As with the other risk areas considered in this series, it is important to consider the risks around exiting from an investment at the outset. Doing so allows you to take steps to mitigate potential risks, as the ability to do so post investment can be limited.
It is vital that you have a clear understanding of how you are going to achieve a return on your investment from the outset. Typical options for realising a return include:
- a fixed “coupon” on the investment (such as a fixed preferential dividend or fixed interest on a loan), which will normally provide you with some priority over normal equity returns and can realise a return during the investment and prior to exit;
- an intention to participate in ordinary dividends (payable out of the revenue generated by the company), which carries no priority and is subject to cashflows and the requirements of the business to invest ;or
- the sale of the company and participation in equity returns on sale.
Whatever the intended route for realising a return, it is important that this is discussed and agreed with the company and founders upfront, to ensure that all parties are aligned in their understanding.
Illiquidity of Equity
Shares in private companies are usually “illiquid” and are unlikely to be easy to sell to third parties. Any investment in private company shares is likely to be locked up in the company until a sale of at least a controlling interest in the company is achieved. You will therefore be investing money that you will be locking up for the long term. Attempting to exit early may not be possible at all or may result in a large discount to the value of your shares.
Attempting to fix a guaranteed investment return or a guarantee exit for an equity investment is extremely difficult and is likely to disqualify the investment from the EIS and Seed EIS tax reliefs. Where a fixed exit structure is proposed, it is important that tax advice is obtained to consider the impact on any refiles reliefs that might be claimed in connection with the investment.
Where you are seeking to realise a return on your investment in a fixed period, you may consider structuring all or part of your investment as a loan. While a loan is likely to offer a lower potential return than an equity investment (the repayment and interest payments of the loan will have priority to any return on equity so tends to receive a lower return for the lower risk), it does provide more certainty that your investment will be realised by a certain date.
Waterfalls and Preferential Returns
It is possible for equity investors to receive a preferential return on the sale or liquidation of the company. Typically, a preferential return right entitles the investor to receive the amount of money they invested back, in priority to other shareholders. This can be a way to reduce some risk on the investment, but it is often the private equity investors in later rounds who will have the power to negotiate this for themselves, at the expense of the earlier investors.
Where a company goes through several funding rounds, it is common to end up with layers of preferential return, as incoming investors insist on their own preferential return rights. These layers of return create an exit “waterfall”, where the proceeds realised on an exit flow down through the various level of preferential return, before the remaining balance is distributed to the shareholders. Where a company is planning on raising further funds, you should be aware of the risk that new funders may require preferential return rights which take priority over any return on your shares.
Ratchets and Management Options
Ratchet provisions are a mechanism for adjusting the split of exit proceeds between shareholders, depending on the value achieved on exit. Ratchets can be a useful means of bridging differences of option on the initial value of the company and of further incentivising the company’s management team. Obviously, if the management team receive a greater slice of the proceeds on exit, the other shareholders, including the angel investors, will receive a lower percentage.
A typical ratchet will increase the proportionate return to founders if certain thresholds are met – e.g. if the exit proceeds are greater than a pre-determined target. Ratchets can also be structured to work in reverse, reducing the founder’s return if the company is sold below a certain target value.
Another common management incentive mechanism is the share option scheme, particularly tax efficient EMI options. Share options allow managers to acquire shares in the company, with the options typically being exercised once an exit is agreed. Options can be particularly useful to incentivise second tier managers, by aligning their interests with the shareholders and incentivising them to remain with the company until exit. It is important that, prior to investing, you discuss any share option plans with the company and understand how these may dilute your own investment.
It should be remembered that if an incentive scheme is working well, the managers will only get the increased share in circumstances where a greater exit value has been achieved, which should be positive to the value received on exit by all of the shareholders.
Pre-emption rights require any shareholder who wishes to sell their shares to first offer them to the existing shareholders in the company, prior to them being offered to third parties. Pre-emption right provisions often provide that the shares must be offered to the existing shareholders at fair value, which will be agreed between the board and the selling shareholder or determined by the company’s auditors or an independent accountant. Fair value provisions protect the remaining shareholders of the company, by preventing a selling shareholder from extracting a premium above fair value. They may also protect against sales at discounted levels, which can have downward pressure on the share values, negatively impacting upon later funding rounds.
It is important to understand that the pre-emption mechanisms are not attractive to third party purchasers, so make the shares more illiquid. They are not designed to create an internal market for your shares.
Drag and Tag Rights
Drag along and tag along rights are an essential part of managing exit risks.
A drag along right allows a majority of shareholders to “drag” the remaining shareholders along in a sale to a third party. Since most prospective buyers will want to acquire the entire share capital of the company, drag rights are an important way of ensuring that a sale cannot be blocked by a minority shareholder. However, it is important to note as an investor that even if you do not like the price offered, if the appropriate majority of shareholders are happy to sell at that price, they can force you to sell at the same price. Drag along rights may be subject to a certain threshold of shareholders accepting the relevant offer, or may be capable of being triggered by an investor (usually institutional investors) after a certain period of time. Once triggered, the selling majority can force the other shareholders to sell to a buyer on the same terms.
A tag along right is the mirror to a drag along right and allows minority shareholders to “tag on to” any sale of a controlling interest in the company. This right protects minority shareholders from being left behind if a majority of shareholders sell their shares to a third party and ensures that the buyer offers to buy the minority shareholders shares on the same terms.