I do a lot of investing in young, risky (and sometimes very successful) early-stage businesses. Generally speaking, the initial investments are made in return for simple ordinary equity. So there’s one class of shares, with largely identical economics. Quite often, this sort of very risky early investment is made by individuals – frequently by ‘friends and family’ – who, in the UK, can then claim tax reliefs, such as the Seed Enterprise Investment Scheme or Enterprise Investment Scheme.
If the company fails at the beginning, that’s that. But if the business starts to grow, it’ll probably need more money, often in quantities the initial investor group doesn’t have. A ‘professional’ venture capital (VC) group or syndicate may be next to arrive. These investors are rarely fans of simple ordinary equity, so they seek to invest in new classes of shares that include powerful rights.
By way of example, a growing venture might initially raise £1m from individuals for, say, 40% ownership, giving the early-stage company a £2.5m post-money valuation. The next step might be to seek to raise £5m in new equity. A VC might then make an offer at a pre-money valuation, stated to be £5m, for a 50% ownership. Sounds great for the first investors – it’s twice what they paid only a year ago, even though they’ll now have been diluted to 20%.
Show me the money!
Now comes bad news: the professional is actually offering to invest in a new, ‘preferred’ class of shares, which would mean they’d get their money back and share in half of the upside.
Sometimes, the terms are a multiple of their money back before the initial investors see any upside. If they have a simple ‘1x’ preference and the company is sold for £5m, all the proceeds go to the preference shareholders. Initial supporters and managers get nothing. If sold for £10m, the first £5m plus £2.5m goes to the VCs for their 50%. The first investors get their money back – £1m. Management gets the remaining £1.5m. For £20m, it’s £12.5m to the VC, £3m to friends/family, £4.5m to management.
It gets more complex if further rounds of capital are raised – typically, all with fresh and additional preferences that need to be negotiated. These can be complex – perhaps a 1x if there’s an exit in three years or less, or a 2x if later.
To add to the woes of the really quite essential and risk-taking initial backers, preferred investors frequently seek to remove pre-emption rights so that the initial investors cannot protect their positions by putting up fresh cash. The ‘preferred’ may well dictate board membership, too. Sometimes they seek to remove all voting and information rights for non-preferred shareholders. Legal drafting costs become very large. Legals – especially anti-dilution clauses – become very intricate.
In one recent situation I encountered, it became clear that a dominant preferred shareholder with a strong legal position was deliberately blocking other new financings in order to force a sale of the rapidly improving company because they had invested from a fund they wanted to close down. They would be paid their preference, but a quick sale would likely yield nothing for ordinary investors.
A more common problem occurs when a company doesn’t do well, needs new money, but is not worth the existing preference. For it to then be financed by third parties, the preference holder must agree to lose the preference. Such ventures fail because agreement cannot be reached.
Tempting fate
There are considerable drawbacks to using preferred shares, both for the company and the initial shareholders, yet they’re widely deployed.
A common tactic to persuade executive directors to take preferred shares in their companies is to offer a generous equity or options package to management. An aggressive preferred-equity package can, and sometimes does, pretty well wipe out early investors. But typically, the executives control who the new investor will be, so the temptation is obvious.
Section 172 of the UK’s Companies Act requires directors to ‘act fairly as between members of the company’. But in practical terms, this section lacks any means of enforcement against directors.
The law does not help early investors. They have to look after themselves. My advice? Companies can grow without using preferred shares – and should do so where possible.