Startup investors can get tax relief AND liquidation preferences

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[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.

Today he tweeted about something he’s found out concerning liquidation preferences.

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.

  • Danvers

    Not sure that this can be done with “practically no dilution to the entrepreneur” because clearly the whole point of a liquidation preference is to give more back to the investor than otherwise would have been the case. I would also be interested to know if any of investments in question have progressed to a further round of funding and, if so, what has happened to the share rights at that point.

    I am not saying this cannot be done, because clearly it has been and I would rely on the advice on my colleagues who specialise in tax law. But in these straightened times, it is likely that HMRC will not look so kindly on such arrangements, which would appear to fall into the “catch all” wording in their own guidance:

    “They must be ‘full-risk’ ordinary shares, with no preferential rights to dividends, or to the company’s assets in the event of a winding up. There must also be no arrangements to protect the investor from the normal risks associated with investing in shares, and no arrangements for the shares to be purchased by anyone else after the end of the relevant period. ”


  • Ed French

    We’ve seen this structure increasingly become popular. Personally I like the” only-one-class-of-shares” simplicity, and in my view this is much more entrepreneur friendly than most downside protection mechanisms.
    I have seen this structure persist through subsequent funding rounds. Of course if the company and existing investors have a poor negotiating position then incoming investors can put in debt or preference shares to hold their liquidation preference ahead.
    In my view these are still “full risk” ordinary shares, I’ve never heard of the approach being rejected for EIS relief?

    • Danvers

      @Ed – I am not suggesting HMRC are currently rejecting this approach and I agree that the simplicity is great – one class of share is always going to improve the chances of EIS relief being granted. My point was simply that in times when the HMRC are trying to boost revenues they might take a more stringent view of this sort of arrangement which has the same economic effect as a liquidation preference for the investors only – so it could be construed as a “preferential right”.

      The irony is that it has nothing to do with the “risk” element of the shares (the company fails, the investors are unlikely to recover anything), but all about improving the “reward” side.

      Personally, I don’t really like the concept of the liquidation preference (my clients tend to be the entrepreneurs and companies, so I would say that) as it just tends to mask what would otherwise be a lower valuation.

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  • Jens

    I think what William is saying is that in this case, there is in fact no ‘liquidation preference’. Essentially, everybody gets paid back what they paid in, I assume pro rata, but based on the percentage holding.

    What this means is that every share gets paid a percentage of the exit amount, based upon the nominal and share premium value of the shares. Once the total combined nominal and share premium have been paid back to shareholders, the remaining exit amount is distributed according to number of shares.

    This is similar to what is called a ‘participating preferred’ structure but with the twist if just one class of shares, not two, and in addition, all shareholders get money at the same time, but skewed by share premium value.

    Very very neat! Great solution.

  • Tom Allason

    we used this in Shutl’s angel round… is very fair on all parties including entrepreneur (most liquidation prefs you encounter will be > 1x)

  • Alastair Walmsley

    I too have seen this used successfully on a number of my clients. I agree with Ed’s assessment, although there is another benefit which VC’s very often forget – the liquidation preference is “off balance sheet”.

    Loan Notes and Prefs all sit as very large, ugly liabilities on the balance sheet. When start-ups come to commercialise their proposition, one of the greatest challenges they face is getting a larger enterprise to buy it. One of the first things corporate purchasing departments will do is pull the accounts; they see a large negative net asset position caused by the Loans Note/Prefs and this is a major negative.

    Under this method (which I know as “Premium Protection”, BTW!), the liquidation preference is not shown on the balance sheet. This is generally of much greater long-term value to all concerned as it is increasing the likelihood of the business succeeding!

    I think this is a neat compromise between plain vanilla ords and “ugly” Loan Notes/Prefs!

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  • Bez BIK

    Good article. Yours

  • Toya Pilkins

    Oh, man! What a bummer! Where do we go now? Thanks for the brain storms. It hasbeen fun to let it all hang out. This was a no-holds-barred mental jamboree that willbe missed.

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