How many of you have bought shares in a company which have benefitted from the EIS scheme? Now how many of you have bought further “follow on” shares in that company, EIS or otherwise? Not many is the answer and there are a couple of reasons for that.
First of all, EIS investors tend to view those investments as long term punts that give them a nice tax break in year one with other lovely tax benefits in the event that the company provides a decent return on equity. If it all goes to pot, which most EIS investors realise is a significant possibility, at least they only had 38.5p in the Pound at stake, so all is not lost.
For that reason, most EIS investors like to take a portfolio approach and not have too much concentrated in a single company. That way, the chances of the finding the company which gives them a 100x return (or even the 1,000x return if they are really lucky) is increased. When investors are asked to put further capital into an existing EIS investment, therefore, they are generally reluctant to do so and use up their “pot” for investing in that financial year.
Secondly, founders do not want to give away too much of the equity in their business too soon, and particularly not to EIS “angels” who will not necessarily add as much value as a larger institutional investor. Also, founders recognise that the share valuation at a Series A raise will be significantly higher than if they have to do a bridge round (not to mention the legal and introduction fees that it will be charged for that round).
These factors mean that there is often a cash crunch for early stage companies in the run up to their Series A rounds, a time when it is imperative that the company’s story remains coherent and persuasive to institutional investors at they strive to achieve the necessary KPIs. A cash squeeze at a critical time in Series A negotiations can mean the difference between a great valuation or a weak one for existing shareholders, or even a failure to raise funds altogether.
While acknowledging that each case is different, we think that the cost of a bridge round of equity can be anything from 100-300% of the money raised, often for a very short period of time. To give an example, we know of one company which issued £300,000 of shares to existing angel investors to bridge itself to Series A following which those shares were worth £900,000. To put the equivalent debt into perspective, a loan for the same period would have cost 12-15%, including arrangement fees.
Why do companies and their directors make these seemingly irrational decisions? Probably it is a combination of factors but the main ones are lack of information and transparency regarding the available options, pressures from significant shareholders who are aware of this arbitrage and wish to profit from it at the expense of founders and smaller shareholders, and the time pressure and stress that a large fund raise puts on management. These all lead companies to take the “easy” route, at significant cost to the shareholders who do not/cannot participate in the share issue.
What we are trying to do is encourage companies to consider the true cost of raising equity, and compare that against bridging debt products like those offered by Finstock Capital which we feel offer better value for companies and their shareholders.