SME Fund Raising : In this tough economic climate, many SME business owners often need to raise equity for their companies as there is a limit to the amount of debt financing that their companies can get from the banks. This article aims to examine 3 common legal issues that SME business owners should note when raising equity capital from investors.
#1: Board Control
One of the key terms that is negotiated between an investor and the company in SME fund raising is the number of board seats that the investor will have after the investment. There are 2 types of equity investors, the first one is called growth equity and the second one is controlling equity.
In the first scenario, the investor looks to take only a minority stake and looks to invest in profitable growing companies. They will usually take a minority position on the board (i.e. less than 50% of the board seats available). Control of the operations and business will usually vest with the founders post this investment.
In the second scenario, the investor would typically either invest so that it becomes the majority shareholder (or controlling shareholder, i.e. 51%) or acquire an equity stake from the existing owners of the company so that it will become the majority shareholder. In this situation, the investor will take a majority position on the board. The existing founder may retire and be engaged as a consultant or a director for a few years to hand over the business to the investor.
#2: Preference Shares – Preferred Dividends
Most investors typically when subscribing for shares/investing new monies in SME fund raising will want to subscribe for preference shares. Preference shares are a class of shares that has a preference when compared to ordinary shares in the capital of the company. We will discuss one form of liquidation preference – preferred dividends. There are 2 types of preferred dividends: (i) preferred dividends that actually accrue and are to be paid out every year (“Type 1 Preferred Dividends”); and (ii) preferred dividends that accrue but are not paid out but accrue for the purposes of the conversion formula for the preference shares (“Type 2 Preferred Dividends”).
Type 1 Preferred Dividends
These are preference shares which are used to fund yield generating assets like power plants, solar farms and real estate projects (with cash flow so will not apply to real estate development projects that are undergoing construction). Each year the company needs to pay out dividends to the holder of such shares as a yield. Usually people would raise this kind of funding and financing with the expectation that the asset will generate yield and after a while after aggregating them together in a bundle, you can sell the assets (when bundled) at a higher price than if you sold them individually to a large institutional buyer.
Type 2 Preferred Dividends
For type 2 preferred dividends these are usually used to fund companies by way of SME fund raising that are growing and the interest accrues but does not have to be paid out. Most growth equity deals are funded using preference shares with type 2 preferred dividends. At the point of an exit or trade sale, the investor will get such numbers of shares taking into consideration the preferred dividends that have accrued over time (much like a convertible loan with interest). This is done to compensate the investor with preferred dividends over time for the duration that such money was being used for the investment.
#3: Convertible Loans with complex conversion formulas
Most SME owners think that debt is better than equity. One compromise for the growth investor is the use of convertible loans. So if the company does not do well, the investor can trigger a redemption under the convertible loan and if the company does well, the investor can exercise its right of conversion to convert the debt into equity.
That said, one key term that most SME Owners do not understand would be conversion formulas. We would suggest that when drafting such formulas, there should be a minimum and maximum equity conversion upper and lower limit as if not, in certain scenarios, the convertible loan holder could end up becoming the majority shareholder of the company.
In conclusion, raising SME fund raising from equity investment from growth or private equity firms or from venture capital firms brings with it additional complexity. We hope that you have gained insight into 3 key legal issues that SME owners would need to consider when raising equity financing for their companies.
If you have any comments on our article, please leave a comment below.
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