Workshop: Commercial law: advising start-ups

Clients looking to fund a new venture have never found it easy and often ask their lawyers if they're aware of any readily available sources, expecting that we will have clients looking to gain a better return than simply leaving money in the bank.

With that in mind it is worthwhile keeping up to speed with the current options available to the parties and understanding how they are implemented, especially where there are tax breaks available which might just provide sufficient of a sweetener to an investor to convince him to take a risk in such uncertain times.

This is especially true when debt financing is so tight. Quite simply the banks remain steadfast in their reluctance to lend, despite political pressure, unless they are heavily secured on property or debtors. So, in practical terms, this is unlikely to be an option available to a start-up.

In these circumstances, equity becomes the only option. While initially it may appear expensive '“ since investors will demand a good proportion of the equity '“ something may be better than nothing and at least it is available, albeit with the caveat that investors will be very cautious and choosy about the sectors in which they are prepared to invest.

Alternative lending

High-tech, internet, pharmaceuticals, renewable energy and food remain the investors' 'darlings', whereas funding for construction retail or manufacturing is likely to prove neigh on impossible without heavy asset backing.

Tax driven structures have gained increased importance at a time when income tax rates have increased and the number of legitimate tax shelters have diminished.

Whether advising the entrepreneur looking for funding or the investor seeking to assist a start-up, lawyers needs to be aware of the options available.

For an investor's perspective, backing a new business can be attractive for several reasons:

? Any bank deposits will only be attracting a derisibly low interest rate;

? Properly organised one can achieve tax pre-approval for the investment;

? The upside of the investment can be considerable and the downside can be mitigated;

? In some cases it may even provide an interesting strategy as part of a pension plan.

Seed Enterprise Investment Scheme

One particular tax efficient scheme for small start-ups is The Seed Enterprise Investment Scheme (Seed EIS).

For the new business, Seed EIS is perhaps the most likely to be appropriate for a number of reasons, although there are conditions attached:

? The total limit which can be raised by the investee company is £150,000;

? The investee company can have no more than £200,000 of assets pre-fund raising;

? The trade must be less than two years old;

? The investee company must have less than 25 employees;

? No other state funding must be involved.

There are conditions on the investor too:

? He cannot invest more than £100,000;

? He will receive tax relief at up to 50 per cent;

? As well as capital gains tax exemption;

? Additionally there is a capital gains tax ?deferral and for the tax year 2012/13 there is additional matched gain exemption.

The overriding requirement is for the investor to hold the shares for three years. He also mustn't hold more than 30 per cent of the equity, should be neither a director nor an employee before the share issue, and the business purpose has to pass the 'disqualifying purpose test' (see post).

However what may be The key attractiveness of Seed EIS to the cautious investor is that the downside is potentially totally covered should the business fail

? The investor is a 50% taxpayer

? He has sold other assets realising a gain of £100,000

? He invests £100,000 in a start-up business

? Regrettably the business fails

The result is as follows:

? Income tax relief of £50,000 (100,000 x 50%)

? Capital gains tax exemption of 28,000 (£100,000 x 20%)

? Income tax relief of £25,000 (£50,000 loss ?x 50%)

Thus for the investor his initial speculative investment of £100,000 will produce, even though the business fails, a potential £103,000, which certainly must have its attractions.

Achieving Seed EIS status

A word of warning, not every investment is going to achieve Seed EIS status. Broadly all investment and financial activities are excluded activities - so don't look for practice funding in this way!

The investee company does not need to be UK resident but must carry on a qualifying trade in the UK; it only works for unquoted companies.

Most importantly the investee company cannot be in financial difficulty at the time that the investment is taken in; so it is preferable to source funds at a very early stage before the company runs into any problems.

Also bear in mind that it does not work if the investee company is controlled by another company or a member of the partnership.

The funds have to be used within business within a period of three years of the date of the share issue, although rarely can they be used to enable the acquisition of another company. However benefits can be paid by way of dividends which can be a useful way to get funds back to the investor.

Obviously there is a cash-flow implication if the business fails, and the investor will need to wait before he is recompensed by the various tax credits. But at least from his perspective he will not have lost out financially and can be satisfied that he has tried to help a start-up time in difficult times.

And the upside is that he might just have backed a real winner and enabled someone to fulfil their business ambitions.