CandidCapital

Investors and lenders will want to maintain a relationship with an investee or borrower. The investee's success is critical to their success and he, and their other existing customers, is the best source of future business.

a. The Relationship

The management must be committed to making the relationship with the investor or lender work. They have the most to gain and the most to lose from its success or failure. It is almost inevitable that the business will go through periods when its performance is disappointing and it may even need further equity investment or increased overdraft or other bank facilities and there is little likelihood of these being forthcoming in an atmosphere of distrust or suspicion. There is also little chance of their being forthcoming if the need arises unexpectedly catching investors and lenders by surprise: after all they will then ask the question: "did the management know what was happening to the business".

There is also much to be gained from the advice of the investor or banker. He will probably have seen several businesses going through the same stage of growth (or stagnation) and may have timely advice for a management team which is under day to day pressure to perform and which has little opportunity to sit back and take an overview. The equity investor, in particular, should be the first person to whom the manager turns for outside advice....

Dependent on his investment style ("hands on" or "hands off") he may have particular expertise to bring to the company's board as a non executive director.

b. Formal Communication

Irrespective of whether an investor is "hands on" or "hands off" he, and any lender, will want regular, relevant and timely information on the progress of the business. Regular in that it needs to be at least monthly, relevant in that it must tell him what he needs to know about the business, and timely in that he must receive it as soon as possible after the period to which it refers.

Providing information to the investor or lender should not be a burden to the company: indeed the reports should be those which the management would anyway need to exercise effective control of the business. At their simplest they probably should be no more than a P&L account, a balance sheet and an up to date cashflow forecast. There no need for any commentary other than on unusual changes in the current month from previous months and significant variances between the actual performance and that forecast in the current business plan. The commentary could be made in a letter but it is probably best presented at a board meeting which will be attended by the investor or his nominee director. A lender
would not normally attend board meetings, so any significant changes in solvency, interest cover or available security should be discussed in a letter or phone call.

c. Investors' styles

Hands on

The success of the investee is ultimately the success of the investor. Therefore the venture capitalist will want to take every step he can to ensure its success, and the size of the investment will be a major element in its importance to the fund and the commitment he can make. Increasingly, investors portray themselves as hands on and this usually entails direct representation on the board of the investee, rather than nominating a distinguished third party to look after their interests. However the accuracy of this description is variable.

An investor who specialises in technology or early stage investment is likely to be truly hands on. In the technology field he should really understand what the investee is doing and be prepared and able to test management assumptions and offer key advice on strategy, marketing, product development and production issues as well as in the financial management of the business.

Similarly, in a start up or early stage business he is unlikely to have an investee with a complete fully functioning board with all the appropriate disciplines represented. He will have to help the management deal with those functional areas where they are inexperienced. Most difficult of all, he may well have to take an active role in moulding the team and in forcing needed management change where one or more members of it are not up to the demands being placed on them.

In contrast, the development capital funds, specialising in investments in mature businesses or funding buy outs and buy ins, are much less likely to play a critical role in the management of the business. They will take a board seat, and will want to be able to comment on the business' strategy especially financial, but they will expect to have invested in a management team which is complete and which can left to run the business itself. The dirty work of forcing necessary management change is most likely to be the business of a professional, if non executive, Chairman.

Hands off

Some of the bank subsidiaries, especially 3i, never nominate their own investment executives to the boards of investee companies. Their fear of excessive involvement in the affairs of failed businesses has been reinforced by the formal recognition of shadow directorship in the 1986 Insolvency Act and the Company Directors Disqualification Act. Instead, they will nominate a suitable third party director to look after the interests of the shareholders as a whole (as is legally required) and who, they believe, will add especially needed skills to the management team.

The management will often be involved in finding the right man to fill this role, although the investor will normally have the final say in nominating him. This process is not always a success. In the mid eighties every growing company was looking to flotation as their obvious goal and in that expectation there was a temptation to appoint non executive directors who had particular expertise in the flotation field, perhaps stockbrokers or lawyers. In reality it is a misuse of the non executive director's appointment to use it as a way of getting specialist advice on the cheap. Rather, it is essential that a non executive director can test the key business assumptions on which the executive directors are working. This means that the right candidate must have had sufficiently broad experience in that, or an analogous, industry. This experience should normally have been acquired as a general manager, but, at the least, as a management consultant, accountant or other interdisciplinary role.

d. Further Investment

Early stage investment, in particular, is an imprecise art. The young company does not have the track record of an established business being bought out. The management team will be new to each other, the product relatively untested, the market uncertain and the production and operations systems untried. Under these circumstances both the investor and the lender will anticipate that there may well be a call for further funding. There may have been some arrangements for further funding in the original investment agreement although the difficulty of predicting what the precise need might be makes arranging anything more than arranging a small contingency reserve rather a lottery.

The best mechanism for ensuring that the business gets further funding, if and when it needs it, is working to make the relationship between investor and management as realistic and as informed as possible. The emphasis must be on realism and on the effective passage of accurate information, rather than on simple closeness or familiarity. The danger in closeness lies in the false expectations which it arouses. Hands off investors are always on the look out for the non executive director who has "gone native". They fear the lack of judgement that goes with excessive loyalty to the investee management team and to the project itself. Loyalty which causes the non executive director to loose the dispassionate and objective view of the business for which he was recruited and which, in reality, is the most important quality he can offer the management. Similarly, the investment executive who sits on an investee's board will loose credibility and be less able to secure approval for well targetted further investment in his customers if he is continually arguing for support in circumstances where blind faith is the only rationale.

e. Insolvency, failure or rescue

There is no easy way to manage a relationship between management and an investor or lender when the business faces failure. There will, inevitably, be tension between those for whom the business is part of a larger portfolio of investments or loans and those for whom it is both their livelihood and. probably, the most substantial personal investment they have.

Once things start to look grim, the lender, in particular, is going to be most concerned to ensure that he does not go beyond the point of no return. That is to say he will be unwilling to provide further support to the business if it takes him beyond the available security cover, especially where he cannot see clear evidence of sales and profit in the immediate future to give him interest cover and improve his security cover. Even the venture capital investor will be concerned to ensure that the shareholder position is not worsened (if that can be made any worse) and he will, if he sits on the board, be conscious of the dangers of unlawful trading in the light of the Insolvency Act 1986 and the Directors' Disqualification Act 1987.

There are really only three choices: let the business fail; mount a rescue or continue support. The latter is the most difficult choice and can only make sense if the management, investor and, where necessary, lender are all agreed that they understand that there is a specific problem, a clearly visible solution and a finite commitment needed to overcome that solution. In this context a clearly visible solution is not "we'll get out and approach twice as many potential customers this month as last" it is, rather, "Snodgrass & Co have placed an order, we have had difficulty sourcing particular components and we need interim working capital funding until we can deliver" (for which additional overdraft could be a possibility) or, at worst, "we planned on getting the product out by month nine, there has been a development delay but the market potential is looking as good as we anticipated and we should be ready month fifteen" (for which a well informed hands on investor might be prepared to give further support).

A rescue is essentially a fresh investment and while it might need to be put together quickly, it needs to be based on as thorough an appraisal of the business as an initial investment. Crucially, it implies that there was a fundamental flaw in the strategy which the company was following before, or in its implementation. Responsibility for the flaw in the strategy or its implementation can usually be traced back to management which is why management change is so often a condition for the investor or lender supporting a rescue. The new management team, or reconstituted management team, will need to question the fundamentals which underlay the strategy which their predecessors were implementing and to prepare a new plan which identifies the flaws in the previous strategy or implementation and shows how they will manage to avoid the same pitfalls.

The most unwelcome of the three options, especially for the management team, is when an investor or lender decides that there is no chance of further support or a rescue and the business must fail. Usually it will be the banker who declines to continue
providing overdraft facilities and the investor who takes no steps to dissuade him from doing this by proposing further risk investment or a rescue plan.

Chapter 13 Realising your company's worth

Finally, both the investor and managers may want the ability to realise the worth of the business, in cash or marketable shares, without undermining its capital value. Most often this will be by selling the business to a trade purchaser or, if appropriate, by floatation on a public market.

a. Needs of the investor

A venture capitalist's attitude to realising his investments is principally determined by the type of fund he is managing (see Chapter 7 Sources of finance).

The manager of a tied institutional or bank fund will be most concerned to show that his portfolio is giving a strong return on capital. Most of this he can demonstrate by showing growth in the value of the shares he holds in unquoted companies (using some agreed valuation formula), but he will also have to show that he can turn paper gains into real gains. This means, on the one hand, he will be keen to seek a realisation of an investment at a stage when he sees a good opportunity. On the other hand, it also means that he is not constrained by any external timetable in seeking realisations and can support a company and its management through growth or unexpected reverses.

In contrast, the manager of an independent fund (particularly a BES fund) will have raised the fund with a limited life, normally ten years (five years in the case of BES). In the last half of the fund's life he will be aiming to repay the institutions their initial investment, along with the maximum capital gain, and to have completed this process by the tenth anniversary of raising the fund.

b. The options

An exit can be for the benefit of both management and the investor, for the investor alone or for the management alone. The whole business can be sold or only part of it and each of the exit options below offers a different mix of advantages and disadvantages.

Trade sale

The most common realisation path for an unquoted company is sale to another company. This will usually be a sale of the entire business by sale of its share capital but, in exceptional circumstances, may be the sale of the trade and assets of the business. This option gives an opportunity for management and investor to achieve a capital gain which may be an important management motivation especially when capital gains tax rates are lower than income tax rates (as they were prior to the 1988 Finance Act).

The trade buyer will almost certainly require comfort in a number of areas about the acquisition. First, he will require warranties that the company's assets are what they seem (particularly debtors), that there are no exceptional liabilities or contingencies and that ....... Secondly, he may well want to tie the management into service agreements which give him the best change of maintaining the company's performance, and ensure that, should they leave, no dangerous competitors can immediately start up with the benefits of his customer list. Finally, he may well want to defer part of the purchase consideration conditionally on the business maintaining its previous performance (especially if the shareholding management are going to continue working in the business).

The other advantage of a trade sale, particularly over flotation, is the much lower cost of the transaction. There will be both parties' legal costs and the purchaser normally will have paid for an accountant's investigation. In a sale of a company worth £5m this may be total deal costs of £25 30,000.

Flotation

Flotation was the goal of every ambitious management team in the eighties bull market. Since the 1987 crash, however, the attractions are much less. At its best, the market gives a ready source of additional finance (typically through a rights issue), an immediate market for any existing shareholder to change his holding and the opportunity to expand through acquisition by using the acquirer's quoted shares as part of the consideration. The second of these advantages, the ready market, is especially valuable to employee shareholders who can actually trade the shares from an ESOP or other share incentive scheme.

There are significant disadvantages to flotation, however. The markets are particularly tough on small quoted companies and they suffer a disproportionate erosion of confidence, and hence price, when the market turns down. For the very smallest companies it is difficult to find a market maker who carries, or wants to carry, their shares on his book. Under these circumstances the market is little more better a medium of exchange than finding a matched seller/buyer for an unquoted company.

More significantly, flotation entails a significant change in the management culture of a business, as a number of entrepreneurs found in the 1980s (Richard Branson even choosing to de list his Virgin Music Group). The markets are much more concerned about short term performance and will react sharply to unexpected published results whether or not they have real long term significance for the business' performance. Indeed the long term strategic information which an unquoted company will disclose to its venture capital investors and bankers to maintain confidence cannot be shown confidentially to its public shareholders since any investment decision they then made would be insider dealing.
Successful management of a public company needs to focus on investor relations as one of the key disciplines for success. It is rare for the same managers to grow a business entrepreneurially
and then manage it as a successful quoted company.

Share buy back

Venture capital investors divide into two camps on the issue of seeking an exit by selling shares to the investee company itself or to its other, typically management, shareholders. The buy back has the same effect as a sale to the other shareholders pro rata to their existing shareholdings, but it is worth noting that there are a number of legal requirements to be met (including a declaration of solvency by the directors) so it is essential to have the right professional advice (see Chapter ).

The first group, principally bank and other subsidiaries, are reluctant to see their equity bought in by the company or bought by other shareholders. Their main concern is that a buy back, or a purchase by the management shareholders, is unlikely to offer the same return as a well conducted trade sale or flotation. Furthermore, they would rather see the company apply its profit stream to paying a large dividend than to buying out shareholders.
Since they will usually take special share rights both to control their exit and to guarantee the dividend stream, there is little that a management team can do once a deal has been signed with an investor in this camp. It is essential to ensure that management's and the investor's intentions coincide.

The second group of investors, especially those with limited life funds (for example raised under BES), are happy to see a buy back or sale to other shareholders, provided it is on the right terms. They may well even seek a put option requiring the company to buy them out as the end of the life of their fund draws near. For the same reason that the unlimited life funds avoid an exit by buy back, ie that the price is usually lower than that for a trade sale or flotation, management can often benefit from negotiating an investment where this is a possibility.

Private placing

The term "private placing" was coined by 3i to describe its purchase of equity in a successful business, from the management themselves as an alternative to flotation. They capitalised on the publicity they gained from the purchase of 30% of MORI (Market and Opinion Research International) from ?Bob Woodland the company's entrepreneurial founder in 1987. Woodland made a statement that he chose to sell the stake to 3i privately because of the advantages of having a single known investor rather than becoming the potential victim of market sentiment and because of the enormous saving in the transaction costs.

For a company that is successful and which may well have a need of further external equity finance for acquisitions or development, private placing may be a way of giving first round investors an exit. Once again, however, the unlimited life funds may be looking for a better price than an incoming venture capitalist would be prepared to pay. On the other hand it has become a real
option since 1988 89 when the first BES investments reached the five year point when their shareholders could recover their money without tax penalty.