Startup Stories

Get the best investment deal with SEIS

Monday, September 21, 2020

Intro

SEIS and EIS are more than just a tool to incentivise high net-worth individuals to invest in startups. At the core SEIS is a god-sent that protects startups in their very early stages. We recently raised SEIS financing for Deepfinity, a Proptech company that built the most advanced internal parcel tracking software.

TL;DR

The TLDR of this article: SEIS/EIS becomes void when certain de-risking mechanisms are used by investors, mechanisms that favour them at the expense of entrepreneurs.  Effectively SEIS/EIS stops you from making a terrible deal (it tries to at least).

Let's jump into the thick of it, not only will we explore how SEIS/EIS helps you avoid getting a bad deal, we will also discuss how you can use it as leverage. I’ll also introduce you to some great reads that will help your fundraising. But first, an introduction to SEIS/EIS.

What is SEIS/EIS

SEIS and EIS stand for Seed Enterprise Investment Scheme and Enterprise Investment Scheme respectively. These are UK treasury backed policies that allow UK taxpayers to claim back some money from their taxes when they invest in high-risk ventures. Remember those last words: “high-risk” (as it helps to explain why certain mechanisms that investors might use will invalidate this scheme).

I’m providing a top-down overview of SEIS and EIS, but if you want a more thorough explanation, I suggest having a read through the Seedlegal articles. They were my reference point.

An individual can invest up to £100,000 per year under the SEIS, while a company can accept in its lifetime up to £150,000 in SEIS. Investors receive 50% of their investment back from HMRC, so if £100,000 is invested in the tax year they can claim back £50,000. SEIS also provides loss relief if the investor losses money, up to 45% (highest tax bracket of investors) on their loss. So, if an investor makes an initial investment of £100,000 and the investment is lost, they only suffer a £27,500 loss.

(£100,000×0.5)×0.65 = £27,500

This is an excellent deal and I look forward to the day where I can take advantage of it as an investor!

The EIS is a follow up to SEIS and extends the amount that the company can accept in investment. With EIS the yearly investor investment cap goes to £1m and a startup can accept up to £5m in EIS funding in a 12 month period, with a cap of £12m  over its lifetime. The investors can claim base 30% immediately and upto 45% with their loss relief. I suggest you read through the Seedlegal articles to understand the peculiarities of SEIS and EIS. It’s a 10-minute read.

Don’t get a bad deal

Raising funds for a business, much like any other negotiation, relies on leverage.  

The more of it you have, the better deal terms you can negotiate for your company. Deal terms can be broken down into two categories: Economic and Control terms. Often the leverage lies in the hands of the investor to dictate these, however, we will go over a few things you can do to shift leverage in your favour. First let’s go over how SEIS helps level the playing field.

Economic terms are the value of the company and the investment amount. SEIS improves the economics by driving up valuations of companies whilst also encouraging investment through two factors. Firstly the tax relief effectively halves the cost of investing in startups and secondly the increased availability of capital causes demand for startups to increase. Let me elaborate, as an investor invests £100,000 they receive £100,000 worth of shares but are almost immediately  refunded £50,000 by HMRC, which is an instant 50% return for the investor, who now owns equity ‘worth’ £100,000 after having paid only £50,000. This instant value gain encourages more people to invest and increases the amount of money available for startups. This in turn can increase startup valuations as long as the number of startups does not increase proportionally with the rise in funding.

The second and less obvious assistance that SEIS brings to economics is in reducing the use of de-risking terms.  A few are listed below:

  • Full Ratchet Anti-Dilution: This stops investors from having their equity diluted if the company goes on to have a down round. More info can be found in this article.
  • Liquidation Preference: Liquidation Preferences affect who gets paid first among the shareholders of the company if it is sold or goes into administration (fails), these are called liquidation events. The topic of Liquidation Preferences is non-trivial and I recommend you learn about it here.

These are both de-risking mechanisms that can negatively affect the founders of the company. With Full Rachet Anti-Dilution, the founder will bear the full costs of a down round and be heavily diluted, while the investor is not diluted. With Liquidation Preferences, the investor will have priority to receiving payment in a liquidation event, so the founders could be left with almost no money in case of a sale/exit.   SEIS, however, becomes invalidated if the mechanisms listed above are used for de-risking. As SEIS becomes invalid, these terms are rarely used.

There are ways that liquidation preference can be implement and worded in a way not to void the SEIS, so be careful. This is highlighted in the 8 Things You Didn’t Know about SEIS/EIS Tax Relief.

Leverage SEIS to get a good deal

SEIS can be claimed by investors for the tax year when the paid shares are issued to them by the startup. There are ways to backdate SEIS to the previous tax year (called a “carryback”), however, these can be inconvenient and can slow down the speed at which HMRC processes refunds.

The tax year ends in the UK on the 4th of April and investors often set a mental deadline for that date, which you can leverage. The closer you are to the date, the more likely the investor will be to concede certain negotiation points to get the deal done quickly and claim the tax relief back for that year.

I’m not suggesting leaving things to the very last minute, as meeting  investors and getting them comfortable in investing can take 2-4 months in my experience (unless you have an existing relationship with them). If you intend to close an investment round by the end of the tax year, you should start reaching out in January. The last weeks of March will catalyse and speed up negotiations and (hopefully) close the deal.

Having a fixed and specific deadline like the 4th of April that is influenced by outside factors makes it seem more concrete. This further helps speed up negotiations as some investors may keep you in a state of uncertainty until you become increasingly desperate for money (as you burn through your cash reserves). Never allow such harmful investors to partner with your company, but be aware that some investors will do it without meaning to, as closing the round is not their primary priority in a given period of time.

This self-imposed deadline cuts both ways. Companies only have 2 years from the point they begin trading to qualify for SEIS investment. So, if you are coming to the end of those 2 years, investors will know that you are under a deadline to capitalise on the SEIS and hence may use this to encourage to accept their terms.

Standout from the crowd:

The 2-year timeframe can be used to your advantage. Companies are eligible for SEIS 2 years after they “begin trading”, this is not the same as registering. For example, we registered Deepfinity in 2016, but made our first revenue in January 2019, which is when we consider ourselves to have begun trading.

You shouldn’t therefore register for the Advanced Assurance documentation required to become SEIS eligible until you are ready to take on investment. Readying this documentation usually takes 4-8 weeks, however we managed to receive ours within a week of applying for it through Seedlegals.

Startups will often try to raise funding and leverage SEIS without having a validated product that’s revenue-generating. If you can develop your business to generate some revenue, a few £1000s will help you differentiate your business  so you can negotiate an excellent term sheet and valuation. Having revenue shows that you achieved the most difficult stage, going from 0 to 1, and demonstrates a range of skills that most first time entrepreneurs lack. It also shows a  base level of demand for the product and goes towards validating the business,  and helping to de-risk the investment.

Read this

I would suggest that everyone looking into raising finance reads the following three books that helped me. The first is called Venture Deals, it’s the go-to concerning everything on “raising capital and venture terminology”.

You are likely to be raising money from angel investors, people who are experienced professionals, so you can assume they are good negotiators. Be prepared and have some knowledge about negotiation yourself, I read Never Split the Difference and Pitch Anything.

Legal

Seedlegals has been a true ally, if you are raising funds in the UK, you should save yourself the headache associated with legal work and use them. They will provide you with unlimited legal support and the tools you need to build a robust Shareholder Agreement and all the other documentation you require to close your financing round.

People

Have a network of fellow startup founders that you can reach out to and ask for help. Often they will have recently experienced what you’re going through and will be able to provide you with advice and feedback.

Get some more experienced mentors (and VCs) to help you as advisors. They’ll be able to help you spot problems from the outset.

Your Gut Feeling

A friend I deeply respect told me: “follow your gut when it's telling you not to do something, but don’t listen to it if it's edging you onto do something”. The idea behind this is: if something doesn’t feel right, don’t do it. If you have an urge to do something, take a step back and think it over.

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