So, as an Angel you have found a potential investment that really excites you. What happens next?
Sometimes deals are just done on the basis of a stock transfer form or a share certificate in exchange for a payment. Even wealthy angels are sometimes far more casual about the terms of their investments then they would ever have been about spending money in the ventures which made them successful. This can be a mistake. It’s not just as simple as A,B,C. As we shall see there are a number of issues that ought to be covered off in any agreement of this kind. How many of these have you covered in your own investment agreements?
First things first. Let’s have a clear expression of what is being paid, when is it being paid, and how it is being paid. Is the money being paid all at once or in tranches? Are there conditions attached to some of the payments (e.g. performance milestones). If so are those milestones clear, measurable and objective? Everyone benefits from that kind of clarity.
Okay but once we sort out the payment that’s it isn’t it?
Not really, what is the payment in return for?
Is the payment being made as a loan? If so let’s have some clarity on when the loan is repayable, how much interest the loan carries, and what happens if it isn’t repaid. Often investor agreements will provide that in the event of non-payment of loan or interest the loan converts into shares in the company. This creates a need to be clear about the valuation of the overall company in order to work out how many shares the unpaid loan plus interest should convert into (see below). There will also be a debate about whether the loan is “secured” against the company’s assets in some way (eg through a charge on those assets). Secured loans will carry a lower rate of interest than unsecured loans because the investor’s position is slightly less risky, but they may affect the company’s ability to borrow future sums, because future investors will take into account the security holder’s protection.
Alternatively the payment may be in return for shares in the company. If that is the case how many shares in the company is the investor acquiring? This will often be a function of valuation (see below).
Valuation is easy – it’s just a haggle?
To a certain extent that’s true. What’s the company worth is one of those pieces of string which it is very difficult to measure. Especially if the company has low or no revenues so that objective criteria are hard to come by. A willing but careful investor and a passionately committed company owner may have very different perceptions of the current worth of the company, but it is essential that they reach agreement on this point. Sometimes valuation debates can be resolved through “ratchets” – performance milestones which enable an entrepreneur to claw back shares in the company that would otherwise remain owned by the investor if the company hits certain performance milestones which increase its value to the overall benefit of the investor.
For the investor their views on valuation may also be influenced by whether they are able to obtain tax benefits such as EIS or SEIS, which make the whole investment less risky. You need an accountant to help you decide whether you are eligible for either of these tax benefits. If you are then as an investor EIS may enable you to claim 30% income tax relief, capital gains tax relief, income tax loss relief if the investment fails and inheritance tax relief on your investment. SEIS is even more generous and may let you claim up to 50% income tax relief and capital gains reinvestment relief if you have previously paid capital gains on money you subsequently invest via an SEIS investment. Most angels will know about these schemes and the many conditions which must be complied with. There is a brief summary here;
Once agreement on valuation is achieved it’s possible to work out what 100% of the shares in the company are currently worth and then to work out what the investor’s contribution is worth. Normally an investor will get new shares in the company. So if the company currently has 900 shares and is worth, say, £900,000 pre-investment, and the investor is investing £100,000, then after the investor has made his investment the company is worth £1 million and the investor (having contributed one tenth of that amount) should have one tenth of the new shareholding (ie 100 shares out of 1,000).
Okay so we know what is being paid and what the deal structure is and the value of the company is – that’s it isn’t it?
Nope. It’s now worth considering what kind of shares does the investor get?
This is where it starts to get more complicated. Firstly, the shares may be “ordinary” shares – but companies can have more than one class of ordinary shares. They may have “A” shares or “B” shares with different rights (e.g. maybe the “A” shares carry voting rights but the “B” shares don’t). Which type is the investor getting?
There may also be other categories of share available to an investor. Some investors like to get “preference shares”. These are shares which carry a guaranteed return or “dividend” each year out of profits. They may not carry voting rights but at least the investor knows that they are definitely going to get a return ahead of ordinary shareholders if there are profits (perhaps with their dividend accumulating in any years where there are not sufficient dividends to pay it). Preference shares also enable the holder to get preferential treatment if the worst comes to the worst and the company goes under – the preference shareholders will rank ahead of ordinary shareholders in dividing up any available assets of the company if that happens. However, preference shares do not qualify for tax benefits like EIS because they are less risky than investments in ordinary shares. The entrepreneur may be okay with preference shares initially, since they may give him or her more freedom to run the company without the investor having voting rights.
Of course any investor worth their salt normally wants to have their cake and eat it. So some investors like to have “convertible” preference shares which they can convert into ordinary shares after a certain date so as to protect their position if the company starts doing well. At what price would a preference share convert into an ordinary share? You may well ask. Normally a “conversion ratio” is established at the outset which sets out how many ordinary shares can be acquired for each preference share. As the share price becomes more valuable, it encourages the preference shareholder to convert at his or her pre-agreed conversion ratio.
The company may in turn protect itself by making these preference shares (or any other type of share) “redeemable” – meaning the company can buy the shares back at a fixed price after a certain period of time. The pre-agreed price agreed for the buy-back gives the investor some potential measure of reassurance (particularly if the buy-back is mandatory) and the company some protection if the value of the shares gallops ahead.
Okay, finally we can now sign this piece of paper and forget about it…
Well, it’s also important to think about not just the immediate terms of the deal, but what might happen in the future – for example in relation to dilution..
Normally if there is a subsequent investment round the investor will have the right to invest more money first so as to ensure that they acquire extra shares and so their overall ownership percentage is not diluted. Pre-emption rights are normally dealt with in the Company’s Articles. They will often apply to transfers between shareholders and by Statute must apply to the issue of new shares unless dis-applied by the company (e.g. by passing the appropriate resolution). So, the investor will want to make sure that they have pre-emption rights in place. If they don’t exercise those rights then they will be diluted by a subsequent round. However, some investors ask for Anti-Dilution provisions. These are sometimes called “ratchets” as well. They may prescribe that if there is a subsequent investment round (especially if that is at a lower price than the price at which the investor initially invested) then the investor automatically gets extra shares so that overall they own the same percentage of the company as they did before the “down round”. This is helpful for those investors, but may make it harder for the company to raise subsequent investment as it is a disincentive to new investors.
So, as long as dilution is sorted out that takes care of the future then?
Not really. As well as protecting themselves through the type of shares they acquire and the rights which attach to those shares, investors will normally carry out some sort of due diligence on the company before they invest. This may involve a whole raft of investigations including checking of the following;
- the company’s share capital
- the company’s accounts
- its IP
- its trading agreements
- its employment agreements
- the status of its debts
- whether there are any ongoing disputes
- its tax position
- its insurance position
- its assets
- its property
These investigations will result in contractual promises (or “warranties”) by the company/the entrepreneur about the status of these matters. The company and the entrepreneur will try to limit these warranties in a number of ways. Firstly they may “disclose” against the warranties in a disclosure letter. This means disclosing information up-front which shows that certain warranties are not correct and cannot apply in this instance. (E.g. the warranty may state that there are no outstanding legal claims against the company and the company may disclose against this the existence of an ongoing claim). Once the company has disclosed against those particular warranties, the investor cannot hold the company liable for breach of those warranties later, since the investor is on notice that those warranties cannot apply, but has still gone on to invest. So, investors must be careful about what disclosures they allow. Companies and entrepreneurs will also try to cap the extent of their liability under the warranties, either by time, or total amount, or by setting a minimum amount of liability for breach of a warranty beneath which the liability doesn’t count. So, this is another area where investors must exercise caution.
Finally, we’re all done aren’t we?
There is one other area to shine a light on, namely operational controls. The way that the company organises its meetings and manages itself will be set out in the Company’s Articles (or in a shareholders agreement – whether that is a new one or an existing one to which the investor is asked to adhere). The Articles (or shareholder agreement) may also say whether an investor can insist that they are allowed to sell their own shares (at the same time and price) as part of any sale by the majority of shareholders (“Tag Rights”). This should all be checked and if necessary any changes to the Articles or the shareholder agreement made before the investment agreement is signed. Depending on how much money they are putting in, investors may also try to insist that they must sit on the Board of the Company so that they have plenty of visibility. They may also seek to ensure that certain matters cannot be decided without their consent. These are sometimes called “Minority shareholder protections”. Consent may be required for matters such as;
Creating any charge on all or part of the company’s business, property or assets;
Borrowing or raising any further funding;
Creating or issuing any additional share capital; or altering the rights attaching to share capital;
Selling the whole or a significant part of the business;
Significantly changing the nature of the business carried on by the company.
The entrepreneur is likely to resist these kinds of control if he or she feels that they will inhibit the way that the business is run, but may have to balance their desire for operational freedom with the need to inject cash into the company…
So, as you can see funding agreements are not really as simple as A,B,C. It’s more like A to Z with the Z standing for “zero” if the investor and the entrepreneur don’t take the time to work through the issues properly…
Clive Rich- Founder and Chairman of LawBite