Is equity capital for you?
When outside investors take equity stakes its existing management shareholders must recognise that the company can no longer be run for their benefit alone. Outside investment demands a change in thinking and style, with more formalised reporting as outside parties will be independently reviewing results and need to see a steady pattern of progress.
This change of emphasis and the "giving up of part of my company" may be unacceptable to those who prefer to retain total control rather than accept a reduced stake in a potentially much larger concern. Providers of equity capital are primarily motivated by the profitable growth of their investee companies to capital gains when their investments are realised. They look for above average returns at the same time as making sure that management shareholders are similarly motivated by the prospect of even better capital returns based on performance.
If this aim of making money is not wholly embraced by management, or could be diluted by an individual''s personal views, then we would not recommend taking external equity capital on board.
Why do you need it?
External equity investment should not be used to fund normal levels of working capital. Professional equity investors are highly selective giving preference to the types of investment that generally afford the most profitable and reliable returns.
In addition to investing in private companies to finance strong organic growth they are also attracted to investments for specific purposes, such as acquiring companies (both through existing investee companies and new opportunities) and backing management teams in Management Buy-Out''s (MBO''s) or Management Buy-In''s (MBI''s).
Types of equity provider
External shareholders can be:
- private individuals
- managers of funds from private individuals
- insurance companies
- pension funds
- managers of funds from insurance companies, pension funds and other institutions
- investment trusts, unit trusts etc.
Private individuals prepared to invest direct are known as ''business angels'' and can best be accessed through specialist networks.
Those fund managers and institutions primarily investing in private companies comprise the private equity market – although those involved in early stage investments are more normally referred to as Venture Capitalists. Many of the more established players in these markets are members of the British Venture Capital Association.
Management shareholders should take specialist advice before considering talking to any of the 200 plus mainstream providers. Good chemistry between company management and an investor is vital, and organisations can benefit from the varying styles offered by different equity providers. A good provider offers more than finance alone – rather, it should also be the catalyst for maximising profitable growth.
We are in regular contact with most of the active investors in the mid-market sector and are therefore aware not only of their sources of finance but also their prejudices, limitations, preferences, requirements and styles of investment management.
Management Styles
Private equity houses have differing styles of concentrate on three main factors: management, markets and products, in that order – and when reviewing figures they will focus on the underlying assumptions.
If there is a mutual wish to proceed, an investor will make a "subject to due diligence and legal contract" offer covering, normally, involvement with their investee companies – influenced by their differing corporate aims and the backgrounds and training of their executives. Some seek a distinctly proactive "hands-on" role, actively participating in the running of a business; by contrast others will not even require a seat on the board, but are content to simply receive monthly reports on a "hands-off" basis. Most adopt stances between these two extremes (somewhere in the range: "eyes-on" to "hands-on") usually requiring board representation; sometimes together with a further non-executive director as an independent chairman. At the very least most would require attendance rights at board meetings. Where non-executive directors are appointed, fees at commercial rates would routinely be payable for their services.
Investment Criteria
Different houses will have widely differing investment criteria. Critical constraints can include industry and geographic limitations, size of investment required in terms of both value and percentage stake and willingness to syndicate.
What is the process?
Presenting the Opportunity
The correct approach is vital. Business plans must be well thought-out, realistic and both financially and commercially orientated; every plan should therefore include a properly evaluated market analysis. Approaches should be specifically made to only the most relevant sources. Indiscriminate lobbying or "touting" a funding proposal can be fatal. Although the number of funding sources is increasing, the market is a closely-knit community of "friendly competitors" and word soon circulates if a proposal is being blindly offered – and many will then reject it on principle.
In any event, those seeking funding must be careful in their use of any forecasts, such as those included in internal business plans or funding proposals as a means of attracting investor interest. Such papers are unlikely to conform to the specific requirements of prospectuses that are necessary when seeking funds from the public at large.
Business plans and funding proposal really should not be circulated without professional advice.
Initial Review and Offer
During the course of discussions with management shareholders, it is normal for a Venture Capitalist to undertake a certain amount of investigation into the proposal, the company concerned (assuming it is already trading) and the management team. Investors the following matters:
- value of funds to be provided
- any requirement for injection by management
- conditions on clearing bank facilities
- equity percentage required at outset (plus the terms of any ''ratchet'' proposed) together with details of classes of investment regarding terms of dividends, redemption, convertibility, voting rights etc.
- board representation and structure
- operating constraints (e.g. capital expenditure, shareholder managers’ remuneration etc)
- preferences regarding exit method and timing
Due Diligence and Legal Contract
If the offer is accepted in principle by the management shareholders the investor will carry out "due diligence" work, both itself and with external advisers including investigating accountants. This is necessary to gain comfort with regard to:
- financial history and forecasts
- taxation implications
- properties and other assets
- market size and share – current and potential
- products and technology
- production/operations processes etc
- management capabilities
Once comfortable with the likely outcome of the due diligence work, the investor will instruct lawyers to draw up an Investment Agreement – and also to draft new or revised Articles of Association to complement the intentions of the offer and the Investment Agreement. It is the role of the company''s/management shareholders'' lawyers to review and comment on the drafts.
A major part of the Investment Agreement will be an appropriate series of warranties required of the company/management shareholders by the investor. It is inevitable that they will be unable to give all of the warranties without qualification so their lawyers will prepare a letter of disclosure against those warranties. The investors list of warranties is frequently used as a means of procuring further information not previously disclosed and therefore, in general terms, warranties are sometimes regarded as "questions" and disclosures as "answers".
It is essential that both parties retain lawyers who are experienced in private equity transactions so that they can properly and commercially advise their respective clients. Contracts are then "exchanged" and the transaction completed when all outstanding issues have been resolved.
What form does the investment take?
Investors inject not only different classes of equity but also blend an appropriate mix of preference and loan capital; these latter instruments may be redeemable or convertible to equity as well as enjoying fixed or variable interest payments, perhaps with cumulative rights to enable any missed payments to be recovered, or even rights to participating dividends. Investors can develop an appropriate structure for a particular deal as well as accommodating their own fiscal and commercial needs.
Many investors use different classes of equity, or convertibility of other instruments, to motivate management shareholders to maximise performance. They build in differing entitlements or conversion rights for certain investment instruments (exercisable within set periods) depending on performance or exit capitalisation – and perhaps linked to funds drawn down or repaid.
If the capital value is greater than originally forecast in relation to the funds injected, then the investor''s stake will reduce in equity percentage terms – and vice-versa. By this means investors can protect their downside whilst securing some part of the upside – with the major element of the improvement (and hence the real incentive) residing with the shareholder managers. This is known as a ''ratchet''. The timeframes for exercising such rights can also guide shareholder managers to an exit at a time preferred by the investor. Such incentives need to be carefully structured so that gains are not treated as income and thus attract a more penal tax treatment.
What will it cost?
Where investment is made through intermediaries, or with certain fund managers, management shareholders may expect initial fees to be payable to those intermediaries or fund managers. Care should be taken to see that these fees are not unreasonable and that, in return, competent professional skills are provided at least through to completion. Management shareholders must also accept the inevitability of legal and other professional fees in any funding exercise.
On successful investment, the company will typically bear the due diligence costs of the equity investor and banks, who may also charge arrangement fees on their arrangements.
Post-Investment - what next?
Unless satisfied by running yield, private equity investors will ultimately wish to sell their shares to realise a capital gain on their investment – and either distribute the proceeds to the original providers of their funds or reinvest the proceeds into further investment opportunities.
In a privately owned company (i.e. where shares are not traded on a recognised investment exchange) investors are effectively "locked-in" to the investment and will normally wish to agree the style and timing of realisation with the management shareholders.
If a trade sale, rather than a public quotation, is perceived as the most appropriate exit route for shareholders, investors wish for the management shareholders to agree to sell their stakes at the same time as the sale of the entire share capital of a company is likely to attract a higher valuation than that for a lesser or even minority stake.
Both the style of the investment and the structure of the instruments involved are frequently used to "persuade" management shareholders to agree to act in the best interests of all shareholders which is why it is best for both equity investors and potential investees to be frank with each other regarding exit preferences before investment!