We are picking five principal areas of risk that we would usually see managed in some way in the investment documentation: (i) governance, the way that the business is managed; (ii) rights to information to enable effective monitoring; (iii) leavers – protections for the business should a manager leave; (iv) provisions impacting illiquidity in shareholdings; and (v) managing further funding rounds.
There is a balance needed within in business investment. You don’t want too much interference from investors who are not (and should not be) involved in the day to day business and technology. However, there is also a need to monitor the management and to provide a sensible voice with some power from the stakeholder perspective of the investors.
That balance is achieved firstly by the balancing the numbers of management directors, compared to the number of investor directors and the number of non- executive directors (independents). The power play of these groupings at board level can then be manipulated in a number of ways:
- a chairman can be appointed with a casting vote
- agendas can be delivered to all board members (and sometimes to all shareholders) with restricted ability for the board to consider business outside the agenda
- conflict of interest rules can be imposed; a quorum can be imposed to ensure no business can be conducted unless certain groupings of directors are represented
- veto rights can be used so that certain decisions cannot be taken without the approval of certain percentages of the directors or without the approval of certain shareholders or shareholder groupings
The key to good governance is getting the balance right. If the board and shareholders are constantly having to have regard to the legal documentation, the governance is too strict or there is a problem in the make-up of the board. Always remember that companies make good decisions where the board are unanimous. Where this is not the case, then trouble is likely not far away.
It is important to consider amongst angel investors, who would be best to take a role on the board of directors. Such a role will elevate the information they are party to, it will also bind them to independent fiduciary duties to the company, so that they will have a duty to the company, including, for example, confidentiality. The angels’ representative or representatives on the board will not necessarily stay representative of the angels. It is a fairly regular occurrence for appointed directors to “go native”.
Investors need to be comfortable with their choice of investor director and to ensure that they have the right to remove them by majority vote and replace them with someone else if they cease to provide the comfort to the other investors that had been anticipated.
Rights to Information
It is key that the investors have the right to see information that will enable them to properly monitor the performance of the business against its business plan and budgets. It is also key that the investors are not seeking so much information that it becomes an unnecessary burden to management to produce it.
Balance is again important. Management accounts on a monthly basis should be required, with some commentary against budget. Annual accounts obviously should be required. One might expect a budget to be prepared and approved before the commencement of any year. Information beyond this is probably more the remit of a private equity investor or a later stage investment, where detailed cashflows against forecasts are likely to be required, as well as information to monitor whether financial covenants are being breached.
If there are some key milestones or forecast assumptions upon which investors have invested, it may be sensible to require regular reports to see how the business is doing against these.
If any member of the management team leaves the business, this could be a disaster to the company for a number of reasons. It may be that they hold all of the relevant knowledge and expertise and are irreplaceable. This would be unusual. It is more likely that the company needs to protect confidential information, including its IP, making sure that all IP generated belongs to the company.
The company also needs to protect itself from competition from the outgoing manager, who understands the market and the product and knows the customers and suppliers. Another key component is that they do not take with them the other key employees of the business.
Restrictive covenants that are quite onerous should be included in the investment documentation, where they should be enforceable for periods of 3 years and more after the manager leaves.
Confidentiality clauses should also be included and should be in long form. In the service agreements of the managers should be included provisions to ensure any intellectual property they help to create is and remains in the ownership of the company.
Finally, the company will not want a rogue manager who is no longer with the business to continue to hold shares. It is important that the company can get their shares back from them. It is often the case that the price for the shares is significantly discounted, down to nominal value in circumstances where they leave voluntarily or on bad terms. These clauses can be complex and take a long time to negotiate and can create question marks over the goodwill between investor and manager, so need to be treated very carefully.
Illiquidity of Shares
It is key that an angel investor enters into the arrangement understanding that the shares they are acquiring are illiquid. Firstly, for EIS reliefs (if available) they need to be held for at least three years and can only benefit from that relief if bought by way of investment into the company, not off another shareholder. This in itself counts against the likelihood of there being any ready market in the shares. Those involved as investors in the business are likely to want to manage their investment risk by following their money on second and third rounds, rather than buying the shares from other exiting shareholders. The former funds the company and shows confidence in the business going forward, the latter, a shareholder seeking exit, shows no confidence in the company and involves no further funds into the company.
Nearly all angel investments will be subject to pre-emption rights on transfer, which means that they need to be offered to the other shareholders first. There are provisions that make these arrangements even less manageable, such as requiring a valuation to be taken and being fixed on price by that valuation. There are also regularly pre-emption rights that work on a class basis, adding a further administrative step to the share transfers. The angel investor will be looking for the lowest possible level of pre-emption restriction on their own shares allowing them to sell to a third party after following some simple steps. However, they will also want to see the tightest possible restrictions on the management team, maybe even an absolute prohibition on share transfers unless they leave.
Further Funding Rounds
There will be pre-emptions in the documentation that enable any investor to follow their investment should further funds be being raised. These rights mean that they can invest on the same terms as any investor at that stage.
It is sensible that any angel investor takes account of the need for later funding rounds and is ready and able to follow their money during later rounds. This enables them to tackle dilution of their shareholding. At the same time, it shows confidence in the business, something a new investor will rate.
It is likely that a later investment round will include funding from a private equity house or similar entity. At this stage, the power base of the investor will change. Investors not following their money at this stage may find, with the levels of funding coming in, that their investment and any rights they have previously negotiated are marginalised. However, provided that the company has been well funded to that date and is not desperate for the funding, the negotiating positions of the original investors will be strong. It is key for the angel investor to consider at the outset what the funding requirements of the business are over the next several years and how it is planned that these are met.
In our fifth article we will be looking at managing risk on exit.
In the meantime if you would like to speak to Mark Rathbone or Daniel Hayhurst regarding any questions or issues raised in this article please contact 0151 600 3000, email firstname.lastname@example.org or visit www.brabners.com