A young growing company looking to raise finance from investors will need to understand the forms which an investment can take.
This guide explains the most commonly used methods to structure an investment in an SME. It also analyses the implications of each investment method, for both the company and the investor.
An issue of ordinary shares in the company will permit investors to share in future growth, which may be particularly attractive if the company is a high growth business. It will also permit them to participate in the company by holding voting shares.
It will enable the company to increase its equity base and consequently improve its ability to borrow or to borrow further. In addition, there is no fixed servicing cost as there is with preference shares or loan notes, but some investors looking for income as well as capital growth may want to see a sensible dividend policy in place. Normally, however, ordinary shareholders expect lower yields than preference shareholders and loan stock holders because of their participation rights.
The issue of new ordinary shares can lead to a shift in the balance of power in the company. In some cases, the dilution of the equity may be such that the directors and their supporters no longer own a controlling interest.
Ordinary shares in a private company are not a particularly liquid investment. Investors looking for a commitment to a scheduled repatriation of funds may be more attracted to loan notes or redeemable shares.
The attractions of ordinary shares can often depend upon the economic environment and the company’s potential for growth. In periods of rising profits a company which is geared at a low level may not have the growth potential to give ordinary shareholders the returns expected from a more highly geared company. The ordinary shareholder will assess his likely participation in the residue of profits of the company after fixed interest and dividend charges have been paid. However, in recessionary times when profits are falling, a company with modest gearing will not have such a high debt servicing cost to deprive ordinary shareholders of dividends. The decision to participate in ordinary shares may therefore often depend on an assessment of the economic situation, the company’s gearing level, its capacity for growth and its ability to service its debt.
In order to qualify for the tax reliefs available under the Enterprise Investment Scheme (EIS), an individual investor will often seek to invest in ordinary shares. This is because the shares issued to the investor must be “full risk” shares with no preferential rights to dividends or to the company’s assets on a winding up. If the company puts in place any arrangements to protect the investor from the risks of investing in the company, then the investor will not be able to benefit from the tax reliefs. However, it may be possible to give the investor a priority return on an exit (e.g. a trade sale) if that is commercially acceptable to the founder shareholders.
An issue of preference shares, while not conferring an opportunity to participate in future growth or general voting powers, may have certain attractions. Preference shares will usually rank ahead of ordinary shares for dividends and a return of capital but will have limited voting rights relating to such matters as variations of class rights, reductions of share capital, liquidation and amendment of borrowing restrictions.
To the extent that fixed preference dividends are not paid in any year they usually accumulate and are paid out in priority in future years. In addition, or alternatively, they may be redeemable, thus promising cash from the company at a future date. Preference shares, particularly redeemable preference shares, are sometimes considered to be more akin to loan notes than share capital. This is true to some extent but the analogy must not be taken too far as there are some important differences:
- Preference shares may not be issued on a secured basis whereas loan notes can be charged on the company’s assets and rank ahead of unsecured creditors (both present and future).
- Even if loan notes are unsecured they will rank equally with the other unsecured creditors. Preference shareholders receive nothing on a liquidation until all creditors have been paid, although they will normally rank ahead of ordinary shareholders for a distribution in the winding up.
- The obligation to pay loan interest on the due dates creates an immediate debt between the company and the loan note holder for which he can sue, whereas a preference dividend does not become a debt until it is declared and due. It is possible to fashion preference share rights dispensing with the declaration of preference dividends and compelling the company to distribute available distributable profits, but this may not always be desired by the company. A preference shareholder does, however, usually have the right to be paid his dividend before any dividends can be paid to the ordinary shareholders.
- Loan note principal and interest can, if necessary, be paid out of the company’s capital. Preference dividends, however, can only be paid out of a company’s distributable profits. In addition, if the company fails to redeem preference shares on the due date there is no right to damages and a court order compelling redemption will only be available if it can be established that the company has sufficient distributable profits to meet the cost of the redemption. The company cannot be compelled to redeem out of capital. A loan note holder is not hampered by such restrictions if his loan notes are not paid on the due date.
- Transfers of preference shares generally attract stamp duty at one half per cent whereas transfers of loan notes are generally exempt (unless the notes are convertible into share capital).
From the company’s perspective, there may be a number of advantages of issuing preference shares instead of loan notes:
- Because the preference shares rank behind all creditors of the company this will improve the company’s gearing and its ability to borrow further. However, if the preference shares are redeemable this advantage will diminish as the redemption date draws closer.
- Preference dividends can be accumulated if there are not sufficient distributable profits or cash to pay them in a particular financial year whereas, as noted above, loan note obligations are a contractual commitment and must be paid whether the company makes profits or not.
On the other hand, loan notes have the following advantages for the company:
- because the rights of preference shareholders are subordinated to those of loan stock holders, preference shareholders normally expect a higher yield to reflect the difference in risk. Loan stock may, accordingly, have a lower carrying cost;
- the interest payable on loan notes is normally deductible by the offeror for corporation tax purposes whereas preference dividends are not.
Many of the factors which will be taken into account in deciding whether or not to issue loan notes have already been considered above.
The company will have a choice of issuing secured, unsecured or subordinated loan notes. Secured notes have the advantage that a lower yield will be expected because of the lower risk, but it may have an adverse effect upon gearing and the company’s ability to borrow. They will also give the holder direct recourse to the company’s assets on a winding up ahead of all other creditors and the company’s shareholders. Unsecured loan notes will have a higher carrying cost but less of an impact on the company’s gearing. Subordinated loan notes will rank behind all unsecured creditors but ahead of preference shareholders and ordinary shareholders. They will improve gearing and the company’s ability to borrow (unsecured creditors will regard it as similar to share capital) but the holders will expect a higher yield to compensate them for their higher risk, although this should be less than that expected for preference share capital.
CONVERTIBLE LOAN NOTES
Loan notes convertible into ordinary shares have the advantage that they enable the holder to retain the security of being a creditor if he wishes, while offering a share in capital growth on conversion. Typically, the notes will convert into ordinary shares at a premium over the market value of the company’s ordinary shares at the date of issue of the notes.
It should be noted that:
- if investors are worried that the company’s share price may fall, the issue of convertible loan notes instead of ordinary shares may remedy the situation by offering conversion at the current market price of the company’s shares together with a promise of a minimum cash value at a future date with a commercial yield in the meantime;
- the company’s equity is not diluted until such time as the conversion occurs;
- the value of the convertible loan notes will be enhanced if the value of the ordinary shares rises above the conversion price. If the reverse happens, the value of the loan notes will be assessed on a loan note basis only. Much will depend on the conversion terms and the length of the conversion period;
- given the conversion rights, a lower interest yield may be acceptable in respect of the notes;
- because the notes are convertible, any transfer of them will attract stamp duty;
- one disadvantage with convertible loan notes is that there can be a tendency for noteholders to convert when profits and share prices are rising (thus diluting the equity profit of existing ordinary shareholders and depriving them of the advantage of the cheaper gearing which such notes provide) and to retain the notes when profits and the share price is falling, thus maintaining the debt burden of the company at a time when it may be least able to service it;
- if the convertible loan notes are also secured, the noteholders will be in an enhanced position as creditors of the company; and
- unquoted convertible loan notes, which are not issued on terms which are reasonably comparable with the terms of quoted convertible notes, can cause a problem as the interest payable on them will fall to be treated for tax purposes as a distribution meaning that the company will not get a tax deduction in respect of the interest.
CONVERTIBLE PREFERENCE SHARES
Investors will be attracted by an offer of preference shares which are convertible into ordinary shares in due course as they will be able to receive current fixed income while at the same time having the prospect of a capital gain in due course. The respective attributes of ordinary shares and preference shares have already been discussed. The timing and the terms of conversion will, of course, be critical in determining the attractiveness of this type of security.
WARRANTS TO SUBSCRIBE
These are options to subscribe for ordinary shares in the company in the future. Warrants and subscription options are essentially the same thing although warrants are often expressed to be transferable (sometimes subject to restrictions) whereas subscription options are usually not transferable.
The subscription price will usually be struck by reference to the market value of the company’s shares at the time of issue. Warrants to subscribe may be attractive to investors who are looking for an opportunity for capital growth but without paying for the securities straight away. The advantage to the company is that the warrants cost nothing and, when they are exercised, the company receives the subscription moneys.
Warrants may be issued as a package with other securities. For instance, if loan notes are issued with warrants when profits and share prices are rising, the exercise of the warrants will introduce further equity funds into the company whilst maintaining the higher gearing which the loan notes provide (as distinct from convertible loan notes which have the effect of withdrawing the cheaper gearing on conversion into equity).
PREFERRED ORDINARY SHARES
These are much favoured by venture capital and private equity houses. They have all the attributes of ordinary shares but have a preferential right to receive a specified return before the ordinary shareholders on a winding up or on an exit event. The specified return will often be the amount invested plus an ‘internal rate of return’ of a stated percentage per annum on that amount. This return will be paid to the preferred ordinary shareholders ahead of the ordinary shareholders. Any balance available will then be distributed between the preferred ordinary shareholders and the ordinary shareholders on an equal basis per share.
Sometimes the ordinary shareholders will negotiate a ‘catch up right’ which entitles them to receive a second slice of the amount available for distribution on the same basis as the preferred ordinary shareholders. Only after this has been paid will the balance be distributed between the preferred ordinary shareholders and the ordinary shareholders on an equal basis per share.
Preferred ordinary shares are potentially very valuable. Ordinary shareholders naturally tend to dislike them but often have to agree to their issue when securing a sizeable investment in the company.
ROLLED UP INTEREST AND DIVIDENDS
Sometimes preference shares and loan notes will provide that dividends and interest will not be paid each year but will be rolled up and paid on final redemption or on an exit event or, if the securities are convertible, will be added to the amount to be converted into ordinary shares. This may help a company which would struggle to service the dividends and interest in the early years, but there will be an eventual pay back either in cash terms or extra dilution. This will be magnified if the dividend or interest rate compounds during the roll up period.
Sometimes equity investors can feel that they are being asked to pay a very full price for their shares and fear that the company will make subsequent issues of equity at a price lower than they paid. One way of alleviating their concerns is to give them a ‘downround right’, such that if there is a later equity issue at a lower price they are given a right to subscribe for extra ordinary shares at par value of such number as results in the average price they have paid for all their shares equaling that lower price. The share capital may be reorganised into low par value shares so that the price paid for the new shares by the investor with the downround right is minimal.
These are ordinary shares that have special rights attached to them to protect the holders from future dilution. They may for instance provide that they will have a stated minimum percentage of voting, dividend, return of capital and exit rights even though their actual number represents a lower percentage of the overall issued share capital. While a good idea for the founder shareholders, they will be disliked by subsequent investors. In practice they tend to be negotiated away on any subsequent sizeable funding round.
Founder shareholders fearful of dilution may be able to negotiate a ratchet mechanism with incoming investors. If the company hits certain performance targets, the rights attached to the share capital will adjust to ensure that a certain part of the equity percentage held by the investors is clawed back in favour of the founder shareholders. This gives the founders an opportunity to win back a greater percentage of the equity through good performance. The disadvantage with ratchets is that they can be complicated to implement and the founder shareholders can become unduly focused on achieving the targets rather that acting in the wider interests of the company.
A company may choose to offer a combination of securities in order to make the fundraising as attractive to as many potential investors as possible. Also, loans and preference shares can be a useful way of minimising the dilutive effect on ordinary shareholders of a sizeable investment round.