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EQUITY INVESTMENT WHAT TO EXPECT AND PITFALLS FOR THE UNWARY

Posted on Apr 16, 2015 by Sandy Finlayson  | Tags: finance, investment, grants, debts, crowdfunding, equity,  | 0 Comments

Sooner or later, financing becomes a major issue for the founders of every growing business.  There are many different options and they may be categorised as follows:-

Internal Finance

  • Credit control – this is often overlooked but it is at the heart of running a good business.  If a business has £100K of debtors on sixty day terms and it moves its debtors days to thirty it generates £50K of additional cash;
  • Improved supplier terms – this is common in the retail industry but I am generally not in favour of “stretching” creditors which can lead to problems;
  • Reducing or eliminating unnecessary “baggage” cost; and
  • Negotiating better terms with customers.  For companies involved in B2B sales, it may be possible to improve contract terms with mobilisation fees, interim payments and so on.

External Finance

External finance falls into three broad categories:-

  • Grants – there are numerous grants available to business large and small but they are beyond the scope of this briefing note;
  • Debt – the advent of crowdfunding and challenger banks has greatly increased the range of debt offerings available to companies and they now include :-
  • Senior debt – generally from a clearing bank with a first ranking security.  The problems associated with interest rate SWAPs, personal guarantees and so on have been well publicised (and are the subject of numerous blogs on our website) so care should always be taken when negotiating lending terms with a bank;
  • Factoring/invoice discounting.  This is a type of working capital facility which enables the company to general a percentage of the invoice value (typically 80%/85%) when the invoice is issued with the balance payable to the company on receipt by the customer of the finance fees.  This type of arrangement is now generally preferred by the banks to a conventional overdraft as it gives the bank a first charge over the outstanding debtors of the company.

Such arrangements are generally disclosed to customers who are put on notice that this type of financing arrangement exists.  However, in larger cases it may be confidential with the money being paid into a separate suspense account at the company’s bank.  Such arrangements may also be with recourse which means that the company bears the ultimate liability for bad debt or “without recourse” which means that any bad debts are effectively insured by the institution which provides the finance;

  • Hire purchase/leasing.  Such arrangements are popular for acquiring fixed assets as they provide an agreed monthly outlay over the useful working life of the asset.  For large items such arrangements are treated as finance leases for accounting purposes which means that the value of the asset and the consequent liability must appear in the company’s accounts.  For smaller items they are treated simply as operating leases which go through the profit and loss account.  Care should be taken with major items of equipment (for example a printing press) to ensure that appropriate maintenance arrangements are in place as the obligation to meet the finance payments remains even if the equipment is out of commission for any reason;
  • Crowdfunding for debt is growing exponentially and a detailed listing of all reputable crowdfunding organisations in the UK should be found on www.ukcfa.org.uk and www.p2pmoney.co.uk.
  • Equity – fast growing companies generally have to rely on external equity at some point in their development.  Such equity will come from different sources at different stages in the evolution of the company ranging from the founders, friends and family, Business Angels, venture capital, private equity to IPO. 

Anyone embarking on equity financing for the first time may find the whole concept of “giving up part of their company” a bit intimidating.  However, an appropriate financing strategy is key to the success of every business and the final outcome for its shareholders.  If a company simply borrows with security for the loan, the harsh commercial reality is that, if the company defaults, the bank will enforce its rights under the security, take the whole business and leave the founders with nothing.  The bank may even take their houses if they have given personal guarantees.  The risks associated with lending and security should therefore be fully understood.

On the other hand, while the founders may have a perception that they are “giving up some of their equity” the reality is that the company is selling new shares to enlarge its share capital. While this may mean that the founders have a lower percentage of the enlarged share capital, the value of their shareholding should not be diminished in any way and it should be enhanced if they get the financing structure right.  The money which the company gets from investors strengthens the balance sheet and the investors can only get their money back through dividends, share buy backs or the sale of the company.

However, equity financing is not for everyone and this point is illustrated by a few background statistics which are generally accepted as being broadly indicative of what goes on in the early stage equity financing market:-

  • Of all of the companies which start today, only 4% will take in outside equity but in ten years’  time the companies which raise external equity will account for at least half of all of the jobs created by all of the companies starting today. In other words, the companies which take in outside equity are the high growth companies which are most likely to have a long term economic impact;
  • It is a high risk strategy for investors.  It is estimated that for every ten investments which are made, four will fail completely, four should give investors their money back and they must rely on two to generate the return which they are looking for.  However, recent research on the returns for Business Angels suggest that Business Angels investing wisely in a portfolio of investments could generate a return in excess of 20% IRR over the long haul; and
  • Finally, the “3% Rule” suggests that for every hundred business plans sent to an investor he will invest in only three.  However there is now so much demand for investment that this may be nearer one and it is therefore essential that those seeking investment understand the market, hone their pitch to perfection and work out an appropriate strategy to secure investment and investors if they wish to succeed in what is a highly competitive market.

The Investment Documentation

To the uninitiated, investment documents are long, cumbersome and complicated.  However, attempts have been made to standardise early stage investment documentation so that investments can be made quickly and efficiently based on standard documentation which reflect accepted “best practice” in the market.  Examples of such documents can be found on the websites for www.ukbaa.org.uk which contains a treasure trove of background information, www.lincscot.co.uk  and www.bvca.co.uk which contains slightly more complex documents for series A investments.  The company founders need to understand the basic principles underlying these documents, the points which matter and those which don’t and those which may be negotiable and those which are not as it is important to focus on the big points which matter and not get hung up on “nickel and dime” points which are of little or no relevance.

  • Investment Agreement.

The points here are:-

  • It sets out the share capital before and after investment.  The share capital after investment will typically contain some provision for share options for the management team;
  • Warranties.  The management team will be asked to grant detailed warranties about the financial position of the company, the ownership of IP, litigation and so on.  While it is possible to disclose against these warranties, the investors will insist on them and will insist that the liability is capped at the amount of the investment, possibly with the expenses of pursuing a claim on top.  If asked, the investors may agree that the liability of individual members of the management team is capped at two or three times their annual salary rather than the full amount of the investment.  Provided the management team tell the truth and make full disclosure there should be no material risk of any liability arising under the warranties;
  • Covenants and undertakings.  The agreement will contain a series of undertakings, both positive and negative, setting out things which they must do and things which they must not do, at least without investor consent which is usually sanctioned by some qualified majority of the investors.  These protections are essential for investors and, although they are expressed in a different way in different agreements, investors will insist on the basic principles involved so there will be little room for negotiation.  What is important however is that it is clear how an investor consent is to be obtained.  If it requires the approval of every one of a large group of investors it could make life very difficult for the management team and it is therefore normal practice for investor consent matters to be sanctioned by a representative of the investors;
  • Board and information rights. Investors will normally insist on the right to at least one board seat and possibly the right to appoint a chairman together with information rights requiring the management team to provide monthly or quarterly updated.  While investors are generally able to accept bad news, they hate nasty surprises and it is therefore essential to keep the investors properly informed of the progress of the company.  If this is done they will be much more amenable to follow on financing rounds.
  • Articles of Association.

The Articles contain the all important share transfer provisions including:-

  • Offer round.  These provisions stipulate that if any shareholder wishes to sell his or her shares, they must be offered round all other shareholders on a proportionate basis.  There is often a “carve out” for family members and privileged relations and there may be provision to establish an Employee Benefit Trust which may be used as a “warehouse” to facilitate an internal market in the company’s shares;
  • Compulsory transfer.  The Articles will normally contain provisions requiring any shareholder who is a director, employee or consultant to transfer his or her shares in the event of them seeking to be a director, employee or consultant. These provisions are often the subject of much discussion as they determine who takes what off the table when the company comes to an exit.  There is no hard right or wrong answer and each case must be agreed on its own merits;
  • Vesting provisions are often used so that the shares held by the management team vest in individual members over a period of time, typically three or four years.  If they are able to retain any of the shares after they leave the company, issues then arise about whether they retain their voting rights and whether they have the right to follow their money on a subsequent rights issue;
  • Good leaver/bad leaver.  A good leaver is typically somebody who is dead, redundant, retired or incapacitated and everybody else is a bad leaver.  A good leaver will be entitled to get fair value for his shares and a bad leaver would only be entitled to the nominal value.  These provisions may seem harsh but they exist to stop a member of the management team going and working for a competitor or setting up a competing business or to take away the rights of someone who is dismissed from the company as a result of gross misconduct.  They therefore serve an important purpose and all members of the management team must realise that they are there to protect the group as a whole against the malfeasance of one individual;
  • Dragalong and tagalong.  In the event of a company going to an exit then the acquirer will only wish to acquire 100% of the share capital.  The dragalong provisions therefore enable a qualified majority to force the dissenting minority to sell their shares on the same terms.  Conversely, the tagalong provisions provide that, if a majority wish to sell, they must ensure that an offer is extended on the same terms to all shareholders;
  • Service Contracts.  All members of the management team will be expected to have service contracts setting out their roles and responsibilities, salaries, ownership of IP, confidentiality and restrictive covenants as well as the usual employment clauses;
  • Sweeper Assignment.  All members of the management team will be expected to sign sweeper assignments assigning all relevant IP which they may have created or will in the future create for the benefit of the company to the company itself so that there is no question over the ownership of the IP which should belong to the company in all respects. 

It is essential to give investors a reason to invest and not an excuse to walk away and all members of the management team should therefore familiarise themselves with the essential provisions of the investment documents so that they focus on getting the key points right, do not take up time with unnecessary trivia and focus on closing the transaction with “controlled haste” as delay seldom operates to the benefit of the management team.

Conclusion

Once the investment has been completed, the equity investors effectively become partners in the business.  Their interests are closely aligned with the interests of the management team and they can only realise value through dividend distributions, share buy backs or the sale of the company.  Experienced investors will have much to offer the company through their contacts and experience and an investment in developing a good working relationship with the investors should be well rewarded over time.

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