Take these three wise steps before investing in an unquoted company
You have the opportunity to invest in a company. Should you take the plunge? Leaving to one side how much you should invest – usefully metered by the truism ‘only invest money you can afford to lose’ – there are three simple steps any prudent person really should take before parting with their money:
- Ask yourself if you understand how the business will or does make money. If the answer is ‘no’ then this is probably not the right investment for you
- Do you know and trust the management, or have good reason to? Again, unless you are confident in the management, you should avoid the investment
- If the answer to both of the above two questions is positive then taking this last step should stop you making an easily avoidable error: you should read and understand the Articles of Association. Why? Because in the absence of a shareholders’ agreement it is the Articles of Association that set out how a company is run. You don’t want to be caught out and discover only after making an investment that others, perhaps with a different class of share to you, have greater levels of control or receive more dividends
Here is a checklist of the eight key elements in the Articles of Association that you should make sure are clearly worded and reflect the terms you are expecting.
The Articles of Association will give the directors general authority to make decisions relating to the ‘management of the company’s business’. It is stating the obvious, but make sure the directors have not given themselves any excessive powers. For example, directors do not normally have the right to determine their pay and benefits, which are more properly matters for shareholder approval.
A director can be removed by a simple majority of votes at a general meeting. So it follows that if the directors have more than 50% of the voting rights, you, even with the support of the other shareholders, will not be able to remove them by a vote.
Forcibly removing a director is quite an extreme step, but if you are unsure about the directors then do be alive to the fact that if they control more than 50% of the vote you are unlikely to be able to replace them. Perhaps the situation is more likely to be of concern if it is one individual that has more than 50% of the shares rather than the majority being held between three or four directors.
Also, when making an investment check which type of shares you are buying. If there is just one class of share and these shares carry the standard one vote per share then it is quite easy to calculate your clout at a general meeting. It will be harder if there is more than one class of share, each with different voting rights. So, unless you know the rights and number of shares in issue for each class it is impossible to ascertain how valuable the voting rights attached to the shares you are buying will be. The details of the voting rights will be set out in the Articles of Association.
The principal reason for buying shares in an unquoted company is financial. You are expecting a return in the form of dividends. You would normally expect to see that each share has an equal right to dividends, i.e. dividends would be received in proportion to your holding in the company. However, be aware that if there are different share classes they may have different rights to dividends.
Investors should check that each share has the same right to dividends as all the other shares, and that the dividend entitlement of the shares being bought is not limited in any way.
Proceeds on sale or winding up
If a company is sold (or wound up) this is usually when an investor realises a sizeable return (or loss) on their holding. Normally the Articles of Association would provide that entitlement to any capital from a sale or winding up is pro rata to the shares held in the company. However, it is not uncommon for investors, particularly early-stage ones, to want to get as much of their investment back as possible. To do this they may have insisted on a ‘liquidation preference’ provision being included in the Articles of Association.
A ‘liquidation preference’ gives the beneficiary a right to receive a sum equal to their initial investment before any of the other shareholders receive anything. What happens to the balance (if there is any!) varies. Sometimes provisions will stipulate that any residual amount is then distributed pro rata to the other shareholders or even that the balance is distributed pro rata to all shareholders, including those who had the benefit of a liquidity preference payment!
Before investing, always check whether there is a liquidation preference provision that would put others ahead of you on a distribution or indeed whether you should be asking for one yourself.
There is nothing more annoying than being diluted. To stop this happening a prudent investor should make sure they have a ‘right of first refusal’ on any new shares being issued. Such rights are usually referred to as pre-emption rights. The purpose of pre-emption rights is to give existing shareholders the ability to maintain their percentage interest in the company and avoid unwanted dilution.
Typical pre-emption rights provide that the company will offer new shares first to the existing shareholders pro rata to their existing shareholdings. This means that if you have a 10% interest then, provided you take up your rights, you will retain a 10% interest in the company. However, if you do not take up all of your entitlement you will probably find yourself diluted.
Rights to sell or transfer shares
Before investing always make sure you will be able to sell or transfer some or all of your holding if you need to. Many companies give their shareholders a completely unrestricted right to sell or transfer their shares. However, you may find that the director(s) have reserved themselves a right to ‘block’ any proposed change in the company’s ownership, and that means shareholders effectively have almost no ability to sell or transfer their shares.
A common alternative to the above two scenarios is a right of pre-emption. Pre-emption rights allow shareholders to sell their shares to a third party so long as they offer them to the other existing shareholders first. The entitlement of the other shareholders to purchase any shares being offered by the vendor is usually in proportion to their existing holding.
If the Articles of Association do not give you an unrestricted right to sell or transfer your shares then as a minimum you should insist on there being pre-emption provisions.
If the directors or investors in a company anticipate selling the business then they will often reserve themselves a right to compel any minority shareholders to join in the sale. This right is generally called ‘drag along’. The reason for including drag-along rights is so that anyone negotiating the sale of the company can give appropriate assurances to a potential purchaser that, if required, they will be able to deliver not just their own shares but 100% of the company. Well-drafted drag-along rights will provide that if other shareholders are ‘dragged along’ they should receive the same consideration as the vendors negotiating the sale.
‘Tag-along’ rights sit alongside drag-along rights. Tag-along rights prevent smaller shareholders being left behind. If a large shareholder is selling their stake in a company then the smaller shareholders may want an ability to join the transaction (to ‘tag along’) and sell their stake too.
Tag-along rights are a valuable protection that any minority investor should insist on if they want to avoid the possibility of being left as a minority shareholder in a company that has different owners (and probably management) to the one they first invested in.
Do be aware that a tag-along right is not usually automatic. Generally, it will only apply if the shareholding, or combined shareholding if more than one shareholder has received an offer for their shares, exceed a certain threshold. If the threshold is exceeded then the offer cannot proceed unless the same terms are offered to all shareholders. However, if the offer is made for a number shares that is less than the threshold, then the tag-along rights will not apply. If tag-along rights are included, check the threshold level.
The eight items above are the key elements to check in a company’s Articles of Association. There may also be others, so read through everything thoroughly and query anything that you’re unsure about before investing.
There will also be areas not covered by the articles that the prudent investor should investigate. For instance, are there any shareholder agreements or option schemes either already in existence or planned? It is very hard to quantify the impact of options and or shareholder agreements. Perhaps discovering that they do or might exist should act as a catalyst to taking some professional advice before investing.
Investing in private companies can be great fun and very rewarding. Do not let the above put you off – the purpose of this blog is to encourage you to make some elementary checks before parting with your money.
Henry Catchpole is CEO of Inform Direct. Inform Direct sets out to make dealing with Companies House easier. Henry was CEO at Suffolk Life Group, where he built up the team from eight to 200, and the assets under management from £3 million to £3.5 billion, before eventually selling the company to Legal and General for £68 million.
Inform Direct set out to raise £300,000 on SyndicateRoom, but managed to attract notable angels, high net worth individuals and sophisticated investors to achieve a remarkable £450,000 of funding in less than two weeks. You can read about their success here.