For many entrepreneurs, equity investment is something of a doubled-edged sword. On the one hand, the funding available from angels, venture capitalists (VCs), or new business partners often provides the key to unlocking a company’s growth potential. However, investors can bring with them their own ambitions, agenda and timelines, which entrepreneurs may struggle to accommodate. Taking investment is a transformational step, after which the business will never be the same again.
Entrepreneurs are most often concerned with the amount of equity they’ll have to surrender in order to secure funding. If you’ve spent several years building a business, handing over 40% of your company is rarely a comfortable experience, although your remaining equity now has the potential to rise considerably in value.
Equity investment may also require changes to the decision-making process. Perhaps for the first time, your company will be run by not only the founder but also one or more shareholders. The investor may have no desire to involve themselves in the day-to-day running of the business, but when the time comes to make an important decision there will be another influential voice at the table.
Investors – whether they are business angels, VCs or private equity – will also be working to their own timeline, and have their own ideas when it comes to determining milestones on the growth curve and when to exit. Therefore, any business taking on investment must consider how their relationship with shareholders is managed.
The shareholder won’t necessarily be a professional investor such an angel or a VC. If you start a business with a partner, or acquire a partner at some stage during the early life of the company, then ownership will be divided. Unlike angel investors or VCs, your business partner may not necessarily plan to exit in three to five years, although it’s not unusual for the owners’ paths to diverge at some point.
A business partner may resist investing further in the company at a time when you are anxious to push into new markets or develop new products. If that growth plan involves a further injection of finance, the partner may prefer not to dilute their shareholding by taking further investment and more debt. Or the partner may simply wish to cash in and retire.
Seeking an exit
Funding from a business angel often produces a more predictable and straightforward relationship. Typically, an angel is someone who has been successful in business and has chosen to invest a portion of their accrued wealth in a portfolio of companies, while sometimes offering advice and expertise as part of the package.
Angels will usually seek to exit within three to five years, but unlike a VC they won’t necessarily expect you to sell the company at that point. They’ll want to be bought out at a profit either by the other shareholders or by other professional investors at a later funding round.
“If you start a business with a partner, or acquire a partner at some stage during the early life of the company, then ownership will be divided. Unlike angel investors or VCs, your business partner may not necessarily plan to exit in three to five years.”
VC and private equity investors approach companies at different stages. VCs are looking for early-stage companies with substantial growth potential and are prepared to invest millions of pounds or bring in other investors, often during the course of several rounds of funding. Private equity companies usually seek more established businesses. However, both VC and private equity houses are funded by their own shareholders and operate by strict investment criteria in order to receive a worthwhile return. The endgame is usually the sale of the whole company in an exit that allows the original owner/shareholders to also cash in. Private equity houses are increasingly taking minority stakes, although they remain focused on achieving an exit.
The relationship between the owners of a company is defined in the ‘Articles of Association’, a mandatory legal document that defines how major decisions affecting a company will be made and the level of influence by shareholders. If the company secures, say, angel investment, then the relationship with shareholders will be redefined through a shareholders’ agreement that stipulates the rights of the investor and includes revised Articles of Association. It’s important to ensure that you are comfortable with any shareholders’ agreement.
Thankfully, there is always some room for negotiation. “There are no-go areas where you can’t negotiate, such as the rules governing the sales of new shares or taking on debt,” says Mark Winthorpe, Senior Associate, Corporate Finance at Pannone Solicitors. “But in operational matters, you can negotiate. You should aim to set the thresholds at which investor consent is required at a comfortable level.”
Aligning your goals
Aligning your plans with those of your investors is clearly key to a successful relationship. That said, a relationship with a partner or an angel is likely to be more flexible than any deal signed with a VC or private equity house, simply because it’s easier to arrange to buy out or ‘buy back’ the shares. As Mark points out, deals with angel investors can include so-called ‘drag-along rights’, which allow the owner to require the angel to sell his or her shares once they have reached a certain value.
In the case of private equity and VC investment, drag-along rights can point in the other direction, with investment funds entitled to begin a sale process after a set number of years or once they hit a specific trigger. “They can appoint corporate finance advisers at the company's expense,” says Mark.
Valuation is the potential stumbling block to buying out an investor. Typically, the Articles of Association will stipulate that valuation should be carried out by an auditor. The potential problem here is that the figures presented by the auditor may not be acceptable to one or more parties. If an impasse occurs, an independent valuation or some kind of mediation may be required.
Buying out larger scale investors such as VCs and private equity houses is rare. It’s therefore important to understand that in most, if not all cases, you’ll be working towards an exit endgame.
As Mark Winthorpe points out, working with investors should be a positive experience, not least in terms of the expertise and resources they bring to the table. “It can, for instance, be a very good way of accessing talent,” he says. However, businesses must feel comfortable when aligning themselves with the intentions of their investors, and when agreeing to associated ownership and decision-making structures.
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