Many businesses require additional capital to grow the business or to facilitate the exit of an existing shareholder or partner. Some of these businesses do not qualify to obtain funding from a bank, or the balance sheet cannot afford additional loan funding. In other instances, equity funding may be preferred for long term strategic reasons or to facilitate entry into a strategic partnership.
Although equity capital is the most expensive source of finance, it can achieve the highest returns. Robert Peché, Corporate Finance Associate at Bravura, an independent investment banking firm specialising in corporate finance and structured solutions services, highlights some key features of a typical equity investment and the intricacies of shareholder control.
Equity capital comes at a high price tag as a result of risk-return analysis, given that equity investors carry the greatest risk in the business. Providers of other sources of capital typically enjoy priority in terms of receiving repayments on the funding. They have a cap on their returns, whereas equity holders do not. If the business performs strongly and the capital structure of the business is efficient, equity holders will enjoy returns far in excess of other capital providers, but with a greater risk profile.
The starting point for the business should be to clearly articulate the growth strategy, leading to a determination of the stake available for an investor and the type of investor required (strategic or financial).
Does the company intend to receive and invest all the cash raised, or do existing shareholders intend to take some cash off the table? Either is possible, but the rationale behind the capital raising efforts needs careful positioning with prospective investors.
If existing shareholders intend to fully or partially exit, the business must be robust in terms of a sustainable operating model supported by adequate staff and organisational infrastructure. If the business requires growth capital for investment purposes, with existing shareholders diluting rather than exiting, investors will place more emphasis on the intended use of the capital and the projected increased cash flow forecasts.
A key question to consider is whether existing shareholders are willing to give up control, negative control or neither.
Control is usually a stake of 50.1%, for which an investor should pay a control premium. Such a stake allows the investor to fully direct the activities and cash flows of the company, in the absence of any agreements to the contrary in the shareholders’ agreement or in the memorandum of incorporation of the company.
Negative control is a concept based on minority protections afforded to smaller shareholders. Negative control is usually between a 25.1% to 50% stake, based on statutory thresholds to pass special resolutions approving key matters as set out in the South African Companies Act, as well as other provisions typically found in the memorandum of incorporation of the company or other regulatory requirements. It must be noted that this approval threshold can be adjusted downwards in the shareholders’ agreement or the memorandum of incorporation of the company, thus a 25.1% stake does not guarantee negative control. A careful review of the company’s statutory documentation is required prior to investment.
A negative controlling stake still attracts a control premium, but to a lesser extent than a controlling stake.
A stake of less than 25% is generally a purely passive financial investment, part of a broader portfolio of investments, with no ability to influence the strategy of the business. Many investors will not invest in stakes of this size in private companies.
Most shareholders in listed companies hold stakes of this nature, but they benefit from protections set by the exchange (e.g. the JSE) and disclosure requirements for public companies. There are also usually larger shareholders in listed companies who effectively exert negative control over the listed company’s board.
The deal process in raising equity capital is critical. A process that is open to any party may attract bidders who are not necessarily serious investors, but are competitors hoping to gain access to the dataroom during the due diligence stage. These bidders may have an intention to obtain sensitive strategic information on their competitor, with damaging long-term consequences for the business.
The alternative is a more focused approach, with pre-screened potential investors identified, usually with the assistance of independent professional advisors. Whilst this could have the impact of a smaller pool of potential investors and thus less competitive tension towards the end of the process, the risk-mitigating benefits of avoiding bidders with ulterior motives may outweigh any perceived or real cost of a smaller pool of bidders.
The due diligence process itself should be manageable if adequate preparation took place before the overall capital raising process commenced. Any negative information that comes to light during the due diligence process, but which was not disclosed as part of initial engagements with bidders, could result in a significantly lower final offer price.
Once final bids are obtained and the relative attractiveness of shortlisted bidders is assessed, the directors and shareholders should be guided by what their original intentions were when entering into the capital raising process. It may not be possible for a single equity partner to deliver all the strategic benefits that were hoped for, resulting in a need for trade-offs or a phased approach to the equity raising strategy.
It is critical to understand that equity investors think differently to debt providers. If one considers debt to be science, then equity is art. Rather than a purely financial analysis based on underlying cash flows and an ability to service interest payments, equity investors will buy into the strategy, management and underlying fundamentals of the business, which requires an assessment well beyond purely financial metrics.