When Directors Go In Search Of Capital – Seller Beware!

Bees to the money – an opportunity awaits
Over 95 percent of all New Zealand businesses are small to medium sized enterprises – SMEs. Despite this fact there is only now emerging some real appreciation and understanding of the important economic role of SMEs and the investment potential the sector represents.
The trend appears to be accelerating if the recent and rapid establishment of number of venture capital and private equity funds seeking investments in high growth SMEs is any indication.
In general the awakening and development of investor interest in SMEs is positive for the sector and should create benefits for business owners, managers and the country as whole. Taking advantage of this form of financing does, however, present real challenges for owners and directors of SMEs. While the benefits could be considerable in securing additional capital for growth it is not without its risks and potential consequences. Investment in an SME by venture capitalist or private equity investor requires directors and owners to exercise specialist judgement and knowledge beyond what they might normally be expected to possess.

The coming age of private equity – utopia with strings attached
Most venture capitalists and private equity investors currently seek to invest in high-growth SMEs and as general rule have between $500,000 and $10 million to invest in each transaction. Many of these potential investors, while recognising the supposedly higher risk profile attaching to these forms of investment, are also seeking diversification of part of their assets away from listed company shares or other traditional classes of assets.
Attached to each investment are the investor’s expectations and requirements for the often-superior risk adjusted rates of return provided by private equity and venture capital opportunities. Consequently while expansion or growth equity capital is undoubtedly becoming more accessible it can also come at very significant cost to the SME’s current shareholders and owners.
Unless any transaction involving the issue of equity to external investors is priced and structured properly at the outset the potential will always exist for disproportionate transfer of value from one set of shareholders to the other. The true long-term cost of this value transfer could be significant and well beyond that fairly believed and envisaged at the time of original investment.

Everything comes at cost and ignorance is no excuse
Accordingly, in evaluating growth opportunities the associated funding dilemma facing the entrepreneur, business owner or directors sharpens to question of “do we want growth and if so how much of the existing company and future upside must we cede to the external provider of the growth capital?”. The answer is as much function of the then available range of possible investors, negotiation and transaction pricing and structuring, as it is the hypothetical results delivered by valuation spreadsheet and set of earnings projections.
In valuing the company there is very high chance that those SME owners and directors selling pieces of the company and its future often know more about their company, their product, their industry and their competitors than the potential investor. Conversely, there is high chance that the SME and its officers will know less than the potential investor about the then prevailing private equity or venture capital investment market or the typical investment and transactions structures used at that time.
Importantly, the SME will probably also be less aware of the likely transaction terms and values attaching to comparable SMEs or industry participants. Consequently unlike equity investment in listed companies (where there is theoretically fully informed market) the possibility of so called “information asymmetry” between the seller of equity – the SME – and the buyer of equity – the potential investor – is high. This often has resulting impact on the end transaction pricing.
The devil of any deal, they say, is in the detail and traditionally venture capital and private equity deals have plenty of detail and complexity. This is due in no small part to the fact that the smart people who populate private equity and venture capital investment love upside and hate downside. Understandably the same smart people also love high returns and also actively engineer to lay off risk. To mitigate the possible impact of hypothetical “information asymmetry” and to enhance investment performance the potential investor often employs number of transaction structuring methods and mechanisms.
Before seeking equity from an external investor the question should be asked by the SME’s board of directors as to whether their collective competencies deliver an ability to negotiate the transaction without retaining specialist advisers.
• Do they have the skills to recognise and fully appreciate the true meaning of various “value recognition and adjustment” mechanisms fondly and frequently employed by the venture capitalist or private equity investor?
• Do they absolutely know and understand what exactly the “participation in key strategic decision making” type clauses commonly found in subscription agreements mean?
• Do they recognise the explicit and implicit implications of having different classes of shares for existing and new shareholders on the management and development of the company now and in the future – especially if things turn ugly?
• Do they really understand what is meant by “Piggy Back”, “Tag Along” or “First Right of Refusal” features that are different from normal “Pre-emptive Rights” and the implications of these clauses if existing shareholders ever want to sell?
All of the above, and whole lot more, are common features of any venture capital or private equity investment transaction.

The cost of good advice – the value is still enjoyed long after the price is forgotten
Someone said that the barrister who defended himself is ‘a fool and he has fool for client’. Many SME boards seeking to minimise the cost of attracting and securing equity capital have repented at leisure, and great expense, the decision to rely on their own skills in playing an unfamiliar game. In the majority of cases where specialist and objective advice is not obtained the experience leads to one conclusion – “don’t try to play professionals at their own game unless it is also your game and you can divorce your emotions from the game”.
Unless the SME’s directors are fully versed and experienced in negotiating venture capital or private equity transactions using their discretion to retain competent external advisers is the best course of action. Get good set of independent and objective financial and legal advisers skilled and experienced in the game the professional plays. In the long run the cost of retaining competent team of advisers who are familiar with, and experienced in, the private equity investors and venture capitalists game may be the best investment an SME’s directors and shareholders ever make.

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