Sharing the ownership and future of a business is one of the most important and difficult decisions any entrepreneur can take. Getting it right is vital, as is accepting that the investment will be about so much more than just money.
Stories of inbound equity investment going wrong are legion. Here we look at some of the aspects that need to be considered. This can never be exhaustive, because every deal and every equity investor is different, but this is a check list of the more obvious potential pitfalls.
Involvement, control and covenants
All investors will expect some degree of involvement, but what level of hands-on is tolerable? Clearly, if one of the prime motivations for selecting an outside investor is their knowledge, experience and connections, getting touchy about their attempts to influence day-to-day running will be a delicate balancing act.
Deal documentation often includes covenants, setting out the areas where the investor expects to be consulted or even to have pre-approval rights. These will usually impose financial reporting requirements and cover major investment decisions, but could also involve taking on new contracts or senior staff hires. What about if a pay rise for a founder director needs prior approval by the investor?
Personalities and agendas
Constructive relationships will be essential. Can the original owners and new investors have those vital conversations about problems and still be on speaking terms afterwards? Can they agree to differ and come up with satisfactory compromises? Have the respective parties been open about their agendas and sticking points?
Time horizon of an equity investor
An equity investor will almost invariably have an eye on the exit door and a view of when they want to walk through it. As that time approaches, their attitude to how the business is run may change and may diverge from the founders’ plans and objectives. Most importantly, the time horizon should not be a secret. If a potential investor is cagey on the point, beware.
Investors often seek more regular and more complex reporting than those in place before they became involved. They may also see a different set of KPIs to the founders, based either on their experience or their style of monitoring their investments. The extra burden can be a source of frustration to managers.
Once the new equity investor is on board, there could be good reasons to bring in subsequent rounds of investment. There might be commercial considerations, where another investor brings additional skills that could benefit the business, or maybe clinching a significant senior hire requires some form of share incentive package. Many investors will seek anti-dilution protection before committing, so that they have the right to match any further investment to maintain their stake.
Appetite and capacity for second or later round fund raising
What is a potential investor’s track record for backing subsequent equity rounds? Is their original investment already at the upper limit of their normal range of commitments to a single enterprise? For a rapidly growing business this could be a serious issue.
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Are the equity investor’s objectives reasonable?
Equity investors typically have a view of how they expect their investments to perform. It might be revenue growth, increased market share, profit margin improvements, higher EBITDA or bottom-line profits. It could also be capital growth based on a valuation formula. The key questions are whether the targets achievable and what has to be done to achieve them? If they are unreasonable, the road ahead will be littered with disagreements and cratered by intra-shareholder conflict.
Will the equity investor stay if the going gets tough?
Investors face criticism when they walk away from troubled investments, preferring not to throw good money after bad. Others take a more supportive approach. The answer to a request for help should depend on the merits of each individual situation, but it is worth doing the due diligence on a potential equity investor to at least go into the relationship with an informed view of how this scenario might play out.
Initial deal structure
Plain vanilla equity investments on equal terms with the founder do happen, but quite often the incomer will look for some form of advantage through enhanced voting or dividend rights from the outset or a mechanism to trigger extra control in the event that the business under performs, especially if they are buying a minority stake. This may involve issuing different classes of ordinary shares or a mix of ordinary and preference shares.
Exit preference of equity investor
If the equity investor’s exit is through a sale of the whole company, the investor may seek to receive a higher share of the proceeds then their ownership share would imply, sometimes based on a formula in the original deal designed to guarantee a pre-agreed minimum rate of return on their investment.
Having expert support in the negotiations
Taking in an equity investor is a complex exercise, full of unexpected twists and turns. Some of the issues we have highlighted can be technical and, in most cases, will be outside the experience of the original shareholders. This is where the advice of a corporate finance expert and a good corporate lawyer will be invaluable in reducing any potential risks.
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