Startups and debt (VI): Vendor finance, crowdfunding loans and initial trade offerings
In the previous five articles in this series (see here) we saw the reasons and setbacks associated with startups’ exclusive dependence on equity, and the advantages of debt, in what is also a favorable scenario for debt. We saw the difficulty to provide general recipes for getting debt and a few not very promising routes for startups. And looked at venture debt as a suitable mechanism for startups. Together with discussing the importance of security interests and of thinking up ways of using new intangibles, and in the latest article we suggested pledges of future revenues.
Alongside all these mechanisms, the company needs to put effort into getting vendor finance; by this we mean not so much the possibility for the company's advisors and stakeholders to be paid in shares (although that is a financing mechanism to be considered) as the obtaining of what is actually trade credit.
Here again, providing legal security is important to give the counterparty confidence that they will recover the value of the good or service provided. Where tangible capital goods are involved, it is always worth considering classic finance lease mechanisms along with others associated with asset financing. The security lies in retaining ownership and the ability to regain possession of the good until the deferred payments have been collected.
Where the arrangement involves services rather than goods there are added complications because the provided service may not leave behind any recoverable or realizable item of property. Although it will have to be seen how far the service may give rise to any of the intangible rights we described in point 9 above and so form the basis for a security interest or retention of title.
Crowdfunding is another option worth mentioning. The general public are familiar with crowdfunding platforms connecting large numbers of small investors with businesses seeking to complete innovative projects, and organizing financing transactions, usually in very large numbers for very small individual amounts which add up to provide the funds needed by small and medium-sized businesses.
Crowdfunding is a new form of investment that has aroused a great deal of interest in recent years. See also on this subject the European Commission's proposals to open up a market that will enable platforms to operate across the EU (see here).
Although many believe these platforms are there to raise equity, it should be remembered that they are also conceived in the law for loans. The Spanish legislation on crowdfunding platforms is in Title V of Law 5/2015 of April 27, 2015, to encourage financing for businesses. The rules governing the loans provided on these platforms are set out in article 74 and onwards.
Startups are therefore able to use these platforms to raise funds and for them to do so the people promoting and managing these platforms need to take an interest in this potential new market. These types of crowdfunding entities are regulated in Spain by the National Securities Market Commission, and where loans are involved, supervised also by the Bank of Spain; so this device has the seal of official supervision and legal certainty.
Initial trade offerings: differences compared with ICOs
This is another option we wish to highlight which we refer to as initial trade offering to set it apart, and prevent any confusion with initial coin offerings (ICOs). The use of ICOs has proliferated in recent years in certain marketplaces. They involve issuing coins or tokens targeted at the general public, usually enabled by blockchain technology, in exchange for money that is used as legal tender.
These types of coins or tokens have had bad press and a great many warnings have been issued on them by the regulators because, on top of the extremely high risk associated with the investments they offer and the risk of fraud or money laundering, if the issued item has the status of a security or financial instrument, the transactions may be in breach of the laws on prospectuses and markets in financial instruments, and others. In actual fact, venture capitalists often ban the use of this type of finance by the companies receiving funding from them.
Business transactions not financial instruments
However, after looking carefully at these ICOs we found that, as the warnings and decisions adopted by international regulators expressly mention (see for example the warning issued in the press release on November 17, 2017 by the CNMV, disseminating that made by the European Securities and Markets Authority (ESMA), in some cases the transactions are not reproachable from the standpoint of the legislation on prospectuses or on markets in financial instruments. This is true where the item being offered, the tokens in other words, represent or include the right to receive the products or services of the issuing company, as part of the real economy, once they have been produced. So actually it is future clients that are subscribing to the tokens, who put up funds as advance payments for the products or services that the company is not yet in a position to supply.
There is little that can be said with confirmation of the facts on this option beyond the important detail that, where certain circumstances exist, the markets and securities authorities do not consider it falls within their domain, and oversight powers lie with the consumer or other authorities.
A closer look at the regulatory risk
This regulatory factor is complex and must be approached with extreme care. Even where it is a token that is offered not strictly a cryptocoin, so an underlying asset exists consisting of the startup’s own nonfinancial products or services, there may still be a marketable security or financial instrument in that a gain is being offered to the subscriber as a result of the rise in price of the instrument or associated payments.
The CNMV gave a very important warning in its press release on February 8, 2018 revisiting the subject of ICOs to give details as to when and why an offering of tokens may be treated in the same way as an offering of marketable securities. Much more recently, a significant legislative initiative was announced by the European Commission in its “digital finance package”, the details of which may also give shape to the legislative framework applicable to the transactions we are discussing (see here).
What needs to be done therefore is to check thoroughly in each case whether the transaction is subject to the prospectus directive or the markets in financial instruments directive (MiFID). This would make the transaction almost impracticable for a young startup.
More details on the profiles of possible transactions
We have seen that the transaction must have a business nature and not become a deposit or other form of attracting people’s savings or an investment in securities. The people it targets must have a genuine interest in the product and service itself. It may be seen how the mechanism comes close to the types of strategies we described in the fifth article in our series , except that the funds are provided by future clients, not by a finance provider to whom future revenues would be offered as a security interest.
Needless to say some sort of advantage or enticement has to be given to subscribers. While we are aware that it cannot consist of a gain obtained from the rise in price of the tokens or otherwise consist of payments or returns that the company is able to offer, it does seem that the economic or financial advantage could consist of a reduction to the standard prices of its future products and maybe also of the option to refuse them or exchange them with third parties in return for the price they have when the company starts supplying the products or services.
Beyond that, various contractual and accounting issues remain to be resolved when designing a mechanism of this type in detail. It is nevertheless worthwhile to bear this alternative in mind and continue looking into it.