How to Reduce Risk
How to reduce risk when investing in early stage companies.
Many of our investors and guests at our inaugural investor day held in June, expressed interest in hearing more about how we invest to reduce risk. Specifically, what were some of the terms used, such as ‘Preference Shares’, and what’s the difference between these and ‘Common Shares’ and why do we negotiate these as part of our investment? In response here’s a brief overview of some of the structures and terms that we use to reduce risk and increase returns for our investors when we make investments in early stage companies.
Preference Shares: are one of a number ofmechanismswe negotiate to mitigate downside risk and protect our investor’s capital whilst aligning the interests of investors and founders to add value. Here I will outline a few of these headline terms, why we use them to structure our deals and what are the real world implications of incorporating them.
There are a number of uncertainties in investing in earlier stage private companies however the one uncertainty people focus on is return – specifically, the potential for tremendous, Facebook or Google like upside. However, what is often overlooked is the very high level of risk involved. Structuring an investment correctly is critical to managing some of the risks faced in early stage investment. To be clear, structuring an investment correctly will not save a company from failing, however it can serve to protect some, or all, of the capital invested.
There are two fundamental principles that underlie the terms we negotiate – economicsandcontrol. Broadly speaking, economic termsare the financial elements of the investment (price and valuation), whilst control termsare largely the non-financial (e.g. board decision making).
Economic Structuring:Of the economic elements the most important mechanism is often preference shares. The majority, if not all of our investments in the Real Estate Industry Venture Capital Fund will be made in exchange for Convertible Preference Sharesin the company – as opposed to Common or Ordinary Shares. The main benefit of preference shares is that in the event of an exit (i.e. sale of the company), the holders of preference shares receive their money before the holders of common shares, generally at face value (i.e. the amount originally invested). For PieLAB it often means that even if an investment sells for less than the valuation at which we invested our investors still get all their original investment capital returned.
To illustrate, consider the following scenario:
Investor A gets approached by the founder of ABCTech for an investment of $2m for 40% of the company (and 40% of voting rights) – thereby valuing the early stage company at $5m. Investor A makes the investment today. Tomorrow ABCTech receive an offer for $2m for their company by a competitor. This is potentially great for the founder of ABCTech – yesterday, before they received their investment, arguably their company wasn’t worth much at all, now they can sell it for $2m, and they control the vote on the decision.
In the event Investor A had invested using ordinary shares, and ABCTechwas sold for $2m, Investor A who owns 40% of ABCTech would receive 40% of the $2m sale price. So, Investor A Invested $2m yesterday for 40% and today that 40% is only worth $800k.They would lose $1,200,000on this transaction – literally overnight. The founder of ABCTech receives $1.2m (good result for him, yesterday he was a broke founder).
In the event Investor A had invested using preference shares convertible at face value, they would be entitled to receive the full $2m on this transaction, leaving the founder with nothing for selling the company. In this scenario, the preference share structure has effectively aligned the interests of the investor and founder to continue to build a valuable company whilst protecting the capital of the investor.
Preference shares also carry the feature of being convertible(to ordinary shares), so that in the event the value of the company on an exit is greater than $5m at exit (say in the case of a competitor buying it for $30m), the investor would convert the preference shares to ordinary shares and end up with 40% (i.e. we end up with $12m in the example of the $30m sale).
The next key term is Anti-dilution. Anti-dilution is best understood with a little context – earlier stage technology companies will generally require multiple rounds of capital. You may have heard the terms such as Angel, Seed, Series A, Series B etc. The reason for this is to fund the company over its life as it reaches different stages of development.
As a company goes through various stages of growth – and raising capital – it will generally grow in value, however if the value of the shares has gone down (it is revalued each time it raises capital), an anti-dilution clause triggers so that our shares are revalued at the lower mark to ensure that we maintain our percentage holding of the company. Issuing equity at a lower price is not ideal as it indicates the company value is not increasing – this is called a ‘down round’ – so the anti-dilution provision stops PieLAB from being diluted if the company raises capital at a lower valuation than when PieLAB invested originally.
Control Structuring:Contrary to popular belief being the majority shareholder in a private company does not always give that shareholder complete control.
Given PieLAB is unlikely to be majority shareholders in most investments, control provisions are used to disconnect control on important issues from those that have majority shareholding. That is, certain critical actions or decisions cannot be made without approval of certain minority shareholders (eg. selling major assets, changing the terms of shareholdings, changing the size of the board of directors, executive pay or declaring a dividend, borrowing money etc.). Negotiating investor representation on boards (board member or observer) and or independent members is a key part of structuring an investment.
The Real Estate Industry Venture Capital Fund is a fixed term fund.We therefore need a means to trigger an exit (e.g. trade sale) in the event there is not a clear path as we approach the end of our fund term. Drag Along Rightsare a means to doing this. Drag Along Rights at their most basic level, allow us (after a certain time) to find a buyer for the company and force all other shareholders to accept the offer and sell. Conversely,Tag Along Rightsprevent a different shareholder from selling to a buyer without that buyer also being required to buy our shares as well, protects us from being left with a new business partner that we believe is unsuitable to run the business.
This has just been a brief overview of some headline considerations when we are looking at structuring an investment. They are not all encompassing, not all terms will exist in the structure of all of our investments and they will take different forms – each investment will carry different risks, the companies will be at varying stages of growth and ultimately it should be remembered that the terms are negotiated, sometimes between multiple parties. Ultimately however, we use this framework of terms in structuring investments to help mitigate downside risk, whilst aligning interests for maximum upside returns for companies, founders and investors.