A couple of apparently contradictory articles in recent editions of Real Business have caught my eye and are worthy of comment.
The first one suggests that businesses may not trust equity investors and the second piece suggested that EIS relief is running at record levels and may have been claimed on as much as £1.5 Billion or £2 Billion in the financial year to 5th February 2014 which represents a very substantial increase on the previous year. Why would people seek this type of investment if they do not trust investors?
The best possible way to finance a business is through generating cash from operations – getting money from your customer. However, if your customers are not able to give you enough money and you need additional finance from investment, the choices are grants (which might be regarded as free money, albeit with strings attached), debt from a bank or a crowdfunding platform and equity from external investors. I am often struck by the fact that businesses seem only too willing to borrow as much as they can from a bank because they do not have to give away any equity and the perceive this as much less risky than “giving away” equity. However, a brief analysis of the reality reveals a slight different picture. Paraphrasing a bank Facility Letter the key points are as follows:-
“Dear John, we the Bank, hereby offer to lend you gazillions of pounds (“the Loan”). In exchange for the Loan you will:-
- Give us back all our money when we want it, together with interest and all of the other charges we are entitled to;
- Give us a Debenture/Floating Charge. This is a really good thing for the Bank as it means that if you do not give us our money back when we want, we can take your company away from you;
- We might even persuade you to give us a Personal Guarantee with a security over your house. If we get that, we can take your house away from you as well if you do not give us back our money. We could even make you bankrupt;
- If you breach your banking covenants (the lending conditions which we impose on you) we will be entitled to ask for all of our money back at once; and
- If you give us all of our money back and do not breach your banking covenants we will release the Debenture and Personal Guarantee and we will all be happy.”
A bank Facility letter might extent to thirty or forty pages but, when it is distilled down to its essence, that is essentially what it means. On the other hand, if you get equity from an investor, that equity belongs to the company and not to the investor. All the investor gets in exchange for his money is a Share Certificate which may become worthless if the company fails to perform although he will get the benefit of the upside if the company is successful.
The investors only hope of a return is from dividends payable out of distributable profits which will arise only if the company is successful, or from a liquidity event (the sale of the company, a listing of the shares or a share buy-back). Naturally the investor will want to ensure that his money is properly looked after and he will want to impose reasonable covenants on the company to ensure that the management team does not take out excessive remuneration or benefits, undertakes to run the business in a responsible manner, provides the investor with reasonable information and enables the investor to appoint a Non-Executive Director who, if he or she is properly selected, will have a significant contribution to make to developing the business.
While the bank’s only interest is in getting its money back, the interests of an equity investor are much more closely aligned with those of the management team and a good investor will have much to contribute to the success of the business. However, just as the investor will do extensive due diligence on the business and the management team, it is essential that the management team should undertake due diligence on the investor to ensure that they are happy that they are entering into a business relationship with a party who they believe will have the wellbeing of the business at heart and will work with the management team to build the business for the benefit of all parties.