In previous posts we talked about trade finance and debt, and tried to define the "flavour" of each of those pieces of the funding puzzle. In this post we will discuss equity. This blog doesn't seek to replicate or substitute for the training that young lawyers receive from their professors and seniors - it aims to supplement that training with a new, client-centric, business-focused perspective.
So here's a way of thinking about equity: Unlike trade credit and debt, equity involves ownership. Ownership confers control. Control means the ability to shape the business. As a lawyer, you might represent one of the existing owners, a potential future owner, or perhaps you are representing the Board or the management of the business. But regardless of who your client is, it is worth understanding the aims of the investors, because this help you anticipate what kind of control they want, and how they might exercise it.
But first, we'll run through some basics.
PART 1: The basics
The cash story
Simple: An investor gives cash to a business.
Of course, there is plenty of work to do in getting the cash from the investor to the business (moving money into and out of escrow accounts, managing foreign exchange risk, complying with capital controls, and so on...) but really it's still just a cash infusion.
The operational finance story
Also simple: The business uses the cash to pay for things.
No new cash outflows for interest payments, no holding cash in reserve to serve as collateral… just more cash to do more things with.
The accounting story
Also fairly simple. On the balance sheet, in the short-term assets section, there will be an increase in "Cash", and there will be a corresponding increase the equity section,
The cap table: Welcome to the arena
Haha! Now things get interesting. Almost everything you care about as a lawyer supporting an equity transaction happens here. To summarize briefly, you and opposing counsel (acting in concert with incredibly expensive bankers) will fight over the following:
- Valuation: How much is the business worth? And therefore what is the price of a percentage stake in the business?
- Allocation of voting rights and design of governance: Should control be proportional to the size of the equity stake? Does there need to be one or more classes of shares with different voting rights?
- Protecting the value of the equity stake from future dilution: Once ownership and control has been allocated among the existing investors, how is this delicate balance going to be preserved or disrupted by the addition of new investors?
Part II: What do different types of investors actually want?
As a young lawyer, you are going to be eyeballs deep in all of the above. And there is no shortage of ways to distinguish yourself by being a competent legal technician, and a diligent legal project manager. But the point of this blog is to help you see beyond the mechanics of the matters you are working on, and see the bigger picture. So let's think a little more about investors: what they want, the value they might bring to a deal, and the risks that they may create.
In order to do this, we are going to create some stylised "personas" - these are too extreme to be realistic, but you can use them as a starting point for understanding how investors think.
"Pure" returns investors
This is the stylized investor we encounter in classes on valuation and rational actor analysis. These might be venture capitalists, asset managers, or the investment arm of a large corporate group. (Note that in reality, these investors may well have additional motivations beyond pure returns. Remember this is a stylized case.)
What does a "pure returns" investor want?
To achieve their target return on investment, in an acceptable timeframe, and with an acceptable level of risk.
An aside – remember that, like lenders who have a portfolio of outstanding loans, an investor has a portfolio of equity stakes in a variety of companies. Not every one of those companies needs to be a success – indeed, one common business model among venture investors is to fund 20-30 startups, hoping that just one or two of their investments deliver huge returns.
What does a "pure returns" investor provide?
A investor whose core business model is investing, will likely have a stronger understanding of the funding market than investors who only make occasional deals. They will have fresh and relevant information about alternative opportunities, the availability of capital and macroeconomic trends. Since investing is their core business, they may have better models, better access to capital or more experienced staff involved in sourcing and vetting deals.
All of this may make for a more rigorous, hard-nosed, objective perspective available in the investor group. They may also be more experienced at crafting a narrative around the business they are investing in, to articulate a compelling vision and value proposition, and create buzz and confidence in the market.
What are the risks that "pure returns" investors bring?
For better or worse, an investor who is focused on a certain return within a certain timeframe will use their influence to push the company to achieve their investment goals.
If the investor's aim is to make a profitable exit in a short time frame, that might mean pushing the business to pursue an aggressive, high-risk, high-growth strategy - even if this is unsustainable and sacrifices long-term value creation.
Conversely, an investor who is focused on generating reliable dividends over the long-term may push the business towards a more conservative path, with lower risk-taking, lower innovation and lower growth.
Strategic investors
There may be various definitions of "strategic investor" out there, but for my purposes I am referring to an investor who is taking a stake in a business to further their own broader commercial goals. Strategic investors are often established players in the industry that they invest into, but not necessarily.
Like pure returns investors, strategic investors will have a hurdle rate, a time horizon and other investment criteria, but will augment these criteria with other commercial objectives.
What does a strategic investor want?
It depends on their goals, and the nature of the business they are invested in. One way to think of a strategic investment is to use an "asset acquisition" lens: A business may have technology, trademarks, relationships, contracts or perhaps a team that complements an investor's own business. A stake in the company may be a route for getting access to some of those assets, or for eventually positioning the investor to purchase the business outright.
You could also see an investment through a "competitive intelligence and positioning" lens, whereby a company uses its stake in a business to open up new information channels, or to direct the business to invest in markets, products and technologies that shape the market to the investor's benefit.
You could also use a "learning and culture" lens, to see an investment as an avenue for gaining access to techniques, ideas and ways of working. For example, sometimes when established players invest in younger, nimbler businesses, they send staff to the new business on secondment.
What does a strategic investor bring to a business?
Here are three broad categories of what a strategic investor might bring, which broadly mirror what they might receive from a business they invest in:
First, a strategic investor might be able to make assets and capabilities available to the business they invest in. For example, they might deploy marketing resources, provide competitive intelligence, or provide integration with their technology platforms.
Second, a strategic investor might provide perspective and positioning opportunities within a larger commercial framework - effectively an alliance. One of the most helpful things a strategic investor can do, is to open a market for a business. Better still, it may even become a buyer of the business’s products and services.
Third, a strategic investor can provide expertise, structure and process. Where a strategic investor is more established or mature than the business they invest in, they may help that business accelerate its development into a mature organization by providing training, secondments, sharing of best practices and so on.
For the moment, I am sticking with a scenario in which the strategic investor is a mature business, and potentially an established player in the market. In such cases, I would highlight conservatism, constraints, and eventually total capture as risks that arise out of their involvement.
By conservatism, I mean two things: One is the general trappings of large corporate bureaucracy. Mature organisations need processes in order to run effectively. They operate at scale, they deal with varied and complex situations, and they grow and adapt to survive. As we discussed in the post on businesses organisations, this requires a sophisticated "nervous system". Unfortunately, the more sophisticated the system, the more layers of input and approval are required in order to make decisions. Subjecting - or even exposing - a nimble company to a bureaucracy can slow the nimble company down, frustrate its decisionmakers. Or even worse, it can "infect" the nimble company with more structure and process than is appropriate. Above, I mentioned that a strategic investor can accelerate a young business's organisational development... but is this always a good thing? Corporate cultural osmosis is a powerful phenomenon, and it can hurt as well as help..
This brings me to the second part of conservatism, which is to do with the risk aversion that is inherent in many mature business models. Successful companies that survive into a mature stage tend to start optimising for scale, standardisation and stability. That thinking may be incompatible with how a smaller, nimbler company needs to behave. It takes maturity, restraint and trust for a strategic investor who is in a very mature stage of development, to support a business that is in a very different stage of development.
The next risk is that of hard constraints. Admittedly, this risk could apply to other investor types as well, but I think it is most keenly felt where an established business invests strategically in another business. Established businesses might be subject to export controls, banking regulations, sanctions screening regimes and so on, that prevent them and businesses that they invest in from engaging in certain activities. Supply chain sustainability, ESG commitments, outsourcing and offshoring regulations and of course tax considerations all shape how companies do business, and some of those constraints may cascade down from a strategic investor's world into the businesses they invest in. The more astute, regulatorily-minded among you may also have a weird "monopoly and market abuse" ringing sound in your ears, and you would be right. A strategic investment in a business that is complementary to - or worse, in the same business as - the investor's own business will potentially face regulatory scrutiny, and you as lawyers will make good money by being invited to meetings where you will recite the provisions of various antitrust regulations for the benefit of those present, and will make even more good money by writing detailed minutes of those meetings.
Finally, there is a risk of outright capture. There will always be opportunities that the business wants to pursue, that do not align with what the strategic investor wants. If the strategic investor has enough power to consistently veto anything that doesn't serve its own strategy, then it has effectively turned the business it invest in, into an outsourced function of its own operations.
Mission-driven investors
I use this term to capture those investors who have a non-financial, non-competitive reason for investing in a business. That reason could be philanthropic, political or social, and it might come under the name of "impact investing", "ethical investing" or "corporate social responsibility". I'm also going to include here reasons such as promoting innovation, boosting regional development, or supplementing the supply of public goods.
What does a mission-driven investor want?
A mission-driven investor will make investments that advance its overall social, political or philanthropic goals. They might choose to invest in a particular business because of what the business does, how it is run, or in some cases because of who owns it. It's important to note that mission-driven investors don't necessarily invest in companies that already meet these goals. In fact, such investors sometimes fulfil their mission by transforming companies to make them more aligned with their goals.
Like other investors, mission-driven investors will have a financial hurdle rate, but whatever financial requirements they have will be complemented by others that are linked to their mission.
What does a mission-driven investor bring to a business?
A mission-driven investor is a bridge between the world of business and potentially the worlds of philanthropy, government and other areas of society. Having shareholders with a broader point of view and a different set of motivations might give the company access to ideas, perspectives and information that improve how the business is run. Mission-driven investors might also provide the business with visibility and credibility in important public fora, such as policymaking.
What are the risks that mission-driven investors brings with them?
Mission-driven investors do bring with them some risks, which to some degree mirror the risks presented by other investors. First is that of reporting. The more professionalized the investor, the more onerous their non-financial metrics might be. Second is institutional inertia: the larger and more bureaucratic the investor, the more painful it can be to seek approvals or input on key decisions.
But the key risk is that of political, ideological or methodological constraints imposed by the investor's mission. Remember that a mission-driven investor might care deeply what the business does, or how it does business, or who owns the business - or possibly all three. These requirements can sometimes be more rigid than what would be imposed by an investor who is focused purely on financial returns.
Individuals
I'm adding a brief note on individual investors because these are the wild cards. The most important feature of an individual investor is that they do not bring with them institutional constraints. Their decisionmaking might be informed, sophisticated and even wise, but without the moderating influence of an investment committee or some other hive mind, it is going to be more influenced by the investor's personal predelictions and circumstances, than by a policy or procedure.
What do individual investors want?
Returns, of course, but potentially other things too.
One is prestige: there is a certain amount of social cachet that goes with being "an investor", and for some individuals it represents an aspirational ideal. "Investing" sits alongside "advising" and "sitting on a board" as something that the wise and the wealthy have the experience, skills and resources to do, and certainly sounds more glamorous than supervising the month-end closing process, doing groceries or picking up the dry cleaning.
Another is amusement or engagement. Though I suggested that investing has a certain mystique to it, it's true that many of those who have attained wealth and wisdom, also have time on their hands. And not everyone likes golf, gardening or bridge.
A third one might be altruism, whether in a sense of having a grand "mission" or just wanting to support certain kinds of entrepreneurs, businesses or activities. For some investors, spending their time and social capital on supporting a business is an effective and meaningful form of charity.
What do individual investors provide?
As just mentioned, an individual investor is not necessarily just a source of funds. They may provide advice, and access to resources. But in some cases the most valuable thing that they provide is credibility, visibility and validation in the right industry and funding circles.
What risks to individual investors bring?
The first risk is that the individual is just not very good at investing. There is no professional certificate or specific training required to be an investor, so anyone can join the fun if they have some spare cash. But is it a really a problem if an investor is uninformed, unsophisticated or lacks the temperament or skills to allocate capital effectively? Doesn't it make everyone else's life easier if an investor is a little clueless, and perhaps willing to overpay for their stake? Perhaps... but it also means that they can be a disruptive, distracting influence on the business, especially if they don't really understand it. They may have anchored themselves to a specific valuation or an unrealistic expectation of returns, which makes them unwilling to sell out at a good price.
Another risk is that, unlike institutions, individuals need to eat, buy clothes and send their kids to college. They get sick, they get sued, and they lose their savings at the racing track. Which is to say, they might need their money back very suddenly.
Finally, even if they are wise and solvent, they just might lose interest. Passions and priorities shift. Boredom and frustration can be powerful motivators. An individual does not have an investment committee, a charter or a Board to hold them accountable to a long-term strategy, and so even if they are contractually bound to remain invested in a business, they may disengage and become a source of delay and confusion.
There is one more aspect of individual investors that is worth noting - and this is more a structural factor that arises out of the lifecycle of a business, and applies most commonly to startups. Because many early stage companies get their first round of funding from individuals, those individuals often have an outsize amount of control. Because young companies often have better things to do than negotiate crisp, clear terms with their first investors, those early funding arrangements are often based on poorly documented understandings, with idiosyncratic or nebulous terms. Hence, a big challenge for late-stage startups is "tidying up" their cap table, which involves replacing the well-meaning, generous individuals who originally funded them, with professional institutional investors.
Part III: So what?
I mentioned in the first paragraph that it's worth understanding the motivations of different types of investors. This allows you to anticipate the kind of rights and protections they will demand, and how they will likely use those rights and protections.
Here's the high level intuition that you should take away from this post: Each investor is solving for their own utility maximization function, which includes both financial and non-financial aims. These aims are not necessarily incompatible, but compromise is required. The job of a dealmaker is to help all the parties get enough of what they want, that they stay at the table and see the deal through. As a lawyer, you might or you might not be the dealmaker (and as a junior lawyer you almost certainly are not), but you can still create and capture value as you draft and craft the terms of the deal.
It's all very well for a VC to promise that they will provide exposure and expertise. But can they be help to that promise? A strategic investor might say they will provide access to technology, or integration with a channel marketing scheme. But will they actually spend the time and effort required to make that happen? The answer depends in part on whether the shareholder agreements have been drafted to make sure that the company and the investors deliver on all the elements that create and capture value.
So when you are hacking away at another round of comments at some ungodly hour, don't forget that you are well-placed to help make sure all these promises and opportunities stand the best possible chance of coming to fruition. Hidden amongst all the boilerplate are the nuggets of commitment that really matter. Hopefully by keeping the overall shape of the deal in mind, and a keen awareness of the value that each party brings, you can recognize those nuggets, and make sure that they are drafted in a way that unlocks value.