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Finance and funding

Equity funding

Any business is on a more secure financial foundation if it has funding sourced from permanent capital as distinct from borrowed money which must be repaid and until repaid carries interest.

This section deals with funding by permanent capital as distinct from borrowing. The following are considered:
* Nature of permnanent capital and equity funding
* Sources of equity funding
* Tax incentives for equity investment
* Legal aspects of issuing shares and debentures including regulation of financial     promotions and public offers

Legalese comment: due to the regulation and complexity of the public offer, it is highly desirable to obtain legal advice before seeking to raise funds in t his way. Legaleze has experience in this area; try our Legaleze Direct Services. Premium members may access our Guide to company fund raising.

What is permanent capital?
In its broadest sense, permanent capital is the money invested by the proprietors of the business to enable it to start trading, to provide working capital or funds to buy assets or expand the business, with the intention that the funds remain in the business until the business is closed or the business no longer requires ther capital and returns it to the proprietors. This applies whichever legal form the business takes, e,g. a sole trader, partnership or limited company.

However, this section is concerned with businesses trading as a private limited company. This type of business organisation has the ability to issue shares to investors in exchange for money paid to the company as part of its permanent capital. Shares normally represent permanent capital in the sense that the funds paid to the company by the original shareholder will not generally be repaid to the current shareholder until the company is wound up or the company is in a position to return the funds because they are no longer required.

The rights attached to shares are defined in the articles of association of the company. The most common type of share are "ordinary shares" which have the right to participate in profits of the company declared by the directors to be available as a dividend, the right to vote on a one vote per share basis and the right to share in the company’s assets available after payment of debts when the company is liquidated.

Shares are usually transferable so long as they are "fully paid", i.e. the investor has paid the full price of the shares to the company.

A company may create more than one class of share, each class carrying different rights. For example, a company may issue "preferred ordinary" shares which may carry the right to participate in profits in priority to the ordinary shares. "Preference shares" may carry the right to participate in a fixed percentage of profits in priority to the ordinary shares, but no right to vote unless the dividend has not been paid.

In more complicated share structures, it is possible to create a special class of "redeemable" shares on which the issuing company will repay the capital after a fixed period or upon certain conditions. This is not the same as a loan because under company law, a company cannopt be compelled to redeem shares unless it has adequate reserves.

Debentures are legally a form of a loan because most debentures are repayable by the company after a fixed period. However, they are usually transferable and may be regarded as permanent or long term capital, particularly if they are not repayable for a long period. Some companies do in fact issue debentures which are "irredeemable" i.e. are not repayable unless the company is wound up. One major distinction from shares however is that interest (at least if at a commercial rate) payable on a debenture is deductibel from taxable profits, whereas dividends on shares are paid out of profits after tax.

Sources of equity investment
Apart from the traditional "family and friends", there are various sources of potential investment.
"Private equity" and venture capital firms generally invest in established businesses rather than startups. There are networks of "angel" investors who are willing to back early-stage businesses, particularly in an innovative or high-tech area. In connection with the latter, information is available from Nesta.
A relatively new concept in this field is "crowd funding" i.e.connecting via the internet with relatively large numbers of investors individually investing small amounts.
The range of sources is large; this will be revealed by internet searches for "private equity", "venture capital", "business angels", "crowd funding" etc. See for example:

http://www.ukbusinessangelsassociation.org.uk
UK Business Angels Association members are formally structured business angel networks with an active involvement in raising equity funding for SMEs. Only registered BBAA Networks have agreed to abide by our Best Practice Code of Conduct and Disciplinary Procedure. A list of Angel Networks to whom applications for funding may be made is available.

http://www.crowdcube.com
Crowdcube claims to be the world’s first equity crowdfunding website. The minimum target amount which companies may seek is £10,000. There is no maximum target but the 'optimum' range is up to £150,000. Crowdcude.com t is authorised by the Financial Services Authority (FSA).

http://seedrs.com
Open for business since July 2012, Seedrs is the first fully FSA authorised online platform for investing seed capital in UK start-up companies. It enables investors to invest in start-up companies seeking to raise up to £150,000 by the issue of ordinary shares

Legaleze news item:
17/08/2012: FSA warns about Crowdfunding.

The legal and tax implications of any fund raising should be carefully researched; see below.

Tax incentives to equity investment
The Enterprise Investment Scheme and the Seed Enterprise Investment Scheme are important tax incentives designed to encourage new share investment in small and medium sized companies. See Tax for further information.

Legal aspects of issuing shares and debentures including regulation of financial     promotions and public offers

Contractual liability and misrepresentation
The issue of new shares or debentures by a company to an investor will be based on a contract. The simplest form of such a contract will be an application form setting out the amount and price of the shares or debentures applied for and the name and address of the applicant. Normally  however there will be additional terms and conditions of the offer.

The terms and conditions will deal with any conditions which must be met before the shares or debentures ("securities") may be issued (e.g. a minimum amount which must be raised) and the timetable for issuing the securities. In cases where the investors require certain assurances from the company before investing, and in the case of offers of securities to the public (see below), the application form will be accompanied by an offer document which contains detailed information about the company and its financial status. Depending on the nature of the offer and the negotiating strength of the investors, the information given in the offer document may be "warranted" i.e. the company promises that it is accurate. If it transpires that the information was not accurate, the investors will be entitled to compensation for any loss suffered and, if the inaccuracires are in law fundamental, the investors may be entitle to rescind or cancel the investment and have their funds returned (assuming the company is solvent).

Even if the information about the company in any offer document is not warranted, under English contract law, if a person is induced to enter into a contract by a misrepresentation, he may be entitled to recover damages or have the contract set aside. A misrepresentation is a statement of fact which is false. The representation must be one of fact rather than opinion, but a statement that a particular opinion i held when it is not may amount to a misrepresentation.

From the point of view of the issuing company, it will usually be advisable to make any offer to issue securities subject to terms and conditions which limit or exclude any liability for the accuracy of information, and to put the risk of investment entirely upon the investor. This may be achieved by including detailed disclaimers of liability and t o deny any liability for misrepresentation. The company will still be subject to the law on misleading statements, financial promotions and public offers (see below).

The detailed rights and obligations attaching to the shares will be set out in the company's articles of association. In the case of debentures, the rights and obligations will not normally be set out in the articles but in a separate debenture instrument.

Misleading statements
Regardless of anything stated in an offer document, in relation to an offer or sale of shares or debentures, it is an offence under the Financial Services and Markets Act 2000 s.397 for a person to make a statement, promise or forecast which he knows to be misleading, false or deceptive in a material particular, or to dishonestly conceal any material facts whether in connection with a statement, promise or forecast made by him or otherwise, or to recklessly make (dishonestly or otherwise) a statement, promise or forecast which is misleading, false or deceptive in a material particular.

Financial promotions
There are regulations which prohibit any person from issuing a “financial promotion” i.e. communicating (even if not to the public) an invitation to buy shares or debentures (Financial Markets and Service Act 2000 s.21) unless the communication is exempt or is approved by a person authorised by the Financial Services Authority.
If an investor suffers loss as a result of an unlawful promotion, he may be entitled to cancel the investment and/or to compensation.

There are certain exemptions from the prohibition on financial promotions, subject to strict conditions, such as those mentioned below:

*High net worth individuals (who can certify they have a specified income and/or net worth);

* Sophisticated investors and "Self-certified" Sophisticated investors (who are certified, or in some cases self-certify, that they have previous experience of a minimum amount and type of investment);

* One off financial promotions (communication of an invitation to invest to a small number of persons on a one to one basis and not as part of an organised marketing plan).

The above exemptions are contained in the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 and are subject to strict conditions.

Public offer of shares by a private company
A private limited company may not raise funds by making an “offer to the public” of its shares or debentures. This is a right exclusive to a public company (Companies Act 2006 s.755), although a co-operative society (see Co-operatives) may also issue shares to the public.

An offer to the public includes an offer to any section of the public, however selected. However, an offer is not regarded as an offer to the public if it can properly be regarded, in all the circumstances, as:
* not being calculated to result, directly or indirectly, in securities of the company becoming available to persons other than those receiving the offer; or
* otherwise being a private concern of the person receiving it and the person making it
(Companies Act 2006 s.756).

There are certain exceptions which allow an offer to be regarded (unless the contrary is proved) as being a private concern of the person receiving it and the person making it if it is made to a person already “connected” with the company or it is an offer to subscribe for securities to be held under an employees' share scheme.

Public offer of shares or debentures requiring a prospectus
It is unlawful for 'transferable securities' to be offered to the public in the United Kingdom unless an approved prospectus has been made available to the public before the offer is made (Financial Services and Markets Act 2000 s.85).

'Ttransferable securities' are defined in Directive 2004/39/EC of the European Parliament and of the Council on markets in financial instruments], but there are excluded money-market instruments for the purposes of that directive which have a maturity of less than 12 months.Legaleze comment: in practice this definition catches any shares or debentures which are transferable.

The prospectus regime is quite separate from the Companies Act and the definition of “offer to the public” is very wide and different from that in the Companies Act. There is no exception from this definition for offers of a private character (see above: Public offer of shares by a private company).

There are certain exceptions from the requirements to produce a prospectus, including an offer:
* made to or directed at “qualified investors” (i.e. certain professional investors) only;
* made to or directed at fewer than 150 persons, other than qualified investors, per EEA State;
* under which the minimum consideration which may be paid by any person for transferable securities acquired by him pursuant to the offer is at least 100,000 euros (or an equivalent amount);
* under which the transferable securities being offered are denominated in amounts of at least 100,000 euros (or equivalent amount);
* the total value of which is less than 5 million euros (or equivalent amount) taken together with any other offer of the same class of securities by the same person which was open in the previous 12 months.

Tax considerations
Two important incentives designed to encourage equity investment in small and medium sized companies companies are EIS and SEIS. These incentives provide special income tax deductions, capital gains tax and loss relief for investors who subscribe for new shares issued by certain unquoted small or medium-sized companies: (EIS) and in very early stage small companies (SEIS). Where appropriate, the rules for these reliefs should be checked when arranging an offer of shares. For further information, see Tax incentives for investment in shares.

Enforcement of regulation of invitations and offers
Civil enforcement: an investor who suffers loss or damage as a result of any unlawful financial promotion, breach of the prospectus requirements, breach of contract or contractual misrepresentation or any misleading statement or omission as described above may be entitled to recover compensation or damages, or alternatively may be entitled to rescind (i.e. cancel) the investment.
Criminal enforcement: the making of an unlawful financial promotion is an offence, punishable on conviction on indictment, to imprisonment for a term not exceeding two years or a fine, or both (Financial Services and Markets Act 2000 (FSMA) s.25). There is a defence ifr the accused shows that he believed on reasonable grounds that the content of the communication was prepared, or approved for the purposes of section 21, by an authorised person; or that he took all reasonable precautions and exercised all due diligence to avoid committing the offence.
The making of a misleading statement or omission as described above is an offence punishable on conviction on indictment, to imprisonment for a term not exceeding seven years or a fine, or both (FSMA s.397).
There is provision for Director’s criminal liability regarding these offences.
It is an offence to make an offer of shares or debentures in breach of the prospectus requirements punishable on conviction on indictment, to imprisonment for a term not exceeding 2 years or a fine or both (FSMA s.85).

[ Page updated: 15/02/2013]

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