• Jonathan Tam, Director |

3 min read

Treasury answers small business’ SOS

As part of UK Government’s initiatives to keep businesses afloat during the current period of economic disruption, the Chancellor announced in April 2020 an investment scheme to issue convertible loans between £125,000 and £5 million to help innovative companies. In November 2020 in view of a second national lockdown, the Government announced an extension of the Future Fund co-investment scheme until 31 January 2021.

With business disruption from the pandemic lasting longer than many businesses anticipated, start-ups will be relieved to receive additional support to help them extend their runways and protect jobs until the economy begins to recover. The Future Fund’s convertible loans benefit from interest income in the short term while retaining the potential upside of equity should the business be successful.

However, if you have already taken advantage of the Future Fund investment scheme, or are thinking of applying, there are a number of important factors to bear in mind. 

Investors will want to understand the value implications

For the companies borrowing from the Future Fund, the borrowings must be matched by co-investment from third party investors.

The inclusion of debt funding in the company’s capital structure will have the effect of lowering its cost of capital, which theoretically should increase the enterprise value of the business. However, the funding is short-term in nature (36 months), and the companies borrowing from the Future Fund are unlikely to be generating positive cash flows in the near term. Therefore, realistically, the benefit of leverage from debt funding is unlikely to be realisable in this case. In fact, the debt liability might create a drag on value, particularly given the 100% premium payable on redemption. The alternative – closing up shop – is significantly worse.

Third party investors will no doubt want to understand the value implications of Future Fund borrowings not only from an economic perspective, but from an accounting perspective as well.

Accounting and measurement of Fair Value of convertible loans

Under IFRS, depending on the agreed terms of the convertible loan, the conversion option could give rise to a separable embedded derivative (whereby a fair value may need to be calculated periodically).

Where the accounting treatment recognises a host loan, the initial measurement of the liability component of the convertible loan would be at fair value, and may be determined by an income approach, i.e. discounting the future cash flows of the bonds (accrued interest and principle) at the rate (or bond yield) of a similar debt instrument without the conversion option. If an embedded derivative is recognised, one would typically value the conversion option using a binomial lattice model or Monte Carlo simulation approach, since the Black-Scholes model would be inappropriate given the terms of the conversion option. An option may also exist to measure the whole instrument at fair value. The treatment may differ under UK GAAP FRS 102. However, fair values may still be required. Other potential issues that may arise include consideration of transaction costs and deferred tax implications.

Depending on the determination of accounting treatment, the key valuation judgment areas for initial and subsequent fair value measurement will be:

  • The discount rate (including consideration of the credit worthiness of the company) to apply to the loan cash flows i.e. a reasonable borrowing rate for the company; and
  • The equity value of the company (including price volatility).

While a recent funding round might provide an indication of the equity value, if the company plans to raise new capital prior to the maturity date of the loans, an updated equity valuation will be required in order to value the convertible loan for reporting purposes. In the current market environment, particularly in certain sectors where long-lasting structural shifts are expected even after a return to normalcy, it is paramount to have a robust valuation that reflects the changing business environment with an aim to reduce the variance of the impact on profit and loss.

If you have participated in or are considering applying for this investment scheme, it is imperative to consider the points above and the impact it may have on your capital structure and financial reporting. KPMG has a team of specialists offering accounting, tax and valuation advice. If you want to discuss any of the considerations discussed in this article with KPMG’s valuation experts, please get in touch.