CandidCapital

For many venture investors the presence of private investors, or angels, on the shareholder register of an investee is a decidedly mixed blessing, but times are changing and angels are an increasingly important source of capital for all growth companies. Angels also bring with them greater expectations for transparent and accountable corporate governance. How should venture investors adapt to this changed landscape?

Two trends, apparently unrelated, are starting to impact on the management of early-stage, high-growth businesses, especially those involved in technology or other innovative products or services. The first of these is the universal pressure to improve transparency and participation for investors – a trend which has driven a whole investor relations industry in the quoted company arena. The second is the increasing prevalence of external, non-management equity investors in unquoted companies.

Multiplying Investors
In the past, most unquoted companies which raised equity finance did so either from friends and family or from a single private equity provider. For example in the 1980s, 3i, at a time when it had over 3,000 investees, was the only non-management shareholder in the vast majority of these companies. Today, especially for young technology companies, that situation has changed. They are likely to have raised capital from a diverse range of investors, including business angels, small seed venture capital funds and trade investors - as well as family and friends. In addition, they'll often have other non-management shareholders, such as the university or research body in which their product or technology originated. With the plethora of new government and EU initiatives (e.g. University Challenge Funds, Regional Venture Capital Funds and Objective 2 Funds) and the creation of new business angel networks, more complex share registers will increasingly be the case for growth businesses.

Previously, with a single venture capital investor or a small syndicate, managing the relationship with investors was relatively straightforward, if not without its tensions. The investor(s) would usually insist on comprehensive control and consultation rights, expressed in a lengthy subscription agreement, new articles of association and a range of supporting legal agreements. Other, preceding, investors would be cut out of the loop by the new agreements, other than to the extent required by law or any informal information channel they might have through being friend or family. Subsequent investors would either join or supplant the incumbent venture capitalist with similar, complex agreements – as an absolute pre-condition to investing.

Things have changed. Not only is the dominant investor or syndicate model increasingly not the case for most early-stage businesses, but it can be a significant handicap in an age where businesses have to raise money more frequently and in widely varying circumstances. Most obviously, the preferential share status and control rights taken by the most recent venture investor discriminate against other non-management investors who participated in preceding funding rounds. There's little incentive for the investor to exercise pre-emption rights or otherwise invest further, when facing the loss of any real influence on the running of the business as well as standing behind the venture investors in the event of a return of capital. It's only where the investor's money is crucial to the business’s survival, permitting the imposition of a ‘crush-down’ with even more draconian share and control rights than the incumbent venture investor has in place, that disenfranchisement can be avoided. But, by this stage, is the business in a fit state to make use of any new money?

The reality is that the "dog eat dog" process of successive preferential investment rounds does nothing to allow a business to raise additional growth capital in an orderly, flexible and cost-effective way.

Corporate Governance
Of course, a private company is not the same as a public one. It's unrealistic to expect the same corporate governance infrastructure and processes in a business with one or two directors as in one with a board of ten. Even if most early-stage companies these days have more shareholders than simply the founders and a sole investor, the power of the executive directors in such businesses is vastly greater, in relative terms, to that of the management of a well-governed public company. All the more reason for even the smallest private company to embrace the spirit and practice of good corporate governance – regular, formal board meetings with comprehensive minutes that are available to all shareholders to read; open processes for determining directors’ pay and benefits; regular communications and meetings with all shareholders (or any that want to take part).

However, the reality of the relative power of the executive directors in a private company, combined with the illiquidity of its shares, does put third-party investors (i.e. those without the benefits of the ties of friends and family to the executive directors) at a significant disadvantage compared with those in a public company. They're unlikely to be able to remove the directors (who may well hold a majority of the company’s share capital) nor can they sell their shares, if they loose confidence in the direction of the business, as a public company shareholder would. Under these circumstances it is understandable that shareholders should seek arrangements that constrain the directors from making decision or taking actions that could materially affect the value of their shares – unless they have sought shareholders consent in advance. So, what can be done?

Although the management teams of most high growth, early stage business don't want to deal with the demands of formal investor relations, many do value and, indeed, look for the support and input of 'value-adding' investors who can contribute industry expertise or general management experience (or other more specialised advice). This process also works to the benefit of intelligent early-stage venture investors who, having to spread their time and support across a significantly larger number of businesses than later stage investors, welcome the involvement of experienced angels.

More the Merrier?
Herein lies both the challenge and the opportunity for the venture capital industry (especially in Europe): either build effective partnerships with business angels who can add value to your early stage investments or continue to generate the disappointing returns that have characterised venture as an investment class. It seems to me that there are four steps that a sensible venture investor should take:
1. put in place investment structures that treat all investors the same as far as is practicable, while recognising important distinctions (e.g. that, on the one hand, UK angels usually need to make investments that comply with the Enterprise Investment Scheme rules and, on the other, that venture investors with limited life funds need to invest the bulk of their capital in instruments that have redemption or repayment rights);
2. maintain pre-emption rights, so that no investor is discriminated against in a subsequent investment round, especially where the share price has fallen;
3. exclude liquidation preferences, which put one shareholder in a more privileged position than another (except to the extent that a shareholder has subscribed for preference shares and that that option was available to others - who may not have taken it up for reasons such as tax efficiency);
4. build a board and consultation structure in each investee where the views and expertise of experienced, value-adding angels can made available to the company and where the angels feel that they have an effective voice in the development and funding strategy for the business.

I realise that the fifth point begs a whole raft of questions about how such a "board and consultation structure" might work, but I'll return to that in a later blog.

Meanwhile, in the words of Sir Adrian Cadbury "The objective should be to design structures that make it as easy as possible for the office-holders to do what is expected of them" - i.e. create long-term value for all shareholders.

14 August 2007

Reference:
From The Company Chairman quoted by Elaine Sterberg in Just Business: Business Ethics in Action

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