Poor Felix. His owner, let’s call him Mr Schrödinger, imagined the little moggy being locked in a steel box with a small amount of radioactive material. As that material decays a dose of prussic acid (think, lethal toxin) is released. The prospects for Felix are not good, but until the box is opened we do not know whether he is dead or alive. Non-intuitively it can be said he is both dead and alive until this point. This teaching is to do with absurdity, quantum theory (wave function particle collapse… as if you needed to be told) and observation.

Similarly, the Future Fund is both a roaring success and an abject failure.

As a quick reminder, the Future Fund is a £250m venture capital scheme to be deployed by the British Business Bank. It allows for convertible loans to be made by the bank in the £125,000 to £5m range provided that: (a) the amount applied for is matched in convertible loans provided by other investors, and (b) at least £250,000 of equity funding has been raised previously.

The scheme was originally announced on 20 April and between the announcement and the roll-out, there has clearly been much work undertaken in refining the terms, establishing FAQs and importantly laying down the eligibility criteria (all of which can be found here).

In terms of success, it would be churlish not to recognise the Government’s attention and support of the UK’s growth companies. Achieving a twofold oversubscription on day one of the scheme is by any measure substantial. Further it is noteworthy that the end-product (as of 20 May) is largely consistent with the original announcement. There have been no U-turns, embarrassing gaffes or changes of policy. This is additionally borne out by the form of convertible loan agreement which dutifully reflects the heads of terms published on 20 April. This is especially pleasing for me, as my assessment of those terms (which can be found here) remains relevant.

What has become clearer in the intervening period is the process. The application is made by the lead “matched funding” investor and the convertible loan terms cover both the matching investors and the Future Fund. The fact that there is one set of agreed terms means that initial concerns as to matching separate agreements with potentially differing terms is no longer germane. Another benefit is that the Government appears to be relying on diligence undertaken by the lead investor and therefore this should expedite a decision to invest and release of funds.

There are drawbacks. As with any lending document, the drafting of a convertible loan is customarily proposed by the lender. In normal circumstances the borrower (typically represented by the founder(s)) would then be engaged in a negotiation (even if limited) over the terms. Here the terms are pre-set, so there is to be no negotiation. In this way, the UK Government has clearly opted to wear the shirt of the VC team. Some say that this is an inevitable consequence of its role as a lender, but others may suggest that the Future Fund is to promote start-up business and that role should be undertaken without taking sides.

Reliable data is difficult to find as to how many growth companies have considered the Future Fund and have decided to walk away. Below are some of the experiences and thoughts of our own clients.

The reasons are worth noting, not only for would-be applicants, but looking forward too. The Chancellor of the Exchequer confirmed on 18 May that the Government would be “more than happy” to expand the scheme if demand outstripped the initial money allocation. We believe that Future Fund v2.0 may come with some adjustments.

With the prior funding requirement of £250,000 (and with the matched funding requirement being a minimum of a further £125,000, so a total of £250,000 new loan funding) the Future Fund is clearly aimed at start-ups that are beyond the initial seed stage. This leaves a sizeable gap between the Future Fund and the Start-up Loan scheme which has an upper threshold of £25,000. Further, it is argued that VCs ought to be supporting their portfolio companies with their own funds, and the Government is merely using precious taxpayer’s funds to cover the gap vacated by, or diminishing the exposure, of those VCs.

There are some very good reasons why the eligibility criteria are pre-set at the early scale-up level, though government support at this stage has been the subject discussion for a long time and it is not obvious why this necessarily needed to be implemented as a crisis measure. There is little doubt that the challenges have increased over the last months, but is it any worse than other sectors? Conversely if one takes aim at too many targets, then you are likely not to hit any of them.

What we do know is that the Government is considering other measures concerning long term advancement of R&D tax credits for those businesses more at the seed level, perhaps with a stapled warrant. Given that HMRC already has the data on previous credits given, this could be executed fairly quickly and has the additional benefit that this amounts to a credit rather than an investment or worse a bail-out. The warrant gives an upside participation too.

The prior funding requirement relates to the day before the original 20 April announcement. There are some unfortunate consequences of this. More than one of our clients had immediate funding requirements in April and could not wait for a prolonged roll-out. Taking the funding from 20 April onwards has led to that new funding being considered ineligible in terms of satisfying the pre-19 April funding requirement. This seems to be unintended and unfair.

A major hurdle is that the Future Fund and importantly the structure that it requires of the matched funding is not EIS/SEIS compatible. More than one half of UK start-up funding is generated from private individual, angels, HNWs, family offices and bespoke (S)EIS funds, all of whom are claiming the EIS or SEIS relief (on income tax). This pool of potential funding is inaccessible to those companies wishing to use the Future Fund.

Its architects have argued that to do otherwise would have led to a delayed roll-out, owing to navigating state aid difficulties and the need for implementing legislation. A more philosophical take is that if relief were to be offered alongside co-investment the UK taxpayer would be over-exposed to a given investee. In any event the press is widely reporting that the Government regard this issue as being “very live”. Make of that what you will. It could well be that the Government bolsters existing angel programs as a separate measure though at the risk of adding more complexity to its already-tangled web of start-up support packages.

Note also that investment at an early stage often originates from founders and their connected persons. The eligibility criteria require that both the prior investment and the matching investment must be undertaken by third party investors. Deep in the weeds of the Investor FAQs we learn that founders, employees and their connected persons are not eligible for matching. We have been asked about nominee structures and shielded contributions via crowdfunding structures, but this is a thorny path given that the satisfaction of the eligibility criteria is specifically dealt with (by warranty) in the convertible loan agreement. A shame, and particularly given that there is good data showing that repeat founders (who are more likely fund their new venture at the early stage) have a far greater success rate.

I also noted in my previous article that HMRC has somewhat neutered the ability of start-ups to raise (S)EIS compliant capital by ASAs at any point beyond six months prior to an equity financing round. We have heard suggestions that this guidance may be less rigorously followed in current circumstances, but an official statement (or updated guidance) would re-open that pool of potential investment in difficult times. ASAs are not eligible for matched funding so there would be no concern about how to match them up with Future Fund terms.

Though I have written about this previously, an article such as this must reference the redemption premium (defined as such in the convertible loan terms). If conversion does not occur 2x the principal of the loan plus interest is repayable 36 months from the date the agreement is signed. In most other commercial agreements (other than a lending document) such a large and disproportionate sum would likely be considered as a penalty. Pre-crisis, this was not even a standard term in VC-friendly convertible loans. It gets worse. The interest rate (proposed at 8 per cent.) and the discount rate (relevant to the conversion price and proposed at 20 per cent.) are not hard-wired into the standard terms, thereby suggesting that they are capable of being changed. This is not the case for the redemption premium. Some clients are prepared to accept this in the hope that it will never apply (as the loan will convert), but several have walked away from these arrangements citing this as a factor. Of course, the VCs get the same deal as the Future Fund.

Note also that there are UK–specific requirements to the Future Fund.  These have consequences. One is that the start-up must be a UK-registered company. That may sound uncontroversial, but some UK companies which undoubtedly represent UK success stories are required by initial investors to establish overseas, for example to participate in Valley-based accelerator programs.

There is an additional requirement for businesses to have either at least half of its employees be UK-based or at least half of its revenues from UK sales. Hmm… This is somewhat at odds with Project UK, that is the marketing to overseas founders to establish in the UK to access key skills and finance. No loans 4 U.

There is no doubt that the Future Fund is a step forward in terms of focus on the start-up market. We don’t yet have much data on how funds will be distributed. It’s unclear whether this will be on first in, first out basis, though I suspect that the Government will take steps to deploy funds as even-handedly as possible.

There are also questions about who the Government will field to look after its interests and whether debt/equity participation is the right solution here. But that’s for another day.

Have I challenged the orthodoxy of quantum mechanics? Maybe not. In the meantime, let’s check on Felix. Ohh…