[UK] William Reeve is one of the most experienced Internet entreprenuers and investors in the UK.
Just check out his speech at GeeknRolla this year.
This is basically the procedure for paying investors off in a sale or winding up of the company. It’s the ‘protection’ VCs or Angels expect to have as a baseline of any equity investment.
What he’s found out is this: that it is possible to give investors Enterprise Investment Scheme tax relief *and* liquidation preferences.
EIS is designed to help smaller higher-risk trading companies to raise finance by offering a range of tax reliefs to investors who purchase new shares in those companies).
The upshot of this is that if it’s easier for investors to protect themselves via this method, they will be more likely to invest. And that’s good for startups.
I asked him to elaborate. He doesn’t have time to blog for us right now, but I asked his permission to reprint his email, so here it is below.
It is quite a serious issue as there are lots of investors who believe that you can’t have EIS (which is a very worthwhile tax break for UK tax payers) and get liquidation preference (under which investors get your money out first if things go bad; often there isn’t any left, but it is still comforting to know that in a firesale you’ll get something, and in any case you don’t want the entrepreneurs making any money if you haven’t got all your cash back first).
The reason for the misunderstanding is that one of the conditions of EIS is that you can’t have ‘preferential rights’. So the most common way of doing liq pref, which is to have two classes of shares only one of which gets liq pref, isn’t EIS-compliant.
But there is a way of giving all shares the same rights as each other, in a way which has near-identical outcomes to liquidation preference. Which is basically to design it so that everybody gets their original ‘subscription’ (in the legal parlance) back first and then the rest is divvied up after that (this is a simplification but it’s still correct to say this). The founder shares, or sweat equity, are issued at par e.g. £0.01p per share, so the entrepreneur gets his pennies back too, but the investors (who buy shares at £1.00 or £10.00 or whatever per share) get their investment back with practically no dilution to the entrepreneur.
The lawyer who does this a lot is Gordons LLP. They have done this for me 2-3 times. It works. They call it the ‘Elderflower approach’ or somesuch after a Mrs Elderflower who first figured it out. Lots of lawyers, particularly the ‘US implants’, don’t know you can do this and so they tell everybody you can’t and it muddies the waters.