In our previous article, we explored just some of the different types of investments available to entrepreneurs and investors, ranging from bootstrapping and seed rounds to venture capital and private equity.
This time, we aim to delve into the potential structuring of these investments (excluding debt), focusing on the variety of mechanisms typically adopted such as preference shares, convertible shares and redeemable shares. We also touch briefly on tax-efficient schemes like the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS).
We talk through some of the advantages and disadvantages of these structures from the perspectives of both companies and investors interchangeably. Needless to say, what might be a disadvantage to an investor will no doubt be an advantage to the company and vice versa.
As with the points addressed in the last article, many of the following models overlap and are often used together. For example, companies and investors often adopt a combination of preference, convertible and redeemable shares and sometimes use all three at once!
Preference Shares: Prioritising Investor Returns
Preference shares are a popular investment vehicle, offering investors certain privileges over ordinary shareholders. These shares typically guarantee a fixed dividend, which must be paid out before any dividends can be issued to ordinary shareholders. In the event of a liquidation, preference shareholders also have a higher claim on assets than ordinary shareholders.
Key Features:
- Fixed Dividends: A set return that provides a steady income stream.
- Liquidation Preference: Priority over ordinary shareholders during asset distribution.
- Non-Voting Rights: Typically, preference shares do not grant voting rights, allowing founders to retain control.
Advantages:
- Guaranteed returns for investors via fixed dividends and a higher claim on assets during liquidation.
- From the company’s perspective, founder control is maintained due to typical non-voting status of the preference shares.
Disadvantages:
- The investors’ returns are typically limited to fixed dividends with no additional upside.
- Fixed dividends can cause a cash flow issue for the company.
Redeemable Shares: Defined Exit Strategy
Redeemable shares give the company the option to buy back the shares at a future date. This can be attractive to investors looking for a clear exit strategy.
Key Features:
- Exit Strategy: Provides a clear mechanism for returning capital to investors.
- Fixed Terms: Typically, terms are agreed upon issuance regarding timing and price.
Advantages:
- They provide a clear exit strategy for investors where the redemption is mandatory.
- The company can retain some level of flexibility with an optional redemption.
Disadvantages:
- Mandatory redemptions can cause problems for the company where there are not sufficient funds
- Investors may feel constrained by the redemption terms as they cannot choose when to sell their shares independently; they must wait for the company to initiate the buy-back.
Convertible Shares: Flexibility and Potential Upside
Convertible shares can typically be converted into ordinary shares from either preference or redeemable shares at a predetermined ratio, offering investors the upside potential if the company performs well.
Key Features:
- Conversion Option: Converts into equity, often at a discount, allowing investors to benefit from future growth.
- Conversion Trigger: Can be time-based or event-based (e.g., hitting certain milestones).
Advantages:
- Potential for significant and uncapped returns for the investor if the company grows.
- Company can benefit from a cash flow perspective if shares are converted from preference to ordinary.
Disadvantages:
- Existing shareholders may face dilution.
- Conversion values typically depend on future company valuations leading to uncertainty for the investor.
- Non-voting shares can become voting ordinary shares impacting on founder control.
EIS and SEIS: Tax-Efficient Investments
The Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) are UK government initiatives designed to encourage investment in early-stage companies by offering tax relief to investors. Specialist tax advice should be taken. These schemes can be particularly beneficial for startups looking to attract investors by reducing their risk.
Advantages:
- The potentially significant tax reliefs can enhance investment attractiveness.
- Deferral or exemption of capital gains tax improves investor returns.
- Loss relief reduces risk for investors.
Disadvantages:
- Must Be Ordinary Shares: Limits the flexibility in structuring the investment from both parties’ perspective.
- In particular, the fact that ordinary shares must be used means that there is a pro-rata equality of voting/dividend rights. This can lead to a reduction in founder control and, from the investors perspective, no guaranteed return on investment.
- Eligibility requirements can limit applicable companies.
Conclusion
Structuring investments effectively is crucial for fostering strong relationships between entrepreneurs and investors, ensuring both parties can achieve their financial objectives. By understanding the nuances of various investment structures, from preference shares to tax-efficient schemes like EIS and SEIS, businesses can attract the right kind of capital to fuel their growth.
Whether you’re a startup seeking seed funding or an investor looking for lucrative opportunities, we can offer comprehensive legal guidance to help structure investments that align with your business goals.
To discuss any of the points raised in this article, please contact Adam Convisser or fill in the form below.
