Startup not working out? Read this before you offer to give your investors their money back

You’ve tried to make a go of it but your product isn’t taking off. No matter what you try, you just can’t get customer traction, and you and the team are running out of ideas.

You still have cash in the bank from your last funding round so can you just return the money to your investors, close the business and move on to something else? Rather than soldiering on to the bitter end and using up all your investors’ funding, can you call them to say it’s not working, and here’s the remainder of your money back…?

At first glance, it might seem like a good idea and one that your investors would welcome. They get at least some of their money back and you get to walk away without spending more time on something that’s not working.

But it turns out to be more complicated because:

• investors often don’t want their money back,
• SEIS/EIS investors could be worse off if they get some of their money back than if the company goes out of business, and
• there are only a few legal ways to return cash to investors, and not all of them may be available to your company.

In this post, we explore some of the issues to consider carefully before you attempt to refund your investors.

Contents

• Do your investors want their money back?
• What if only some of your investors want their money back?
• SEIS/EIS investors could be better off not getting their money back
• What else can you do?
• Frequently Asked Questions
• Talk to an expert

Do your investors want their money back?

Astute investors know that the return on investment in startups obeys a law like this:

• 1 in 10 investments will give a 30X or more return on investment
• 2 or 3 in 10 investments might give a 3X to 10X return on investment
• the remainder will return somewhere between zero and break-even

For VCs, funds and angel investors who make many investments, the fact that many or even most of their investments will make no return doesn’t worry them. They know that’s just how investing works.

While you’re agonising about your investor losing their money, from the investor’s side (at least for serial investors who make many investments) in fact they might prefer that you keep going, with the hope of turning things around and returning a multiple on their investment, even if the chance of that is low.

So if things aren’t going well and you ask investors whether they want their money back, you might be surprised that many – especially VCs – won’t want their money back, and instead want you to persevere until you succeed, or use up all the money trying.

Of course, not all investors think the same way. Before telling them that you plan to pay back the remaining funds you have, it’s worth testing the waters with them – particularly if it’s a VC – before you make a decision.

What if only some of your investors want their money back?

Here’s another problem that can arise: what if some investors want their money back, while others want you to keep going? Could you give back, say, half the company’s remaining funds to buy out half the investors and cancel their shares? It isn’t that easy – here’s why:

• EIS rules don’t allow it
  You can’t use EIS funds for this purpose – it’s against the rules. And regardless of how you fund the buyback, the remaining investors’ EIS relief can be withdrawn if you buy out other shareholders.
• You might not have enough money
  There are complex legal rules in place for share buybacks, and if you buy and cancel shares other than with distributable profits (see box below), it gets even more complicated.
• You need consent from other shareholders
  Share buyback contracts need to be approved by the shareholders – and, depending on the circumstances, you may need additional, separate consents from the holders of affected share classes.

In summary, if some investors want to be paid back but others want you to keep going, then paying back some of them might not be possible.

SEIS/EIS investors could be better off not getting their money back

If SEIS/EIS investors keep their shares for three years then they qualify for this tax relief:

• 50% (SEIS) or 30% (EIS) of their investment deducted from their taxable income
• no Capital Gains Tax on sale of the shares
• if the company is wound up, they can write off the remainder of the investment from their taxable income

So if the company does brilliantly and the investors keep their shares for 3 years or more, SEIS/EIS investors are winners.

And, if the company folds – even if it’s within three years – they get to write off their investment… That makes them not exactly winners, but with the initial tax relief and the subsequent write-off, the actual loss is a small fraction of their investment.

But what if you give them some of their money back?

HMRC maintains a long list of ways that SEIS/EIS investors will lose some or all of their SEIS/EIS benefits if their money is returned. This means that if you repay, say, 50% of an investor’s money (because you used up the other half) and the investor has had their shares for less than three years, the investor might need to pay back to HMRC half of the tax relief they previously claimed. And if the company folds, they won’t get loss relief – which would be on their entire investment.

In summary, your SEIS/EIS investors might be better off if your company does not repay them, even if you go out of business. It will depend on the amount you can repay and how long the SEIS/EIS investors have had their shares. And there’s always a chance that if you keep their money and keep going, you might reach product-market fit and turn the business into a success.

What else can you do?

Being a founder means it can feel like you have the weight of the world on your shoulders. You’ve persuaded people to give up their other jobs and join your mission. You’ve persuaded investors to invest in your business. Every day your team is looking to you: oh wise one, what do we do next?

If you reach the point where you’re burned out, you can’t see light at the end of the tunnel, your investors don’t want their money back, and indeed might be better off not getting their money back – then what are your other options?

Sell the company 📦

It might turn out that someone out there is looking to build something similar and would love to have your code. Or your team. Or your customers. You might be able to sell the business, even if for a few hundred thousands pounds. Let’s say the founders own 70% of the equity and you sell the business for £200,000. The founders get something back for their work and will probably pay just 10% Capital Gains Tax with Business Asset Disposal Relief.

The trickiest part of selling a company is finding a buyer. But marketplaces like Foundy are changing that. The legals for selling a company used to be insanely high: lawyers routinely charge £30,000 to £50,000 or more for the sale of a company. But SeedLegals is changing that – the legals for selling your business should be no more complex or expensive than doing an SEIS/EIS funding round on SeedLegals.

Go into ‘hold’ mode to wait out the 3 year SEIS/EIS holding time ⌛

Let’s say you’re two years into the three years investors need to hold their shares in your company to claim their SEIS/EIS tax benefits when they sell their shares. If you reduce all your big outgoings and operate at a minimum, you buy yourself time to work out how to scale up operations again, or find a buyer and if you make it to three years, you’ll make sure your investors can get their tax relief and minimise their loss.

Hand over the reins to your team 🛷

Have you run out of steam as the CEO? Rather than winding up the business, if your team is full of ideas (maybe ideas you’ve rejected) you could consider stepping back and giving control (and some or most of your equity) to the team so they can give it a go. You could let them use the rest of the funding to give it a go. Who knows, you might be in for a pleasant surprise.

Frequently asked questions

What happens to leftover funds when closing down a company?

If you decide to close your company, the money that’s left (after paying all debts, taxes, staff, and other closure costs) belongs to the shareholders. That includes you, any co-founders you have, and any SEIS investors, in proportion to the shares you each hold (with any holders of preference shares being paid out first).

If the company is solvent and you close it down properly, that leftover money is simply split according to shareholdings (again, subject to any preference shareholders getting paid first).
If the company is insolvent, creditors (people you owe money to) get paid first. Usually in that situation, there won’t be anything left for shareholders afterwards.

If SEIS/EIS investors end up getting back less than they put in, they can claim SEIS/EIS loss relief on their actual loss, which helps reduce their tax bill.

What happens to SEIS or EIS tax relief if the company closes within 3 years?

If your company closes within 3 years of issuing SEIS or EIS shares, your investors may lose some or all of their tax relief. That’s because one of the conditions of both schemes is that the investor holds the shares for at least 3 years.

But there’s an important exception.

If the company closes within 3 years for genuine commercial reasons – like the business simply failed – HMRC usually allows investors to keep their SEIS or EIS tax relief. If they lose money, they can also claim loss relief on their actual loss to soften the blow.

But if the company is sold or shut down early for reasons that aren’t genuine business reasons (for example, you closed it for a strategic reason), HMRC may claw back the relief and make investors repay it.

So yes – closing within 3 years can put the tax relief at risk. But if it’s a genuine business failure and you document it properly, investors usually keep the relief and can still claim loss relief too.

Do we need a formal liquidation to make sure investors keep their SEIS or EIS loss relief?

No – you don’t need a formal liquidation. A strike-off (dissolution) is usually enough, as long as it’s done properly.

The key thing to remember is that SEIS and EIS loss relief become available when the investor’s shares are “disposed of”.

That can happen in a few ways:

• the company is liquidated,
• it’s struck off the register (dissolved), or
• the shares are declared of negligible value.

A voluntary strike-off counts as a disposal under HMRC’s rules. So as long as the closure is genuine, properly documented, and the shares really are worthless (or close to it), investors can still claim their loss relief.

How do you explain closure to investors without damaging relationships?

Be honest, clear and respectful. Most investors know startups often fail – it won’t come as a shock to them. But what they won’t appreciate is being kept in the dark.

Tell them early and explain the real reasons, whether it’s the market, money, or the business model not working. Make it clear this is a genuine business decision (so they don’t think it’s a tax dodge or something) and show you’ve handled debts and obligations properly.

You might need to adjust your tone to the investor – more personal with angels and family, more factual with VCs – and thank them for their support.

Closing well can actually build your reputation, not ruin it.

Talk to an expert

If you have questions about fundraising, SEIS/EIS or startup governance, hit the chat button at the bottom right of this page. We’ll be happy to help.