What are they? Why are they needed? How do they work?
It would be quite wrong to suggest that investor preferences are the subject of a raging debate. At best, it is a whimper but it is nevertheless one of the most important issues facing the early stage investment community. The recent “Thin Markets” report produced by NESTA suggests that the “funding escalator” is broken and this is one of the main reasons.
As the supply of venture capital has gradually dried up at the bottom of the food chain, businesses are increasingly turning to Business Angels for their seed and early stage funding. Investors are attracted into this market by the availability of EIS relief. However, investors who are looking for EIS relief can only invest in ordinary shares with no special rights attaching. However, institutional investors have much greater flexibility over the type of financing instrument which they are able to use ranging from:-
• Loan stock which may be secured or unsecured;
• Convertible loan stock, which may again be secured or unsecured;
• Preference shares;
• Preferred ordinary shares (which are the subject of “investor preferences”); and
• Ordinary shares.
These instruments give the investor more opportunity to structure a preferred return which may enable the business owner to release a smaller percentage of the equity if he is willing to accept the risk associated with a preferred return.
Many Venture Capital Trusts, which raise the bulk of their funds from retail investors, are attracted by structures which enable them to obtain a high running yield on their loan stock giving them some degree of certainty with the opportunity to participate in the equity risk and reward for a relatively modest outlay.
There are three main types of investor preference:-
This means that if there is another re-financing involving a “down round” (ie one at a lower share price than a previous investment) the investors are given the right to acquire additional shares so that the average cost of their investment is brought down to the share price of the subsequent round. This principle is often extended so that the average price for the investor may be brought down to the “floor” price on every subsequent round of investment. The principle is easy to understand but the “wide range anti-dilution formula” which is expressed in the BVCA standard templates is a highly complex piece of drafting.
• Liquidation Preference
This provides that, on a winding up, the investors are entitled to the return of their investment before any distributions are made to the ordinary shareholders. The investors may also look for a multiple of their original investment or some pre-determined rate of return before any payments are made to ordinary shareholders and they will in addition be entitled to participate pro-rata in any distributions on the ordinary shares.
• Exit Preference
This provides that on an exit (whether by way of trade sale or IPO) the investors are entitled to the return of their investment before any distributions to ordinary shareholders. This may again include a multiple of their investment and/or some pre-determined rate of return in addition the right to participate pro-rata in any distributions or listing value accorded to ordinary shareholders.
Many Business Angels, who are themselves sophisticated investors, are unwilling to expose themselves to the risk of having their investment wiped out by the preferred return demanded by venture capital investors. Venture capital investors on the other hand are frequently unwilling or unable to structure investment transactions without a preferred return. The net result is that the two different categories of investor find it very difficult to work together meaning that it is difficult for rapidly growing businesses to attract the funding they require from other sources to grow rapidly.
Representations have been made to Government to enable Business Angels to structure their investments in a similar way to venture capital investments. However, while the Government has recently offered significant additional tax relief it has not altered the basic rule that, in order to attract EIS relief, the investment must be in ordinary shares.
For some venture capital investors, this is a matter of principle, they are simply not willing to invest without investor preferences. For others, it is merely a matter of pricing and risk.
To build successful global businesses takes enormous amounts of capital and this fundamental issue is one of the major stumbling blocks in the way of increasing our stock of such businesses. Fast growing successful companies which are able to trade internationally in an increasingly globalised world must have access to the capital required to enable them to grow. There is therefore an urgent need for a constructive dialogue between market participants to look for a practical solution to this seemingly intractable problem.