Robert P. Mollen, Counsel at Fried, Frank, Harris, Shriver & Jacobson (London) LLP.
This blog is a bit more technical (and longer) than most of my blogs. It is aimed at a particular problem –our need to facilitate more cross-European investment by business angels in order to build competitive startups.
I frequently see quality European startups that have the potential to be global market leaders but are starved for early stage capital as compared with their US counterparts. Bootstrapping is a good thing, and too much capital, too early, can be a problem for startups. Nonetheless, there is a point at which the failure of high-quality European emerging companies to secure sufficient early stage investment puts them at a significant competitive disadvantage. Business angels play a critical role at this stage.
This problem especially troubling where the startups are engaged in innovation with clear potential social benefits as well as commercial opportunities, such as in healthtech and life sciences. Consequently, I would like to help build a cross-border angel network focused on that vertical. However, this is an issue for all business verticals.
The need for cross-border angel investment
A key challenge for UK and other European startups seeking early stage investment is that business angel communities in Europe are separated by national boundaries and, in any case, are still in a development mode (with relatively small numbers of business angels). These constraints on angel investment are particularly important for startups in those sectors, such as healthtech and life sciences, that may have limited opportunities to secure investment from early stage European venture capital funds.
While the atmospherics around Brexit are not making it any easier to address European startup funding on a cross-border basis, the obstacles to such investment predate Brexit and are largely unrelated to it.
Startups that are unable to secure adequate early stage financing in Europe may be forced to decamp to the United States or, increasingly, to China, may struggle against better-funded competitors, or may simply fail. That is a big loss for Europe.
The need to increase the number of European business angels will hopefully be cured by time, particularly as the startup and scale-up tech sectors in Europe expand, and more European entrepreneurs successfully exit businesses and themselves become angel investors. Additionally, a very constructive role is being played by governmental subsidization and co-investment programs. For example, the tax subsidization provided in the UK by the Seed Enterprise Investment Scheme (SEIS) or Enterprise Investment Scheme (EIS) encourages high net worth individuals to become business angels.
In any case, though, further cross-border angel investment could help to overcome some of the issues associated with national fragmentation.
Facilitating and structuring cross-border angel investment
Organizations like the European Business Angel Network (EBAN) and Business Angels Europe (BAE) are already focused on encouraging the development of cross-border angel investment in Europe, but they face a number of obstacles.
A starting issue is that angel investors have a strong tendency to invest locally for reasons, e.g., of general comfort and business oversight. Consequently, a key cultural issue is the need to persuade European angel investors to take a broader view of what is “local”.
However, there is also the problem that angel investors in different European countries may have differing commercial perspectives and fiscal objectives.
On the commercial side, business angels may be familiar with their own markets but may not be comfortable whether a business has the capacity to scale in other markets.
On the fiscal side, tax and other incentives for business angel investing vary from country to country. For example, early stage investors who are UK taxpayers generally want their investments to qualify under SEIS and EIS, and angels in other countries with tax-incentive-focused schemes (such as Portugal) may be looking for similar advantages.
Additionally, continental European and Irish investors may prefer Euro-denominated investments, whereas UK investors may prefer sterling-denominated investments.
Several years ago I wrote a blog, published by Notion Capital, that described how UK – US cross border equity financing could be made to work. This blog focuses on the UK – other Europe cross-border equity financing, where I think the issues are broadly similar.
So – how can we make cross-border angel investment work in Europe?
1. Choice of holding company
While there may be other options, I think that a UK or Irish limited company continues to be the best vehicle for cross-border investment in Europe and globally. These company forms are broadly accepted internationally (both because all of the documentation is in English and because there is a general level of comfort internationally with UK and Irish company law and courts). UK and Irish limited companies are relatively inexpensive to set up and administer (no need for recourse to a notary, no minimum capital requirements, public filing requirements that are not excessive etc.).
In addition, these structures have a reasonable level of flexibility. For example, it is possible to have multiple classes of shares with differing rights. Indeed, these classes can even be denominated in different currencies.
Furthermore, much of the Silicon Valley legal technology for early stage startups (convertible debt, simple agreements for future equity (SAFE), “reverse vesting” of founder and employee shares etc.) can be implemented in English and Irish companies without much hassle.
Perhaps the one countervailing argument to use of a UK or Irish holding company is that this choice may affect the eligibility of the business for certain types of continental European government-funded venture capital investment or grants. Furthermore, Brexit is an additional complication, particularly where European Union grants are concerned. Given Brexit, use of an Irish entity with a UK permanent establishment could make sense in some contexts, although I’ve only seen very limited use of such a structure.
2. Addressing different investor needs
A key issue one faces in putting together UK and other European angel investors in the same company is that the UK investors typically will want the company and their investment to qualify for SEIS and/or EIS, whereas European angels from other countries will want to structure their investments in a more conventional way.
For UK angel investors, key elements for SEIS/EIS qualification include: (a) that the company have a permanent establishment in the UK (it need not be an English company, but it does need to have a branch in the UK); (b) that the investment be in ordinary shares (or an SEIS/EIS-qualifying SAFE, known as an advance subscription agreement); (c) that the company be in a qualifying line of business (not generally a problem with a tech startup); and (d) that there be a reasonable expectation that the angel will be able to hold the investment for at least three years in order to secure the exit benefits of SEIS/EIS treatment.
Conversely, non-UK European investors typically will want to hold preference shares (or convertible debt, or a SAFE, convertible into preference shares).
There are no tax or legal obstacles to a startup issuing these two kinds of securities at the same time to the different investor groups. However, as a result, UK investors taking ordinary shares will be subordinated to non-UK investors with preference shares.
I don’t think this subordination should be problematic: (a) the UK investor is making a free choice to take ordinary shares (he or she can always take preference shares and forego SEIS/EIS benefits); and (b) assuming a standard 1X preference in the preference shares, the main contexts where the UK investor is likely to be worse off than the European investor are (i) where the business shuts down and has remaining cash (not very likely!); or (ii) where the business is sold for a low price that permits the preference shareholders to recover some or all of their investment but leaves ordinary investor shareholders with less.
In exchange for this subordination, the UK investor gets an immediate tax benefit equal to 30% or 50% of the investment, very favorable tax treatment on exit if the interest is held for three years, and a tax write-off for any loss. I believe most UK investors would find this to be a more-than-reasonable trade-off for subordination.
Except for this preference, the shareholder rights of all of the angels can be generally aligned.
A lot of angel investing is local, and investors value proximity to the startups in which they are investing. However, the definition of proximity can vary widely, and business angels in the US take a much wider view than I typically find in Europe.
I think angel investors should be comfortable if: (a) there is a business- and investment-savvy lead investor who knows the local market, has geographic proximity to the company and can meet with the founders periodically; and (b) there is a lead investor who has the substantive knowledge of the field of activity to assess the international prospects of the business and, after investment, provide useful guidance and introductions.
Particularly in technical areas, such as healthtech and life sciences, these do not necessarily need to be the same individual, and a dual-lead structure may make sense. Relevant technical expertise from individuals who are also prepared to invest is frequently in short supply. Cross-border angel networks with a specialized focus increase the likelihood that experts can both kick the tires pre-investment and help the investee companies post-investment. In turn, this will increase the likelihood of successful investments.
Thus, in an age where (virtually) free video-conferencing and other means of communication are widely available, it makes sense for investors to take a broader view of proximity so long as appropriate oversight can be exercised. Crowd-funding platforms, some of which are angel-led, already operate in this way. Online investor platforms, which match business angel groups and investors with appropriately vetted companies, also can be very useful. Tech London Advocates’ Funding Connector, a volunteer effort powered by the Capital Pilot platform, is one effort to develop such a platform (as is Capital Pilot itself). One of the Funding Connector verticals, which we expect to launch in the near future, will focus on curated healthtech and life sciences companies. I am hopeful that the platform will come to operate successfully on a cross-border basis and facilitate greater collaboration among business angel groups in Europe.
Business angels have a critical role to play in the development of successful European startups. Business angels do not just bring money – they also bring business experience, technical expertise and network that can be invaluable to startups. However, we can only properly leverage business angel networks in Europe if we can organize them to invest successfully on a cross-border basis.
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This discussion is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions or comments, feel free to contact [email protected].
You will find a listing of Bob’s startup and scale-up blogs on US and international expansion and other startup and scale-up matters here: http://bit.ly/StartupGuidesIndex