The price the investor pays for their shareholding proportion is a critical commercial term that will likely be subject to negotiations. Entrepreneurs usually aim for the highest cash input for the least shares, while investors seek a fair share of the equity and other share capital. The ultimate valuation depends on an assessment of the company’s prospects, which involves considerable uncertainty and risks.
This investment sits at the high-risk, high-reward end. The success and scale of financial returns are uncertain, more so compared to cases qualifying for bank or debt financing.
Investors base their actions on an evaluation of the company, conducting a corporate finance assessment of the present value of future prospects, considering risks and their relevance to the company, its markets, prospects, and management. They also weigh prospects for future financing, exit mechanisms, and realization of their investments. The investor assumes a risk-reflective return.
Typically, investors acknowledge the need to align the interests of entrepreneurs/promoters with their own. Equity incentives are commonly provided to encourage maximizing shareholder/investor value, potentially granting management a higher equity percentage if they achieve specific returns.
A business that is expanding might require additional capital, possibly through further round of funding. If the later round of funding from the initial investors, mirrors the earlier proportions, it’s less likely to necessitate changes to existing agreements.
However, if the new investors in the second round contribute in different proportions, it could create issues concerning the structure and balance of power, potentially requiring amendments to the investment agreement.
Introducing new investors often demands substantial changes. Obtaining consent from the original investors is usually necessary, as are the majority shareholders, pursuant to the rights outlined in the initial investment agreements. Negotiations will likely occur regarding the price paid for the second round shares, reflecting the company’s value at that stage, potentially greater or lesser than the original investment.
Investors often subscribe to ordinary share capital and convertible redeemable preference shares in the company. Preference shares might contain clauses allowing redemption or conversion into ordinary shares based on the company’s performance. Meeting certain expectations allows the company to redeem preference shares at a fixed price, while unmet targets might lead to their conversion into ordinary shares, offering promoters a larger equity stake.
In many instances, the investor’s contributed percentage, especially in management buyouts, gives them majority control, which the entrepreneurs/promoters may resist. Similarly, investors/promoters may not want the company treated as their subsidiary.
This is less likely to happen in a syndicate or fund. Alternatively, the share capital may be varied so that a greater portion of the investment may be by way of non-voting preference shares or loans. Preference shares may become voting shares if dividends are in arrears. This may happen automatically or when exercised once the relevant threshold, as defined, is crossed. This will enable the investor not to become a holding company unknowingly.
Even with control of more than the majority, the investor will not wish to have ongoing control of the company. It may be that key management decisions require joint decisions or ongoing day-to-day management is for the entrepreneur/promoter.
The entrepreneur/promoter may itself require greater protection where its position is less than majority. The balance must be struck in the investment agreement.
In some cases, it may be necessary to reduce the nominal share capital to give the entrepreneur/founders an appropriate percentage of the equity. For example, the share capital may be reduced from one Euro to one cent. The investors may invest one cent nominal capital and a large premium. The shareholders may have their existing shares or must pay at least one cent per share.
The existing founder loans or contributions may be capitalized, as may existing reserves, to give the managers/founders/entrepreneurs their agreed shareholding.
The investors may seek a combination of growth with some income during the short to medium period, pending final realization and exit. There may be a particular combination of equity and debt, including preference shares and convertible loan stock. Loans inherently carry priority and are repayable regardless of the availability of distributable income.
Where the investor is a financial institution, subsidiary, or associate, it may be more likely to offer a combination of debt and equity. Some investors have a preference for convertible loan stock. The loan may be serviced without capital maintenance issues but converted into shares if required. The interest payable may be by reference to a financial benchmark such as Euribor.
From the promoters’ perspective, if they wish to maintain as much of the equity share capital as possible, there may be a combination of debt and equity. This depends on whether it has a preference for debt or equity, and it depends on its ability to service the obligation.
A company that can service its obligations may prefer a correspondingly reduced stake in the equity on the part of the investor. Equally, greater equity may imply fewer shorter-term obligations of debt servicing which may ease the burden on the company.
Dividends are payable when declared only. There may be a mechanism in the investor agreement which requires payment of dividends to the parties where distributable funds are available. The preference shares of the investors may have voting rights in the event that dividends are not paid, and this will alter the balance.
The controllers may be precluded from paying salaries above a certain level to themselves. The entrepreneur may be precluded from paying salaries and other benefits above a certain level. Its ability to declare dividends is likely to be limited and controlled.
If the company is growing quickly and has significant prospects in the short to medium term, with perhaps an initial public offering, there may be less pressure for debt servicing and dividends in the short to medium term.