Trading Conditions for U.K. Businesses

On 14 May 2020, the U.K.’s Office for National Statistics published its latest indicators for the U.K. economy and society in view of the COVID-19 pandemic.

According to the report, 61% of U.K. businesses trading during the period 20 April to 3 May 2020 reported their turnover had decreased to some extent compared with normal and 25% reported their turnover had decreased by more than 50%. More critically, 44% of respondents reported their cash reserves would last less than six months.

Government Assistance Programmes – A Focus on Debt

The U.K. government has launched a number of schemes to assist businesses through the lockdown and beyond. These include the Coronavirus Job Retention Scheme, the Coronavirus Business Interruption Loan Scheme and the COVID-19 Corporate Financing Facility.

Such support is hugely welcome. But, the common thread of most of these schemes is that they require businesses to take on additional debt to mitigate their cashflow issues in the short to medium term.

Voices for Equity

There is nothing wrong with debt financing in principle. Nevertheless, there have been notable calls in recent weeks (including from the editorial board of the Financial Times) for a “new approach to corporate finance” and a shift towards equity financing. The argument being that even viable and innovative businesses can be undone by increased debt burdens and the severe legal consequences which result from technical defaults.

Such calls are largely directed at changes in national economic policy and legal and tax frameworks — for example, removing incentives to rely on debt rather equity, reorienting government assistance programmes towards equity injections and, most revolutionary of all, allowing companies to raise up to 20% of their capital without shareholder approval. These and similar arguments will no doubt play out over the coming months and years.

More practically, for those investors (whether domestic or international) considering making an equity investment, or for companies open to receiving one, it is worth restating some of the key aspects of the investment process for private (non-listed) U.K. companies, particularly in the current circumstances.

Making or Receiving Equity Investment 

No investor will part with their capital without sufficient due diligence on the target company — especially in the context of the COVID-19 pandemic’s impact on business models and operating conditions.

This would usually involve a full suite of legal, financial and commercial due diligence. To move quickly — even more critical in view of the pressures exerted by COVID-19 — directors should (where appropriate, in conjunction with shareholders) collate key corporate and commercial documentation as early as possible to avoid unnecessary delays to any potential investment.

The due diligence period will run in tandem with — and inform — drafting and negotiating the principal investment documentation. At a minimum, this will be an investment agreement (otherwise termed a subscription and shareholders’ agreement) and new articles of association. Both of these documents are extremely important. They set out the protections and safeguards to the investment and regulate the company’s governance structure. Getting these documents right is a critical component of the target company’s future success.

Every equity investment has its unique set of drivers. Due diligence and preparation of the principal investment documentation will reveal target-specific, industry-specific, and market-specific risks and opportunities.

Recurrent legal and procedural issues that all parties — target companies, existing shareholders and new investors — must consider include: 

• How will the equity investment be structured and how will management be incentivised?
• Do the directors have authority to allot new shares and do existing shareholders have pre-emption rights (whether statutory or contractual) that must be disapplied?
• Will new investment trigger any rights under outstanding options or warrants issued by the target company?
• What approvals and consents are required from third parties (e.g. under an existing investment agreement or under the terms of any of the company’s banking facilities)?
• Will the investment result in a “change of control” granting the company’s contractual counterparties a right to terminate key agreements?
• Will the investment prejudice the company’s continued or future participation in any government assistance programmes in the context of the COVID-19 pandemic?

An unfortunate side effect of the COVID-19 pandemic is the escalation of existing geopolitical sensitivities. This has resulted in more stringent regulatory oversight of foreign direct investment, together with increased media and political focus. The increase in protectionism and mutual suspicion is regrettable, but not one that companies or investors can afford to ignore. Depending on investor nationality and the company’s industry sector, parties will need to consider U.K. and international foreign investment restrictions and approval procedures, together with any political issues that may arise from media focus on the investment.

More Than Just an Injection of Capital

Debt is an important tool for companies — it helps companies grow and bridge cash flow problems. In the short term, the COVID-19 pandemic has precipitated the implementation of legal and tax measures that have tended to favour debt financing. But, companies should weigh their options carefully before taking on significant debt and remember equity investment is about more than just capital. Executed well and with the right partnership between target company and investor, it is an injection of knowledge, experience and connections, in addition to capital, to the mutual benefit of all stakeholders.