Private equity investors can become involved in a company at any stage of its lifecycle. This could be during the early stages as a start-up to raise essential capital, or later on to support planned growth and expansion into new markets.
Introducing an investor into your business typically affects the balance of power within the company, as many investors will seek some form of equity return in exchange for their investment. This might involve the allotment or transfer of shares to the investor, which often come with voting rights and/or dividend rights, thereby diluting the existing shareholders’ voting power.
Common Mistakes in Private Equity Deals
- Lack of a Clear Investment Purpose: Not defining the specific goals and purpose of the investment can lead to misaligned expectations and objectives.
- Inadequate Due Diligence: Failing to thoroughly investigate the financial, legal, and operational aspects of the target company can result in unforeseen issues.
- Overpaying for an Investment: Paying too much for an investment can reduce the potential return and increase financial risk.
- Selling Too Much Equity Too Early: Offering a large portion of equity early on can dilute the control of the original owners and reduce future financing options.
- Ignoring the Value Proposition: Not clearly articulating why the business is a better investment compared to competitors can deter potential investors.
- Assuming All Private Equity Firms Are the Same: Different firms have different specialisations and strategies, so it’s important to choose one that aligns with your business needs.
- Inflated Valuation: Setting an unrealistically high valuation can turn away potential investors and complicate negotiations.
- Not Having an Exit Strategy: It’s crucial to plan how the investor will exit the investment to avoid future conflicts and ensure a smooth transition.
Key Considerations Before Engaging with a Potential Investor
Before starting discussions with a potential investor, it is advisable to enter into a confidentiality agreement, or non-disclosure agreement, to protect any commercially sensitive information shared during the process.
What Rights Might the Investor Seek?
Investors typically expect certain returns for their investment, often in the form of shares. Common rights investors may request include:
- The right to appoint a director to represent them at board meetings, with the ability to remove and replace that director. This could lead to the founding directors being outvoted on management decisions.
- The right to appoint an observer to attend all board meetings, with advance notice and access to relevant documents.
- The right to veto “Reserved Matters,” which are actions the company cannot undertake without the investor’s consent. These can include entering into significant contracts, transferring shares, issuing new shares, amending banking facilities, and varying employment contracts.
- The right to be paid ahead of other shareholders or creditors.
- Security in the form of debentures over company assets or personal guarantees from directors or shareholders.
Caution should be exercised here, because some of these rights can significantly impact the day-to-day operations of the company and its board.
How Will the Investor Exit?
It’s crucial to consider the investor’s exit strategy from the outset. Questions to address include whether the investor can transfer their shares within their group, whether the company has the first right of refusal to buy the investor’s shares, and whether the company or its shareholders can buy the investor’s shares after achieving certain profit levels.
An exit strategy is also important in case the relationship with the investor deteriorates. Documenting the terms of the investor’s exit in the investment agreement is essential to protect all parties involved.
Documenting the Relationship with an Investor
Proper documentation of the investment terms is crucial and typically includes:
- Confidentiality Agreement/NDA: To protect confidential information.
- Investment Agreement: The main document outlining the investment terms, investor rights, exit strategy, and company management.
- Articles of Association: The company’s constitutional document, which may need amendments to reflect the investor’s rights.
- Shareholders’ Agreement: This document can outline obligations between the investor and shareholders, and is useful for future-proofing the relationship with the investor and any new shareholders.
- Security Documents: these might include personal guarantees, a debenture, or a registered charge over the company’s premises as common examples. These are all intended to help the investor get their money back if there is an insolvency situation, or significant breach of the shareholders’ agreement or investment agreement and so on.
- Board minutes and Resolutions: these “ancillary” documents are required to record the authorisation of the company entering into the rest of the documentation. They are very important largely to protect the directors of the company, and show how a proper process was followed.
Your Next Steps and How Scott Bailey LLP Can Help
If you are a director of a business and are considering private equity investment, it is vital to think about how your company will operate in the future, and what protections are reasonable for both you and the new investor. The experienced Company and Commercial law solicitors at Scott Bailey LLP, conveniently located between Southampton and Bournemouth, have extensive experience advising SME businesses on receiving investment, and in advising investors on how best to protect their interests.
To discuss how we can help you with your investment matter, please contact us to speak with a member of the Company and Commercial team.
Alternatively, you can find out more about the business legal services our experienced solicitors in Hampshire offer to SME businesses across the Solent region. Our solicitors regularly advise on business sales and purchases, shareholders’ agreements, fixed fee contract reviews and a range of other corporate and commercial law matters.
Ben Ironmonger is a Partner and head of Company and Commercial at Scott Bailey LLP, solicitors in the New Forest, Hampshire.
