The IBSA Podcasts
IBSA podcasts contain information from a global community of entrepreneurs and professional advisors dealing with international business structuring and regulatory compliance.
Hosted by Roy Saunders, who has over 50 years’ experience within the financial sector, these podcasts delve into enlightening conversations with a wide range of leading professionals aiming to demystify the complex world of business and provide invaluable insights to help listeners deal with various complex technical matters to best support their business and clients.
Disclaimer: We believe the information in this podcast to be correct at the time of recording. The information given is relevant at the time in line with governmental legislations. Competent counsel in the jurisdiction(s) whose laws are involved should be consulted. The podcast is made available by the IBSA for educational purposes only and to provide general information. The information should not be used or relied upon as a substitute for competent legal advice from a licensed professional in your jurisdiction.
The IBSA Podcasts
Lucie Burniston Reveals Essential Strategies for Securing Start-up Funding and Navigating Investor Relationships
Unlock the secrets to fueling your entrepreneurial dreams as Roy Saunders teams up with start-up savant Lucie Burniston to dissect the vital elements of start-up funding. From the seedlings of angel investments to the towering oaks of venture capital and private equity, our conversation lays bare the essential steps for founders to secure their business's financial future. Lucie imparts her wisdom on moving from personal networks and accelerator programs to wooing institutional investors, emphasizing the crucial role of formal documentation to protect all parties involved.
Venture into the strategic decision-making that faces founders, as we scrutinise the choice between venture capital and private equity with Lucie’s expert lens. We dissect the implications of drag-along and tag-along rights, delve into the preferences of investors, and confront the challenges that surface during funding rounds.
This podcast explores a fictitious case study centred around an entrepreneur’s ambition to develop a task management software company. Click here to read the case study in full.
These issues will be examined in greater detail at our upcoming conference in May. Click here for full details of the conference and to book your ticket.
Hello and welcome to this IBSA podcast on the topic of funding start-up companies and the next stage of secondary funding with venture capital and private equity funds. My name is Roy Saunders, founder and chairman of the IBSA, the International Business Structuring Association, which is a multidisciplinary global association of entrepreneurs and their professional advisors, dedicated to sharing their expertise with each other within a great networking platform. Today I'm joined by Lucy Berniston of Memory Crystal and I'm changing my identity to become Nicholas, the entrepreneur behind my fictitious case study, which formed the framework of our autumn workshops and which will also feature in the forthcoming annual IBSA conference. I would direct our listeners to read the case study on the IBSA website under the conference page at the IBSAorg to fully understand what we will be discussing today. So, lucy, as we discussed, I've got an Austrian company which created my task management software program, tash, and, via my time in the US with TASH Inc, which I formed, I've now come to the UK and created TASH App Ltd, which needs some funding to get going.
Speaker 1:And what I want to particularly to discuss with you is whether I'd be able to attract secondary funding with VCs or PE companies. But firstly, where do you suggest I look for angel equity investments to fund R&D and early stage operations in TASH App Ltd.
Speaker 2:Well, there's plenty of sources of angel equity investment available for those seeking investment in the UK market or indeed from elsewhere, or a combination of both.
Speaker 2:We tend to find angel investment comes sometimes from what we call accelerator or incubator programs. Which accelerators are organisations which provide sort of mentorship and guidance to founders to help them build the early stages of their business and sort of hold their hands through the angel fundraising process, and what they do is they take a slice of equity in return for their services, but they do frequently invest directly themselves, usually around the sort of five, sometimes 10% mark. You've also, of course, got your own founder friends and family to call on, possibly again if they've helped you. So far. You've got high net worth angels, possibly some VCs at this stage, but they tend to want to come in once your new career is more proven in the market. And then, particularly in the technology sector, you could look to university or government grants. But when you hear people talk about the sort of angel investment rounds, what you tend to envisage is giving away sort of 10 to 20% from across all of these sources. It tends to be a lot of smaller investors making up that 10 to 20% up together.
Speaker 1:And do they agree to dilution if I go for further funding?
Speaker 2:Things are relatively informal at the angel stage. They know that I'll have obviously hope that there will be further fundraising rounds to come. You will have to go back to consent from them when the VCs come in. There'll be a new suite of documents that you'll effectively be starting again. But you would structure things so that they can't block anything.
Speaker 1:Is it expensive to start with the angels with the documentation that's required, or can we do this very informally with some of the angels?
Speaker 2:You do want to make sure that you've got formal documentation in place, what you're doing, the documents you're looking to. There'll be a heads of terms perhaps that you send out to all of your angels. Heads of terms are non-binding but they set out your key headline terms that you're prepared to offer and if they sign up to those, it's very much a signal of intent and there's a moral obligation to move forward on those terms unless there's any material changes. And then you move on to the legal documents that there's usually three. You've got your articles of association, which set out your share rights, dividends, capital returns, voting rights and that'll include basic minority protections for those angels, just to prohibit mass dilution. Then your second document is a shareholders agreement, which is sometimes called investment agreement. That's more about regulating the ongoing relationship between you and your investors and the company. And then the third document is a subscription agreement. That's the actual binding document that sets out the terms of their investment how many pounds for how many shares. The idea is that subscription agreement, once they've invested, just falls away and you are left with the articles in your shareholders agreement governing things going forward.
Speaker 2:Now the temptation is to try to cut costs at this stage and obviously all advisors are aware that costs are tight in the early days.
Speaker 2:But it is advisable to seek proper legal advice at this stage because a good suite of angel investment documents should see you through a number of pre-series A fundraising rounds without significant amendment, and what I have seen on counter-settate occasions is, without proper legal advice, founders do often give too much away too soon to these smaller angel investors and that can make it difficult later on because obviously there's a snowball effect. So when your next fundraising round or investors will ask for slightly more and slightly more and it becomes an unattractive proposition when your VC's are ready to come in. And also, like I said before, you would probably have to go back to your angels to get some sort of consent to your VC series A round, and they're going to be less keen to do that if it involves relinquishing too many and hard strikes that you've given them already. So there are benefits to getting proper advice at this stage, particularly if you're wanting to make sure your AIS compliance throughout.
Speaker 1:Yes, I mean I've seen a lot of programs on Dragons Den where the founders actually can't accept the offer from the Dragons because of the initial funding arrangements. So, looking forward, I know the company has got difficulties, my company has got difficulties, and if I need to restructure my business and form a new company, a 2024 company called Tash App and then I approach venture capital funds, what would be the difference in approach versus angel funding?
Speaker 2:Okay. So as you're sort of progressing along your fundraising journey and you're getting to your VC stage, that's when you're tending to look for that one single institutional large investor, or sometimes what we call a lead or a cornerstone investor, and in those circumstances your VC will be your main point of contact, with whom you negotiate the documents, and then other smaller investors will piggyback onto that and inherit the same terms VCs. At this stage they're tending to look for more from the company. It's no longer about a good idea that might have been enough to attract angels. Now they're wanting to see some proper strategy and a robust business plan and certainly some many VCs do have minimum financial metrics for the company to meet before they will consider investing.
Speaker 2:This is what people loosely call the series A round. It's your first institutional fundraising round, sort of looking at that one to five million mark. It can be for more 10 to 20, but obviously the more you're trying to raise, the more advanced business model and higher valuation you're going to need. But yes, you will have to prove some track history, albeit not significant, as this is, vcs are still prepared to invest at a relatively early stage and at a relatively high risk, but in return. They're still looking for high returns.
Speaker 1:Now the intellectual property that I have in the TASH software. Originally I had it in the Austrian company but I created it. I then moved it over to the US to be licensed there and then to the UK. If I've only got a license in TASH app and I'm the one that actually created the copyright, so therefore it's my copyright how tight are the venture capitalists going to be in looking at the intellectual property and other assets in fact of TASH app? The due diligence, I guess, is quite heavy.
Speaker 2:It is much, much heavier at the VC stage than angels will do, although obviously as a technology IP-based company, even at angel stage, you can expect to have to give some warranties on ownership of IP.
Speaker 2:But yes, due diligence is much heavier on the commercial side and financial side at your Series A round At the VC stage as well. It's very common to use what we call the BBCA standard form investment documents, which are sort of model pro-former child's agreements and articles produced for use by VCs and then you can tailor them to the particular trials action. But those BBCA documents are very clear that they do expect the IP ownership to rest with the Investee Company and the founder will undertake to assign or future IP to the company in those. So yes, you can expect thorough due diligence and any deficiencies you would expect to have to remedy with long-term license arrangements or assignments prior to the investment completing. Also, that will be backed up. They will want to see warranties that your employees have got adequate employment contracts with IP protections for the company in those and you're likely to enter into a new service contract yourself at the VC stage which will obviously include the same or similar protections.
Speaker 1:Right, okay, what about control of the company? How much control do I have in the company, or will venture capitalist demand quite a bit of control?
Speaker 2:I guess it's kind of a spectrum, with your angel investors demanding the minimum sort of control and as you go further on, perhaps series B, series C, private equity investment, you have the other end of the scale and VCs. They fall in the middle, perhaps closer to the angel end than you would expect. They do take a longer-term approach to their investment. They're coming in relatively early in the business growth cycle still and there is usually less rush to exit than perhaps on the PE side. They're very much coming from the point of view that they're still backing the founder and so the control that they ask for is much more economic. They want to protect the value of their investment, so they're looking at restrictions on dilution and controls on the amount of debt the company takes on, capital expenditure, that sort of thing, rather than trying to straightjack the founder in terms of how they run the business on a day-to-day basis.
Speaker 2:But I mean in terms of the board, regardless of whether it's VC or PE investment that at this stage investors will be looking to see a formal board with independent appointments and a commitment to hold regular meetings. Who's on that board is always a key part of any negotiation and at the series A VC stage. What you tend to see is that the VC will want some board representation and then to see that the company has a good board balance with some independent appointments and independent chairman, for example, just to make sure. Really again, it's about that economic protection they want to make sure that there is a check and balance on the founder and really they just want a good information flow. That's sort of what's motivating them Not to be on the board, so they know what's going on, rather than to unduly restrict.
Speaker 2:Unlike private equity. They won't want to influence, you know, put their own people on it in their executive positions, or anything like that.
Speaker 1:Yeah, well, I come onto the private equity, because that's one of my questions. Will I be able to do anything else whilst I have venture capitalists on board? Will I be able to pursue any other activities or is it 100% for TASH?
Speaker 2:It doesn't necessarily have to be 100% of your time, but there will be restrictions on competing, and that would probably be the same if your angel investors have been well advised as well. The difference at VC stage is that it's there are much stronger incentives to stay with the company. Perhaps it's more accurate to say there are much stronger deterrents against leaving the business, and that's what we call this sort of good and bad lever. Again, it's a very significant part of the negotiation, like the board representation. What the good bad lever basically says is if you have as founder leave, depending on circumstances, you can you can lose your equity. So in the worst case, if you're a bad lever for example, you've done something very fault based, you've been negligent or fraudulent you are likely to lose your share, all of your shares, for no value and will be documentation with it.
Speaker 2:That is in the articles. Yes, and it's that that deters a founder from going, from going elsewhere. When coupled with the restrictions on taking part in competing businesses At the other end of the scale, you have a good lever situation. So if you leave, there are no fault reason if it goes of illness or retirement, and you very much, are risk free and you get to keep your shares. And the heavily negotiated part, as you would expect, is in the middle. So what happens if you resign or if you're dismissed for poor performance? And that's when it can get quite clever. We can negotiate a sliding scale depending on when you leave for those reasons and, yes, there is no standard form for that. That's one area where the BBCA model documents do give you scope to negotiate.
Speaker 1:Okay, so now. Moving on now to the private equity funds that you've mentioned. What's the distinction between venture capital funds and private equity funds, and what can I expect if I then go on from venture capital to private equity?
Speaker 2:Well, technically speaking, a venture capital fund is a form of private equity, but as a general rule of thumb, when people talk about private equity, they mean more sophisticated funds who are investing later on in the business growth cycle. They're investing more for a larger slice of the pie and usually at a less risky stage. So with that, with taking on that larger slice of the equity and putting more money in, your company tends to be more mature and the private equity investors are looking for more control over it in return. So you see them wanting to have more management control, perhaps putting their own people in there and certainly being more involved. It's also a lot more complicated on the documentary rotation side in that they have their own structures to work around and to work with.
Speaker 1:Would venture capitalists stay in with private equity or would they go out at that stage and private equity buy out the venture capitalists and invest more money? What's the normal?
Speaker 2:I would say the latter is probably more likely. But there is no set route in the growth cycle. You might cut out the VC stage altogether and go straight to private equity. You might frequently skip the private equity and go straight to exit from venture capital. So there is no set path.
Speaker 1:No. And on exit, I mean, if I want to get out, can I force a sale to the private equity people, or can they force a sale as well and get me out? What's my security if I go with private equity?
Speaker 2:Well, the basic rule that applies throughout the investment process, whether it's from angels or further on, is that a majority can usually force an exit, force a sale or a listing. The way that works is through what we call the drag right. That's one of the clauses in the articles, and what a drag right says is that if a third party buyer wants to buy 100% of the company, as long as X% of the shareholders want to sell to that third party, they can force the other shareholders, they can drag along those minorities to sell to the same buyer at the same price. Now that threshold, that X%, can vary. It's totally free for negotiation.
Speaker 1:If a private equity firm has what is it, is it typical to have 30%, 3035% usually that threshold is set at 50, between 50 and 75.
Speaker 2:So a founder can either can either sometimes do it on their own or with a collection of the minor investors. They can certainly, you know, force through a sale.
Speaker 2:But at 3035% stake the private equity firm it is, yes, it's, and what I will say is that's just looking at the drag rights alone. In your shareholders agreement, they will have certain consent rights, which is a list of consent rights. Restricted matters they have different names, they're all the same thing. It's a list of things that the board or the company can't do without the investors prior consent, and a listing would be one of those, for example. So you are going to need your major investors on board for any sort of exit.
Speaker 2:But when it comes to a sale, the drag right is the key sort of turning articles that you're looking for there. That differs from a tag right. People talk about drag and tag in the same breath. Tag right is sort of the reverse of a drag. It's minority protection. What the tag right says is that if a majority of the shareholders are selling to a buyer those are not, the minorities can tag along to. They can force the buyer to offer them the same deal to make sure that they're not just left behind. And again, for that one the threshold is a little bit more stable. That's very frequently seen at more than 50%.
Speaker 1:Okay, now finally, the concern that I have been told is that I'm not quite sure whether venture capitalists would do this, but private equity certainly. They might put money in by way of loan rather than equity capital, or perhaps a combination of both. What is your experience of that and how? When they put money in by way of loan, how nasty could it get, let's put it this way If the private equity fund says I want my loan repaid and the company hasn't got the money to do so. So what's the? What's the way that private equity or venture capitalists maybe would invest? Would it be primarily equity capital or would it be by way of loans?
Speaker 2:So venture capital is very much by way of equity. They're looking to utilize various tax incentives that are available to them. Your difficulty, but your complication there, is ensuring that your documentation, your running of the company, continues to comply with the rules that are needed to continue to bear from those tax reliefs. So we're talking about ECT, EIS, SEIS, that kind of thing. So that's what comes up on the equity side of things. Private equity tend to do. As you say, they tend to do more of a mix.
Speaker 1:I know that somebody had a problem with private equity where they wouldn't advance any more money to the company and the company almost went bust because of it. How difficult it is to work with private equity firms.
Speaker 2:Perhaps they have a bit of a worse reputation from stories like that than venture capitalists. But as with all investors, they are taking a slice of the company. It's in everybody's interest that the company succeeds, so I think that very much remains everybody's objective. I think the difference perhaps is that when you're on the earlier stage of things the venture capitalists are backing the founders, so the founders' interests and the venture capitalists are perhaps more aligned than those between the founder and the private equity investor. But as I say, by then the company should be more mature and hopefully the founder will have naturally relinquished some control anyway as the company has grown, perhaps we won't find it so hard to deal with the private equity influence Fascinating.
Speaker 1:I think you've answered a lot of the questions. I'm sure I've got loads more, but thank you, lucy, for joining me today. It was really interesting. I'm sure Nicholas will have more questions at our conference on the 23rd of May, but they can, of course, contact you at membycrystalcom in the meantime if they need to do so. All the details of the conference are on our website at theibsaorg, so now it just remains for me to change back again from Nicholas to Roy Saunders and conclude the podcast by thanking you again, lucy. It was excellent and thank you for listening.