kickstart and expand their startup.

Investors are eligible for SEIS/EIS tax relief

An investor using an advance subscription agreement benefits from SEIS/EIS tax reliefs. However, the structure of the advance subscription agreement is critical to ensure SEIS/EIS eligibility, and HMRC will look at this on a case-by-case basis.

What is the difference with convertible loan notes?

Convertible loan notes are similar in that ordinary shares are issued at a future valuation. Conversion is triggered in the same way by a next funding round, a sale or a listing with the shares being issued at a discount to the then share valuation.

Investment through convertible loan notes, however, is debt. Investors have entitlement to be repaid and receive interest. Repayment is typically at the third anniversary of the investment, with investors having the right to claim for their money back early if the startup become insolvent before then.

Investors also have the right to receive interest, although this is usually ‘rolled up’ so that interest is paid only when the convertible loan notes become repayable as above.

As convertible loan notes are debt, they do not allow investors to claim the tax reliefs under SEIS/EIS.

What are the benefits of an advance subscription agreement?

If you're a start up or seed business, you may need funding early on in order to help your product or service to develop. An ASA can help you to get hold of finance quickly. Established businesses may want to make use of the equity from an agreement.

Benefits to investors may include potential tax relief under EIS and SEIS schemes.

What are the cons of an advance subscription agreement?

Founders and business owners may be giving shares away at a discounted rate and thus  diluting their own shares. ASA investors may also have the same rights as new equity investors, which could deter future investors.

Investors may find that convertible loan notes are preferable as they can receive interest on convertible loan notes.

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