When reviewing business performance and strategy, many business owners will be looking to grow their businesses and a lack of available finance will often be a key obstacle to delivering those growth plans.
There are a huge number of different sources of finance – from high street banks to crowdfunding all of which have their pros and cons. This article focuses on one of those sources – ‘seed’ investment. Seed investment refers to cash investment by private individuals into early stage companies in return for shares in that company. A well-known example is Dragon’s Den.
The amount of funding and share ownership in a seed investment round will depend on a number of factors including the existing value of the company, the potential for growth and the amount of finance required but typically we see investments of between 50k and £500k for between 5% and 30% of the ownership. Individuals are often able to obtain attractive tax reliefs (EIS or SEIS) on seed investments which make them particularly popular.
Seed investors normally have previous experience running their own businesses, often in the same industry or sector as the companies in which they invest. Their aim is to increase the value of the company and after a certain period (e.g. 3-5 years) they will look to sell their investment (sometimes resulting in a sale of the whole company) for a profit. They will want to use their previous business experience to provide guidance and advice on a range of management and commercial issues. They may also have useful contacts within the relevant industry who can provide opportunities that would not otherwise have been readily available to the business.
Six key areas to be considered when agreeing the terms of a seed investment are set out below. For all but the simplest investments, it is useful and cost effective to agree these in heads of terms ahead of preparing the longer form investment documents.
- Warranties. The investor will want the founders and the company to provide certain warranties about the state of the company. Of particular importance will be the financial position of the company and the basis of preparation of any business projections and plans which the investor may have relied upon when deciding to invest. The founders will need to carefully consider the warranties and negotiate appropriate limits on their liability to apply if there is a subsequent claim under a warranty.
- Financial reporting. The investor will need sufficient information and contact meetings to be able to understand how the business is performing and enable him/her to provide guidance and advice on future strategy. Too much information will be an administrative burden for the founder.
- Remuneration. Before any investment, a founder is likely to be remunerated through an ad-hoc mixture of salary and dividends. Post investment, the founder’s remuneration will need to be solely through salary, the terms of which the investor will want to formalise in a new service agreement between the founder and the company.
- Veto rights. The founder usually retains a majority of the shares which in the absence of any written agreement gives him/her control to operate the company broadly as the founder wishes. It is therefore common for the investor to receive some contractual protection that the founder will not do certain things (aka reserved matters) without the investor’s consent. A founder will want to make sure that the list of reserved matters is not too onerous and that the investor(s) is available to give consent when needed.
- Share transfers. An early stage business may not have a lot of existing value and the investor may be relying on the founder to deliver the business plan to create value. They will therefore want some comfort that the founder will not be able to sell his shares or leave to join a competitor within a certain period. On the other hand a founder will not want to lose control of his company for reasons outside of his control.
- Exit strategy. Often the investor will sell his shares at the same time as the founder because they will both achieve a higher price per share if they can offer 100% of the shares for sale. The investor will have an idea at the outset of how long they would like to hold the shares and a founder should always discuss this with the investor to make sure that there is some common ground. Typically private equity investors look to hold investments for between 3 to 5 years but some investors do look for longer term investments.
If you wish to discuss any of the issues raised in this article please contact the author, Henry Maples, Associate on 01872 226998 or firstname.lastname@example.org.
The information provided in this article is for general information purposes only and does not constitute legal or other professional advice and cannot be relied upon as such. Any law quoted in this article is correct as at 4 February 2016. Appropriate legal advice should be sought for specific circumstances before any action is taken.
Copyright © Murrell Associates Limited, February 2016.