CHAPTER 12
Ownership and equity
This chapter addresses some more complex topics, but they're very important for when you bring on partners or investors in the business, so stay with me here.
What's the long-term vision of your business, and do you have all the skills necessary to complete that journey? Are you planning for your company to be self-funding, or will you need external finance to support the journey? Will that come from the bank or from external investors, or both, and do you want those potential investors to be actively involved in the running of the business?
These are the fundamental questions you'll need to ask yourself when contemplating partners and investment in your business. It's super important to hold as much equity as you can, but not to be foolish enough to limit your business and put it at risk of failing by not having the skills or the appropriate level of finance on board to navigate the journey ahead and achieve your goals.
There's always a fine balance when it comes time to raise money early in your business's life, as during the early validation period, while you're still testing potential products and services on customers, your business will be seen as a very risky venture for investors. The more risk involved, the more of your company they will want to own for less money, so only ever raise as much money as you need to get you through to the next milestone in your business plan. Demonstrate to your investors that you have successfully been able to achieve what you said you would and that you have added value to their investment.
When I ask start-ups how much they want to raise I often hear a huge figure, generally in the millions, so we then have a conversation around how much they really need to get to the next stage and I explain why. Generally, it's much, much less … and always results in a much better outcome and a faster raise.
The further you can ‘de-risk’ your business by demonstrating real revenue and profits, and a growing customer base, the more your business will suddenly have a real value and the more likely that investors will be willing to pay more money for a smaller shareholding. Giving away too much shareholding in the early stages of your business for relatively small amounts of money makes it difficult to raise significant money later without substantially diluting both the founders’ and earlier investors’ positions. Having numerous small shareholders can also become time consuming and distracting because you have to keep everyone happy — one or two larger shareholders is more manageable.
Assigning shareholdings
Coming from a family with a strong food and logistics background meant my brothers and I had the skills required to see the journey through with Regency Food Services. However, navigating the complex rules and regulations of the electricity market as ZEN Energy transformed from a solar and battery company to a large-scale electricity retailer was certainly beyond my existing skillset at the time.
This became a task of bringing key industry people together who provided different pieces of the jigsaw puzzle, from grid-scale battery technology to industry and government influence, to large-scale demand for energy. It's far better to own a smaller share of a large, successful business than a big share of nothing, which is often an entrepreneur's greatest mistake.
If you decide you need partners who can bring with them certain industry experience or technology, as well as investment for you to undertake the journey, then there are several ways you can structure such an agreement.
In the early stages of setting up a business, where different partners might be contributing a different combination of time, skills and cash, entrepreneurs may choose a flexible model of shareholding as some may provide more cash and less time, while others may provide more time and expertise but less cash. Their shareholding needs to be tied to these contributions so that if they put in less time or cash than initially promised they know there will be adjustments at certain points.
The issue in Australia is that this method can trigger both corporate law and tax implications each time a shareholding formally changes and complicates arrangements, unless a super complicated and expensive model is in place requiring extensive tax advice to set up. Most lawyers in Australia avoid this approach; it's nice in theory but complicated in reality. It's a popular model in the United States but doesn't work well within our corporate and tax context in Australia, which is set up to work with defined interests.
The flexible model may work between founders under a ‘handshake agreement’ in the early stages, but when things settle down and it comes time to formally assign shareholdings, this is usually done by issuing a fixed number of shares to each shareholder at a particular moment in time. Lawyers tend to work with actual numbers of shares issued — for example, ‘20 000 ordinary shares’ rather than ‘20 per cent of the company’. Founders typically create their own internal ‘cap table’ (a capital table listing investors and their shareholding — usually just a spreadsheet) that shows the percentage split, while ‘official’ legal documents such as shareholder agreements, a member register and ASIC records show the number of shares.
In Australia, we would usually rely on a separate shareholder agreement for a company to set out — among its shareholders, including founders and investors — provisions about how that relationship will work, including dealing with things such as control. If you as the founder own a shareholding of over 50 per cent of the issued share capital, you own a large enough share to control the company. Having control of the company enables you to control the makeup of the board of directors as well as the powers necessary to run the day-to-day operations, which also ensures your interests are protected. This may not sit so well with incoming minority shareholders, and they may want their say in certain decisions and not to be left to the mercy of those who own over 50 per cent of the shareholding. (The method for doing this is generally via a shareholder agreement, which I will talk about shortly.)
Such matters are usually noted as critical business matters and would typically be listed in the agreement under management and decision making. If, for example, the salary reviews of the CEO or founder(s) working in the business wasn't listed as a critical business matter requiring minority investors to agree to, then the working founders could decide through a majority to pay themselves double the day after receiving investment in the business. This wouldn't make for very happy investors and could cause immediate problems in the relationship. Investors want to see their money put into the business plan and how those funds will be used.
Shareholder agreements
There are some key issues for founding shareholders and new shareholders or investors coming into the business to consider when forming a shareholder agreement. We'll explore those now.
Shareholdings don't have to be equal
A common trap that people often fall into when starting a business is to go 50/50, which is nice and non-confrontational in the beginning. But business is all about making critical and timely decisions, and when you're not on the same page later on you'll find out the hard way that 50/50 isn't shared control, it's in fact no control! It can be debilitating and dysfunctional for a business if it can't make an important decision quickly and decisively, and it can eventually become a market disadvantage leading to potential failure. Where there are two equal shareholders, each has the right to ‘veto’, or not pass, a proposal since there's no majority party.
Giving minority shareholders a say in critical business matters
You can include a defined list of critical business matters in the shareholder agreement to give minority shareholders a voice. This is a list of items in the shareholder's agreement that require a defined special majority of votes, including those of minority investors. The default company constitution usually stipulates that 50 per cent of directors' votes is required for decision making. However, minority investors may want the right to veto critical decisions about the payment of dividends, selling the company, changing the nature of the company, key employment contracts, loans and guarantees, or contracts over a certain value or duration. Special voting rights in favour of the minority investors are therefore set out in the critical business matters list so that those decisions can't be made without the vote of the minority investors and shareholders.
Preference shares
Look out for preference shares in an investment proposal or term sheet. A term sheet outlines the (commonly) non-binding commercial terms by which an investor will make a financial investment in your company and is applicable to all equity investments, whether they be a smaller angel investor or a large venture capital fund. These terms are reflected in the shareholder or subscription agreements once agreed on.
The most common form of preference is where the preference shareholder is able to have funds returned to them ahead of others in certain situations. If everything goes well and the business is a success, preference shares don't cause an issue. However, in the case of a wind-up if the business fails, the investor holds a preference to get their money out first. For example, if the investor puts in $1 million, and the company fails and the assets are sold for $800 000, the investor takes it all and you as the founder get nothing.
These days, a preference position of 1× the investment is usually the default position. Generally, you won't see a request for preference shares from private angel investors on a low investment base but it's more prevalent for higher investments, particularly from VC funds investing larger sums for early-stage capital raises.
There are participating or non-participating preferences. ‘Participating’ means after the investor receives their preference payment (effectively getting their investment out) they then still participate on the balance of the funds raised in the shareholder ratio returning a profit on their investment. A ‘non-participating’ 1× preference means the investor gets their money out but does not participate in the balance of funds, which are then split among the other shareholders. Most preference shares are non-participating, but the terms would allow the investor to elect to ‘convert’ the preference shares into ordinary shares. In practice, investors don't usually convert to ordinary shares unless this leaves them better off — for example, where there's an exit through a sale transaction, or an IPO or where they end up with more return with ordinary shares.
There are also many different variations of preference shares, and the Australian Corporations Act allows for these different preference share terms if they are in the constitution, or if they are agreed on by shareholders.
Anti-dilution clauses
New businesses that are growing rapidly may need to raise several rounds of financing from investors, which is all good if the business plan, including the use of investors' funds, is working, the company keeps increasing in value and all investments made in the company therefore continue to increase in value.
A problem arises though when the company goes to raise further funds but can only raise those funds at a lower share price than the previous round, resetting the company's valuation and therefore devaluing the shareholdings of earlier investors. Who takes the valuation loss? Should all parties including the founders take a shared proportionate loss in value (which won't sit well with the earlier investors) or should the founder take all the loss and the first investor retain their value and/or percentage holding of the company in full? Or should the founder and the first investor share the loss but in an agreed ratio that favours the first investor?
In Australia it's not uncommon that early investors will insist on an anti-dilution clause of some sort to be effected in the case of a ‘down round’ where a lower share price is offered than the previous investment round. The worst position for a founder is to agree to a full ratchet anti-dilution clause, whereby the founder is forced to take the full loss of a devaluation, which can significantly impact the founder's shareholding percentage. This can also have the impact of disincentivising the founder if they are suddenly a minority shareholder in their own business and cause further problems for all investors. On the other hand, if there was no anti-dilution clause, all earlier investors, and the founder, proportionally reduce their share valuations. The investors may feel uneasy about this when they aren't actively involved in the running of the company and may believe the founder should take more of the impact for the loss in value. To avoid this, a middle ground scenario has been developed called the ‘weighted average cost method’. It uses an agreed formula, which is skewed towards the founder, to share the loss, but the investors also share some of the pain. It basically reflects an average price between two different capital raising prices based on the number of shares in each round, but then adjusted (weighted) through a series of ‘goal-seeking’ mathematical calculations so the correct second-round shareholding is achieved.
These calculations and the formulas involved can be quite complex, so to accompany this book I have developed a companion website (www.essentialentrepreneur.com) that has a model for calculating both pre- and post-investment impacts on shareholdings, valuations and who takes how much of the loss, as well as other extended material and examples that can be continually updated based on requests. I can't emphasise enough the importance of understanding the impact of anti-dilution clauses on your business. This doesn't mean you can necessarily avoid them, but at least you're coming into the agreement with your eyes wide open and can negotiate the best outcome through a weighted average approach if possible, not forgetting this only has an impact if the valuation of the company decreases.
Drag-along, tag-along rights
Minority investors who invest later in the journey don't necessarily want to be ‘dragged’ into a deal to sell the company unless they have achieved their targeted return, whereas founders always want to drag minority investors in if a deal is on the table that suits them and the purchaser wants to buy the entire company. So, an acceptable outcome needs to be negotiated.
Tag-along provisions, on the other hand, aim to protect the minority shareholders from being stranded when the majority shareholder sells. When a tag-along provision is in place it ensures that the same terms and conditions of the sale are extended to the minority shareholders, allowing them to tag along in the deal and sell their shares along with the majority at the same price, terms and conditions.
Good leaver vs bad leaver
These are generally a set of conditions enacted when a key founder leaves the company. A founder or key person leaving and taking fundamental knowledge and IP on the operation of the business can cause enormous upheaval and potentially lead to a business failure.
Sometimes the exit can't be avoided due to matters such as health issues or family breakdowns. In this case, where it's out of the person's control, it is generally accepted that that person would be deemed a ‘good leaver’ and any shares or options that they are forced to relinquish under their arrangements with the company generally would be bought back /paid out at or around market value. This is different from a situation where a key person leaves who is in control of their personal situation and deemed to be manipulating or purposefully jeopardising the business outcome. This is deemed a ‘bad leaver’ and it is generally accepted that bad leavers should not get full value of their shares or options that they are forced to hand back, and therefore the value of such shares or options in the company is significantly reduced.
Reporting clauses
Investors will want a reasonable reporting regime on their investment to feel reassured that the business is on track. However, you as the founder do not want this to be so onerous that it becomes a distraction and time consumer, so it's good to agree on a reporting regime at the outset that is manageable.
Agree on how much reporting is required and what the frequency of reporting should be. If you have a number of investors and some are large and significant compared to others, the larger investors may require, or be offered, substantially more reporting. This could be managed through their subscription agreement rather than the shareholder agreement, so that it is unique to the shareholder.
Options and warrants
Some potential investors will take up options in the company if they are contributing to the company's operations either on the board or through providing other skills and services that the company can't afford to pay market rates for. This is an option provided by the company to the potential investor to invest at a pre-determined point in the future and at a pre-determined price instead of putting cash in now, which is a much less riskier position for an early-stage company. It allows a potential investor to trade their skills now for options on a shareholding at an agreed time in the future at an agreed price now (strike price), which could be a heavily discounted price if the company significantly increases its value between now and then.
Options have key elements, such as exercise price (agreed price that will be paid), exercise period (possibly two or three years into the future) and vesting (conditions that must be satisfied before those options can be exercised). These are crucial in determining how well options work as an incentivisation tool to complement what you're trying to achieve.
We also see options being used as part of an incentive package for employees of start-ups or early-stage companies where the company can't pay the regular market salary. Depending on how these options are structured, there will be varying tax consequences, and if done correctly these are a good incentive. If done poorly, they will penalise the employee from a tax perspective, which is not ideal.
Warrants are similar to options and are issued directly by a company to an investor, but the term is usually used with listed companies and not so relevant to the start-up space.
The Australian Investment Council (www.avcal.com.au) is a good place to start when looking for templates of shareholder and other seed investment agreements. These template agreements, although originally designed to favour the investor, have over the years been seen as the starting point for many investment deals — and commonly used as standard documents for many angel investors, VC funds and companies. The balance to be negotiated with an investor is primarily reflected in the points above and should be discussed with a solicitor with early-stage investment experience. You can also find other open-sourced legal documents for capital raising through other incubators or VC groups — but care should be taken to make sure they are appropriate (i.e. Australian based — or your home region — vs US/Silicon Valley based).
Bringing on investors and partners into your business can be a fundamental key to success, but also a fast track to failure if you lock yourself in with the wrong people who don't turn out like you thought they would. It's very hard to then break free of those relationships without a significant cost attached.
Try working with potential investors for a while before they actually invest so you get to know each other, and the investors have a chance to put their goodwill and passion for the business on display. Any increase in the potential valuation they contribute at this time should be taken into account when negotiating an investment or option position. You could form an advisory board in the first instance and see if they are willing to participate in that way for a trial period to see if the relationship works.