Part 1: Funding Agreements…What’s the real deal?
So, as an Angel you have found a potential investment that really excites you, and as a small company you think you have found your dream investor. 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. Entrepreneurs are often in too much of a hurry to get the money in to focus on any other aspects of the deal. And 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 – from the point of view of both investor and the small company. 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.
2. 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 (e.g. 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).
2. 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.
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 (i.e. 100 shares out of 1,000).
3. 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.
Come back next week for part 2…
Author: Clive Rich, CEO and Owner at Lawbite.