What do investors want?
Private equity transactions cover a variety of arrangements including:
- funding for businesses starting from scratch (start ups),
• the injection of funding into existing businesses to help them expand (development capital); and
• the funding of purchases of businesses by management teams (buyouts).
In this article we will consider some common issues for Investors when providing funding for start-ups and for existing businesses looking to expand.
A key document that any Investor will want to see is a detailed business plan. The business plan acts as an insight for the Investor into the major objectives and key strategies of the business and it helps the Investor understand the business’ strengths, weaknesses, opportunities and threats.
The business plan should be concise and contain a description of the industry in which the business operates, possible new markets, the products, the management team, the key customers and suppliers, the amount of funding required, forecasts of future performance, possible returns for Investors and possible exit routes for Investors.
The abilities and track record of the management team is vital. Where the team is inadequate it should be restructured or have additional team members added at an early stage of the transaction.
Length of Investment
The time period for any investment will depend upon the requirements of the Investor. The rate of return is influenced by the rate at which money can be invested and realised. As a general rule, the longer the investment is held the more difficult it is to achieve a good return, so typically Investors will want an “exit” within 5 years.
On any transaction, the Investor will need to obtain sufficient information about the target company to enable him to decide whether the proposed transaction represents a sound commercial investment.
A review of all material contracts of the business will be needed to determine whether there are any change of control provisions in these contracts. If there are change of control provisions then the Investor may insist that the consent of the other contractual party to the change of control of the business is obtained prior to the completion of their investment.
The Investor will also ensure that the company has good title to all material assets including all intellectual property. All title documentation should be reviewed to ensure that the company has full legal and beneficial ownership.
Articles of Association
The articles of association of a company are the regulations governing the relationships between the shareholders and directors of the company and they typically cover the issuing of shares and the different voting and dividend rights attached to different classes of share.
The Investor will generally seek to take equity in the form of preferred ordinary shares in return for their investment. The preferred ordinary shares will rank ahead of the existing ordinary shareholders so that in the event of an insolvency situation the Investor is repaid ahead of the ordinary shareholders. In addition the Investor will seek to further protect its position by ensuring that in the event that the company under performs, the voting rights attached to the ordinary shares are suspended so that the Investor can then take full control of the company.
The articles may also contain the terms of a ratchet. The effect of a ratchet is to incentivise the management and employees by rewarding them if certain performance targets are reached. By providing them with an incentive the Investor has a greater chance of achieving a higher return on investment.
The Investor will ensure that the articles contain adequate provisions in relation to leavers. When a director or employee (who is a shareholder) leaves the company the Investor will generally require that they offer their shares for sale in a prescribed manner and at a prescribed price. Read more about investors
The investment agreement governs the relationship between management, the company and the Investor and will contain the following key provisions:
- restrictions on what management can and cannot do with the business without the Investor’s consent;
- rights for the Investor to appoint directors;
- restrictive covenants which seek to prevent management from engaging in competing businesses or soliciting customers, suppliers or staff for a period of time following completion of the investment and/or them ceasing to be an employee of, or shareholder in the company;
- restrictions on the ability of shareholders to transfer their shares freely to third parties;
- warranties to be given by management to the Investor about the company, it’s business, staff and customers; and
- possibly provisions under which the Investor takes control of the company if financial targets are not being met or the investment documents are not being complied with.
How can legal advisors help?
Experienced legal advisors who can identify and deal with the issues in a proposed equity transaction in a concise and pragmatic way, leaving their clients the time to deal with the commercial aspects of the equity investment and equally important the running of the business!