This is about non-institutional investors dealing directly with businesses to finance their development and capital growth plans.
Where do they stand? They need an answer.
Are they lenders? Investors? Co-owners? Can they ever be true partners?
We have seen sufficient transactions to know the different factors on which the answer depends. Therefore, answers must be provided. There are variants but the logic of the deal is the same.
A basic structure designed for the logic of the deal is required. That structure needs to be intelligible, cost-efficient, and fairly quick to implement.
Structures presently in use are based on transaction models for private equity, venture capital funds, preferred shares, and limited partnerships. I have recently two such structures fail within 2 years of operation.
What is happening?
The investor is filling a financial vacuum. The investor funds no more than 20 or 30 percent of the capital required by the company. Instead of having its money back with a fixed top-up, the investor wants a share of the rewards the company would make from the enterprise the investor has funded.
What do we need?
The starting point is to acknowledge the true nature of the transaction, in isolation from other types of financing and equity transactions. As soon as we do that, we will be rid of the inclination to replicate structures not fit for the deal. This applies first and foremost to the investor and the company.
A prevailing flaw in current structures
As the law vests on to partners and shareholders the right to share profits, parties are quick to believe that they are creating a partnership. Likewise, it is wrong in logic and law that in order to have the legal right of profit participation, they must form a partnership or shareholders in the company which owns the funded capital.
Beyond profit participation, the rights and duties attached to being shareholders or partners. Creating a shareholding or partnership is to bind parties to a transaction not bargained.
Being partners and shareholders gives the rights to participate in profits, but not all participants in profits become or have to be shareholders or partners.
Rick del Sentro, CEO & Partner at ZGrowth Partners LLC said it plainly and spot-on: “sometimes the person who thinks he or she is a business partner isn’t one at all. In my world, a business partner is someone who helps you advance the company. That is to say, they are creating value by moving the business forward. Do they need to be working in the business every day to do this? No, not necessarily.”
The company should think of itself as a fiduciary, and the investor must not think of itself as a partner or true owner. The investor needs a structure that provides protection from loss and the company needs a structure that provides authority and incentive to make maximum profits.
An original structure would emerge far more easily by reviewing the investor and company profile.
Consider a direct private equity investment with the following characteristics:
The investor profile:
- High Net Worth Individual
- deploying private wealth
- have the ability to evaluate investments opportunities
- do not employ dedicated wealth managers or investment operators
- either has no industry or sector-specific expertise or not expected to contribute it
- near the end on the spectrum the passive investor
- mid-large private companies
- non-monetary priorities – reputation, legacy, …, …
- the business has barriers to entry:
- highly capitalized, or
- regulated, with education and licensing requirements
- brand identity is critical to the business, such as fashion, luxury, hospitality, and restaurant
- multi-generational transfer of reputation and relationships
- acquisition of income-generating asset with a fixed life
- single contract of 7 to 10 years term
- geographical or services expansion
We might be all hands on the deck to win the most innovative transaction award. However, the client is already facing way too much uncertainty.
We can start by asking the right questions to provide the right answers, such as:
- Where do investors sit in the capital stack
- Understanding of risk-reward co-relation. Target return and associated risks.
- Assess risk appetite – Equity interest with high risk and high return, or quasi-debt with preferred returns, you desire guarantees and lien over assets.
- Company’s non-monetary goals – impact investment, wealth generation, legacy?
We must address their vulnerabilities; their priorities. We must conduct accurate risk identification in the light of the nature of the particular project and its specific considerations.
For example, embedded in the functionality of the structure of certain rights and protections, mitigating the need to chase or need to enforce them:
- chasing updates and information. They could be sidelined when considered outsiders and unable to relate to how the industry works
- Having an observer seat for passive investors
- Manage expectations regarding entitlements and appreciation of the company’s invisible equity and operational role.
- Investor relationship management costs – passive investors require substantial time, attention, and maintenance – they have to be mentored and supported.
- Investors creating a significant strain on management – constant monitoring, information management, lack of specialist financial and investment knowledge, renegotiating.
Let’s remember, we have
- An entrepreneur who needs funding
- The investor who wants high returns
- Like a fund manager, the company incurs costs for operating investments
- Average returns of 20% to 30%
It should not be too complex or costly to formulate standard form terms and conditions as the baseline rights, limitations, and entitlements for a typical position in the capital stack.