‘Just one more, wafer thin… EIS round’ – Considerations for EIS investors to help portfolio companies avoid the EIS trap
Dr. Ilian Iliev discusses EIS investment strategy in a feature article for AngelNews’ EIS and VCT September Newsletter. You can read the featured article below, and the full newsletter is available to view from here.
‘Just one more, wafer thin… EIS round’ – Some considerations for EIS investors to help portfolio companies avoid the EIS trap*
There is broad agreement that EIS investment is a key part of the UK early-stage investment scene. Later stage VCs in part depend on this ecosystem to ‘feed’ investment ready companies for scale-up, be it late Series A, B or growth finance. Yet, surprisingly, relatively few high-growth startups make the cross-over from EIS investors to institutional investors. From our perspective, as an investor focused on the gap between early-stage investment and scale-up funding of innovative companies, we are frustrated to see very interesting and exciting EIS-funded companies who end up in the ‘EIS trap’. By that I mean otherwise promising companies saddled with structural issues, at least in part related to an EIS investment strategy, which have not been resolved prior to seeking scale-up funding. I want to share here some thoughts about how EIS investors can either help companies avoid this ‘EIS trap’, or at the very least identify such risks before making an EIS investment.
Follow-on investment and the danger of “EIS stacks”
A worrying situation we have seen many times is where a company keeps stacking EIS round upon EIS round to reach ever closer, but never reached, business milestones. In such situations, the company may be unable to access required scale-up funding because there’s ‘just a little more’ needed to first sales, prototype launching, or that initial commercial partnership – another EIS round becomes the only way forward. The issue is that stacking EIS round upon EIS round may well make the company difficult to fund by institutional investors at a later stage where there are no EIS tax benefit to consider, as I’ll elaborate on later in this article. Multiple EIS rounds also raise questions about the management team – how many times was the business plan revised, and what measures have the investors taken after the 2nd, 3rd or 4th time the milestone deadline was missed?
Due diligence beyond the EIS Assurance letter
The risks outlined above are heavily related to the general risks of being an early-stage investor. However, specific EIS tax break dynamics can sometimes act as a veil to detract from the type of analysis that investors (or their advisors) ought to be undertaking anyhow. It’s not unusual for an early stage company to have an underdeveloped management team, some technology risk and unclear routes to market, but what differentiates a well-run seed stage company from others is whether they have an honest and pragmatic business plan that recognizes and accounts for these risks.
For companies that were not built on solid foundations, cracks will come to the surface when follow-on investment is required. Not dealing with such weaknesses upfront, in a direct and honest manner, may result in follow-on funding becoming difficult to find without undermining any benefits gained from early investment.
Time is the enemy: Every delay or false start in getting to a Series A or B scale-up investment round means the company potentially misses out on early entrant advantage and start-up momentum, but also that the early investors are diluted further through subsequent mini-rounds. The risk then is that by the time an exit happens, the initial EIS holding will be worth a fraction of that expected from the initial business plan.
‘Electoral Roll’ shareholder register risk: There’s another risk that we can call the ‘Electoral Roll’ cap table, where there is a very long list of shareholders that have come in through different investment rounds. While sometimes such dispersed shareholding is well represented by an investment director, different groups or cohorts of EIS investors may have different interests. This risk can be mitigated when there is a nominee structure in place, such as through the custodian acting for an EIS Fund, with some clear investor representation.
Excessive early stage valuation: Anecdotally, we have observed early stage companies that have attracted EIS funding at what we would consider a very high valuation. One could speculate that in part this is due to the lower valuation sensitivity by some EIS investors, either because they are putting in only a small amount or perhaps feeling a ‘pressure’ to deploy their EIS-able funds. Either way, an excessive valuation at the early stages of investment spells trouble for the future, as the company’s management team must work that much harder to justify an up-round. This can lead to an EIS trap; another EIS round can be more attractive than introducing an institutional investor who may demand a lower valuation or preferential share structure.
Risk mitigation strategies
There’s no black magic in successful venture investment, just common sense. Here are a few straightforward suggestions for EIS investors (and their advisors) to move beyond a primary focus on the tax breaks that EIS investors receive, and towards a fundamentals-focused analysis.
· Due Diligence and opportunity cost: If you are investing in an individual company, act like an investor. When analyzing an EIS investment opportunity ask yourselves some questions as if the tax break were not there: Why invest in this and not another investment opportunity? How will the business be funded through to exit? Indeed, what is the exit strategy?
· Piggy-back on larger investors: If you lack the time for deep due diligence, a good way to manage the risk can be to find partners that you already have faith in to lead your EIS investment. This can be in the form of a syndicate led by a trusted investor, or even through a respected fund with a specialized EIS fund offering. Do not be afraid to ask for the due diligence pack or to have a conversation with the investment lead – keep in mind that all investors like to talk to see if they’ve missed a trick!
· Look for multi-round capacity in investment leaders: It is key to focus from the outset on the full investment lifecycle of the company – it’s not just about the current round, but whether investors around the table can support if the company hits a rough patch. An investment lead such as well-endowed angel group, an institutional VC or corporate VC which help the company through multiple rounds can be invaluable.
This may seem all doom and gloom, with the reader asking – why on Earth should investors expose themselves to these risks over and beyond the hazards already present in VC and Angel investing? The answer is simply that these risks can be successfully managed and mitigated with fundamental processes that already form the backbone of good investment practice. With this mindset investors can make the most of the opportunities EIS offers, and result in successes for both investors and company alike.
* Disclaimer: The information and opinions within this article are for general information purposes only, are not intended to provide an exhaustive summary of all relevant issues or to constitute investment, tax, legal, or other professional advice. They should not be relied on for, or treated as, a substitute for specific advice relevant to particular circumstances and you should seek your own investment, tax, legal or other advice as appropriate. In not doing so you risk making commitments to products and/or strategies that may not be suitable to your needs. Neither the writer nor EMV Capital Limited accept any responsibility for any errors, omissions or misleading statements in this article or for any loss which may arise from reliance on materials contained on this article.