Key issues to consider when seeking external investment
by Jaan Larner
29th Oct 2012
Jaan Larner provides a guide to the challenges that entrepreneurs will face when seeking external investment at different stages in the business life-cycle.
Entrepreneurs naturally want to get their idea off the ground as soon as possible. Whilst this is entirely laudable and desirable, the mundane details of planning the lifespan of the share structure and the relationship between shareholders, directors and the company are equally important and should not be overlooked.
Jaan Larner outlines the issues and tensions at various stages in the business life-cycle and explains how planning ahead can protect your position.
Relationships between founders
It is a fact of life that people decide that they no longer wish to work together or circumstances change, forcing them to reconsider their involvement in projects.
Therefore, it is important to have considered how to deal with a founder who wishes to leave the business. The leaving party can be bought out to avoid shares being held by someone outside the company or they could retain their shares and still act as a consultant or silent partner.
If they leave for negative reasons, it may be that they should be required to forfeit their shares, such as in cases of gross misconduct.
If they should fall ill, or die, then the remaining founders may wish to have the right to buy out the shares automatically and leave the exiting founder or their estate with cash rather than a share in the company.
If there is no fault, but the parties simply want to call it a day, they may wish to go to sealed bids in order to buy the other out or have a mechanism to value the shares and break a deadlock.
All of this can be addressed in a well-drafted shareholder agreement.
Relationships between founders and seed investors
With non-executive investors the founders will want to balance their need for freedom to run the company against what will attract investors. The amount of shares the investors receive in return for the investment should be clearly defined at the outset.
If the business plan is credible and the company is attractively priced then the founders may have more than one set of investors ready to proceed, which makes negotiating the final terms of the investment much easier. Even where there is only one set of investors, having a clearly thought out share structure, including realistic growth forecasts and underlying assumptions, with defined exit points, will increase the chances of a smooth negotiation.
Being organised and demonstrating that you have considered the immediate and future needs of the business, and the long-term impact on investors, will make your offer to invest much more credible.
Numbers and values are one thing, but information and other rights can also be set out in the shareholder agreement. Having considered the next few stages, the founders will want to retain certain rights in relation to adjustments to share capital, further fund-raising and exit, including drag along rights, and even tag along rights, if the investor requires.
Negotiating with future investors
Introducing new terms to protect the founders or the original investors will be much more difficult later if new investors come on board, whereas if these terms are in place at the seed stage, they can be retained or exchanged as part of negotiating the new funding terms.
The founders should include significant vetoes and rights to control board decisions in the shareholder agreement to protect them from any attempt to alter control of the business.
Incentivising employees, directors and shareholders
As the company grows the employees, directors and shareholders in the business may want to invest further or be given the chance to benefit from that success. The founders will want to plan the structure of the share capital to allow for the issue of further incentive shares later in the life of the business. The directors will want to have the right to allot those shares and setting this out legally now entrenches these valuable incentives. Trying to introduce them later can be difficult, whereas you can elect not to use them if they are available, but not required.
If the company is a success, tax planning at an early stage can pay significant dividends, especially in relation to employee and investor incentive schemes endorsed by HMRC. Therefore early advice from tax professionals is potentially invaluable and even if the company cannot afford to take advantage of the schemes initially you can return to the plans later.
Tensions between existing and new investors
New investors will negotiate hard on valuation and terms, often requesting significant veto rights and other protections. These may conflict with the interests of the existing investors, who may feel they have taken the significant initial risk and, now that the business is growing, the new investors are reaping the benefit at a much lower risk level.
The degree to which the company will agree to the demands of the new investors depends significantly on the need for further funds and the availability of those funds from elsewhere. If investors are lining up, then the company can afford to stand fast on the terms and then pick and choose who will invest. If cash flow is tight and there are few investors, then the new investors will likely have the upper hand. Either way, the company needs to find a way to manage the expectations of the existing investors.
The company can either make it clear on the initial investment that some dilution will occur, to which the initial investors will hopefully agree in the interest of keeping the business going or developing it, or the company can set out formal rights to allot new shares in the initial shareholder agreement which allow the directors to raise further money as they see fit. The founders would be sensible to ensure the initial investors are on side as early as possible.
Altering the composition of the board of directors
New investors will almost certainly want to have the protection of a presence on the board to look after their investment. Observers without voting rights do appear, but often an investor director has voting rights and this will affect the board decision-making processes.
Founders should think hard about how they protect their freedom to run the business. It is worth remembering that it is easier to give up an existing right in exchange for something you want from the investor, than to find something the investor wants in order to retain your control.
Veto rights for new investors
In order to further protect their investment, investors will often require veto rights in respect of the operation and administration of the business. These may include alteration of the share capital (thereby preventing any further fund-raising without their consent) or limits on spending or borrowing.
The founders will want to preserve their rights to raise more money and may agree to do so within limits to satisfy the new investors. Equally, they will want to make sure their spending and borrowing limits are realistic in order to allow them to run the business.
Professionalising the board
As the business grows, and there will be a need to run professional teams and take advantage of high level contacts. The expertise of the board needs to develop rapidly which means both adding new members and looking at the skill-sets of the advisers to compliment the new board.
In order to bring the right people on board, the company will need to look again at incentives for the board members.and well-connected experienced executives to prepare the company for the next phase of growth.
As the business matures, the company will need to review how the executives and employees are all incentivised to consolidate the existing gains and lay the foundations for further growth.
This may well involve further option schemes and revisiting the share structure once more, but this time taking into account the initial seed and subsequent investors as well as any existing option holders.
Realising the greatest value in a sale
When or if the opportunity arises to sell the business, the founders and investors will wish to maximise their return, whilst trade buyers will always want to pay as little as they can.
Pressure to reduce a valuation may be justified on funding grounds, uncertainty over revenue forecasts or the state of the market and economy. It is possible however to accept this at face value and still benefit from any post sale rise in valuation. So called 'anti embarrassment clauses' allow the vendor to receive a windfall if the actual revenue is higher than anticipated post sale, and has the benefit of only being payable if the revenue arrives, offering a no risk position to the buyer. If the idea is offered early on and backed by all the shareholders this can be an attractive term for the experienced buyer and the selling shareholders.
Locking in key employees and intellectual property
A trade buyer will want to know that the asset they are buying will continue to grow and usually this involves key employees being locked in with employment contracts or share incentives, and the intellectual property developed within the business being similarly protected. The more clearly you can demonstrate that the value of the business is locked in and will survive the sale, the better terms you will be able to achieve.
Continued involvement of the founders post sale
It is common for founders to be required to stay on with the company after its sale in order to assist with handover, or to supervise any earn-outs. They may retain shares in the business and if the founders expect significant growth and only wish to cash out some of their shares, the right to do so can be set out early on in the company documentation. This may not survive the trade sale, but again, if it is there you may be able to extract a concession for giving it up, but you will not if it doesn't exist in the first place.
Negotiations at each stage of a company's growth are subject to many unforeseeable factors and the simple rule that you can only get what someone is willing to offer. However, by anticipating some of the potential developments set out here you can position yourself to be in the best possible negotiating position.
This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.