How to take on equity funding without losing control of your business
This article is by Sam Simpson, founder and COO at Founder Catalyst.
Founders who are considering external funding sources will often be concerned about the impact of taking on investment, particularly about losing some control of a business they may have invested many years in building.
On the flip side, an investor may be concerned about writing a big cheque and not having any ongoing control over or involvement in your business.
Typically, early funding rounds and modest investment sums will be via family and friends or angel investors and the control requested will be relatively straightforward. Later stage rounds and those with larger investment values will typically involve more demanding investors who will provide a much higher level of funding but at the cost of negotiating more control over how you operate the business.
In this article, I thought it would be useful to explore the various mechanisms that investors may wish to negotiate into an investment agreement:
An undertaking is a promise to do or not do something. An investor may, for example, insist that you include an undertaking to preserve SEIS tax relief – i.e. you won’t do (or not do) anything that would put this relief at risk. Breaching an undertaking could give rise to a breach of contract claim, so any undertakings that you or the company gives should be taken seriously.
A founder should be aware of certain rights that are afforded to shareholders that control certain levels of shareholding in a business. For example:
• Owners of >75% of the company’s voting share capital can, according to the Companies Act 2006, pass a special resolution which allows shareholders to adopt new articles of association or to disapply pre-emption rights.
• Owners of >50% of the company’s voting share capital can pass an ordinary resolution allowing shareholders to remove a director of the company.
It follows that, if owners with more than 75% of the company can pass a particular motion, then shareholders with greater than 25% of the voting rights can block a motion.
Board appointment rights
Some institutional investors may insist on board appointment rights – the options are typically:
• Board observer – this gives an investor the right to appoint an individual to participate in board meetings and to receive all information provided to the board. The board observer will not be a statutory director and therefore will not formally vote in this capacity.
• Investor director – this gives an investor the right to appoint an individual to take a formal seat on the board. The investor director will be a statutory director and will have the right to vote.
Step in / swamping rights
Sometimes in private equity investments, the parties agree to step-in rights or swamping rights. This right allows an investor to “step in” and take voting control of the company’s board of directors and/or general meetings of shareholders. An investors right to ‘step-in’ would generally be limited to scenarios such as the following:
• The company is (or is likely to become) to breach banking covenants related to a loan.
• The company is in breach of the shareholders agreement.
The step-in event is typically temporary, allowing the investor utilising step-in the opportunity to address the issue and to implement measures to prevent the same thing happening again.
Founder equity vesting
By default, founder(s) will expect to own 100% of their shares from day one in the business. In many cases, investors will expect to see shares vesting over time – so the shares are incrementally allocated to founders the longer they are with the business.
The investors will also expect different levels of equity to be retained by founder(s) depending upon the circumstances under which the founder is leaving a company.
Pre-emption gives an existing shareholder the right, but not obligation, to maintain their percentage shareholding in a company when the company is issuing new shares. This is an entirely market standard term in any stage investment but it does have implications for founders wishing to raise capital.
Also known as veto rights, ensure that the company seeks consent from specific investors, or a certain percentage of investors, before they can undertake certain actions. These actions may depends upon the circumstances, but typically include items such as:
• Altering the article of association
• Pay a dividend
• Place the company into administration
• Incur any capital spend above a certain threshold
Crucially, investor consents are a right conferred to a shareholder rather than a director of the company. Unlike board level control (via Step In / Investor Director mechanisms), which carry a fiduciary responsibility on the board and individual directors, investor consents are powers which aren’t subject to these rules.