There are some key factors to consider when raising external investment, say ROD HUTCHISON and MICHAEL LEITH
So, you have a great business idea, you have gained some traction in the market and are ready to grow the business to the next stage. Many founders have the entrepreneurial spirit, work ethic and commercial acumen to turn an idea into a sustainable business, but may need external investment to achieve their goals.
External investment in early-stage businesses (often called Seed Investment) can be a major component of a successful business plan.
However, it can be tempting to focus on the short-term benefits of funding without fully considering the future implications. The wrong terms can lock the otherwise motivated entrepreneur into controls that can quickly sour the relationship between the founder and investor.
This guide explains the typical investor protections and rights, plus some tips to keep momentum without giving away too much control of your business.
Methods of investment
Typically, an investor will either invest their money by way of a loan to the business or via a subscription for shares, or a combination of both.
Loan
If the investor puts their money in as a loan, they will want to see a commercial rate of interest with a certain repayment profile to ensure they get their money back in good time.
The investor may also seek security over the business assets to ensure they get their money back in priority to other creditors. In any event, the founder needs to ensure the repayment terms are realistic to ensure the business isn’t under pressure to repay the loan whilst the focus is on growth.
Subscription for Shares
If the investor puts up their money in return for shares in the company, the investor will equally be keen to ensure their investment is protected.
The investor may seek restrictions in relation to key company matters such as (i) share issues to future investors; (ii) the company entering into high value contracts or future borrowing; and (iii) the founder’s remuneration package whilst the business grows.
Further, the investor may seek to appoint a director to the company, obtain oversight of the business plan, secure preferred rights in relation to dividends and sale proceeds and introduce compulsory share transfer provisions to ensure the founder’s long‑term commitment.
If not given sufficient consideration, these points can materially affect the founder’s ability to grow the business in the way they envisage. However, with appropriate legal advice, a balanced position can usually be reached – one that protects the investor’s interests without undermining the agility and operational freedom of the business.
Tips for the founder
Any business founder considering whether to take investment should consider the following:
- Commitment. Demonstrate confidence in your business plan and commit to delivering on it. Provide the investor with sufficient visibility and oversight to safeguard their investment, while ensuring that any protections or restrictions remain proportionate to the level of funding. Keep the focus on strategic objectives and establish reasonable parameters.
- Term Sheets. Take early advice on any term sheet (or heads of terms) to ensure all key terms are captured and the parties are aligned before significant costs are incurred in drafting the main investment documents. A well-structured term sheet also helps the founder assess whether the investor is the right fit for them.
- Preferences. Carefully consider whether it is appropriate to give the investor enhanced rights. For example, an investor may look for a preference in relation to dividends and proceeds on a sale, but giving an investor a preference to dividends and sale proceeds can significantly erode the founder’s economic return for their hard work.
- Take advice. Get in touch with your lawyers, accountants and tax advisers as early as possible to receive tailored advice for your specific circumstances. We recommend that the founder never agrees to investment terms without specialist advice.
- EIS / SEIS. Consider whether any investment could qualify for the Enterprise Investment Scheme (EIS) or Seed Enterprise Investment Scheme (SEIS). These government‑backed tax reliefs can make your company significantly more attractive to investors, particularly at early stage.
Early-stage investment is all about balance. The key is to give the investor sufficient rights on participation, and the prospect of a reasonable return on the funding they advance, whilst being mindful to protect yourself and your business from an unreasonable level of external control or return on investment.
Rod Hutchison is partner and energy sector lead, and Michael Leith is senior associate at Aberdein Considine
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