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Transcript

Edward Hayes, Solicitor, Burges Salmon

Hello and welcome to the new episode of Death and Taxes, a weekly podcast by the Private Client team here at Burges Salmon. My name is Edward Hayes and I'm a tax and trust lawyer in the private client team and together with my tax and trust colleagues, Guy Broadfield and Tim Williams, we will discuss a range of issues facing clients and professionals alike.

 

Each episode we're joined by a specialist lawyer, or lawyers, from around the firm to bring you our views on important topics for private clients. And in today's podcast we're joined by Alex Lloyd. Alex is a director in the firm's corporate team and he works in all areas of corporate finance, but for the purpose of this podcast we're interested in his focus on high growth businesses, their founders and investors. And one example of that is Burges Salmon's Bscale project, spelled b-s-c-a-l-e, which supports such businesses right from inception, to early funding rounds and hopefully all the way through to a successful exit.

 

So Alex, we're really excited to talk to you about scaling your business and raising capital, and if you could just give us a quick run through, what does that mean from your perspective?

Alex Lloyd, Director, Burges Salmon

Cheers Ed.

 

Scaling a business, in my eyes, is going to be slightly skewed because I'm a corporate lawyer and I'm dealing with transactions all the time, so when someone comes to me they're likely to be raising money and they're likely to be raising money in the form of equity, specifically in my case. So we're looking at scaling through a fundraising, and that would be a series C fundraising, a very early one, a series A, perhaps, series B and series C stages of capital growth of a company. Of course there's more to it than that and there's all sorts of operational scaling that's going on in the background, and we would advise on that but it wouldn't be me and the corporate team.

So that's what I'm talking about. The other time that somebody might come to me in the context of scaling is if they're looking to do so through acquiring other businesses. So quite often we'll get a company that's a high growth company in its own right and it's looking to acquire others, so we often are involved in M&A transactions in the context of scaling businesses through acquisition.

Ed

Great that makes a lot of sense and have we got an example of something we've done recently that can map out that pattern?

Alex

Yes I have, and this is what we want to do, we want to get involved really early with the business, act on their initial fundraisings and in doing that, and that's a bit of an investment on our part because at that point cash resources are strapped obviously, but we want to build a relationship there and then we want to follow that company through, and the perfect example, through chance, is we've just done a big exit for a client of ours, that's been a long-standing client that we've been with from the start, so Embark Group it's a digital retirement solutions business, which is a financial services business, tech enabled, think of it like that. So we acted for them where they took some money from some high net worths in the first place, there was a CEO and some high net worths from the city, they went through multiple acquisitions after that where they were buying up lots of other companies and building their assets under management to get them to a point where they could exit, and they were initially looking for an IPO, and through that journey there were those acquisitions, there were joint ventures, and then they started raising capital from significant institutions, so their cap table, their list of shareholders, changed from a list of high net worth individuals to BlackRock, Mary and Chrysalis, Franklin Templeton and some strategic investors as well in the form of their major IT partner, which was a company called FNZ, so they went through that, raised some serious money and then they were looking to exit, it could have been an IPO, it ended up being a sale to the Lloyds Banking Group and they exited £390 million pound sale, so that is the journey that we want for ourselves and for the clients, and that's exactly the sort of example that I'd give.

Guy Broadfield, Solicitor, Burges Salmon

Alex in that example you've mentioned the various different types of investor, but at the outset, for the purposes of this pod, it's probably just worth exploring that little bit in more detail to set out who the parties are and what different types of funding that there is.

Alex

Yes sure, so let's start at the bottom I suppose. So you've got grant funding, is the first one. We wouldn't necessarily be involved too heavily in that, but there's lots of grant funding available from Innovate UK and other government sources. So there's your first source of capital.

 

Next you might look at friends and family around, so lots of startups get their very early capital from their friends and their family, and there are pitfalls in doing that of course, but that's a great source of money early on. If you take a step up from that, I suppose you're looking at high net worths and angel networks. And that source of funds in the UK, is centred heavily around tax advantage schemes, so those people are looking for enterprise investment scheme, EIS, or seed enterprise investment scheme, SEIS, tax reliefs. And so the form of those rounds is often shaped by the tax advantages the investors are looking for, and they'll want the companies to be EIS compliant in order to get those tax advantages, so there's your next bucket, angels and high net worths. And then you're looking at venture capital money, so these are funds specifically designed to invest in early stage high growth businesses. It's a high risk form of investing for a fund, I suppose. And 2021 would be a record-breaking year for venture capital, so there's plenty of money out there from these venture capital funds.

 

Beyond that there are other investors of course, if you think about strategic investors, and more and more of our established corporate clients are setting up venturing arms, so you'll have a big corporate looking to make a strategic investment in a smaller company either with an eye to buying it eventually or to supporting the broader ecosystem that it works in or to get a feel for how things are moving and changing in the industry, so it's a way of them innovating through investment.

Ed

You mentioned that those investors who are really interested in the tax efficient means of investing, and is it fair to say that's one of the key reasons, frankly, why making sure your house is in order early on as a startup is so key?

Alex

Yes, when we're talking about angel investments, I don't know the exact number but it'll be over 80%, are looking for EIS or SEIS treatment, so that company needs to make sure that it's going to comply with the regulations and be EIS compliant. So yes, absolutely crucial that they do that, and there'll be provisions in the documents as well which say you will maintain that status and there'll be consequences if you don't.

Ed

And have you seen examples of businesses who they suddenly realise they need to turn to angel investors, for example, and actually their articles don't quite work, or they've got the wrong kind of shares in issue, and that kind of thing, have you got examples where that's gone wrong in the past?

Alex

Yes, you quite often see, in terms of the classes of shares, you quite often see, because in order to get that EIS relief the investors capital has to be on risk, so you can't have all sorts of protections on your equity state, you have to be at risk of losing it, so you can't have your really funky anti-dilution protections or you can't have preferential shares that are going to give you an element of protection which means you're not really at risk, and quite often you see mistakes being made by both the investors and the investee companies with the investors saying I want this, that and the other sort of protection and the investee company caving in, and then later realising oh dear that means that we've now created a class of shares which doesn't fit within the tax advantage scheme. So that's one error.

 

Also, the EIS and SEIS rules are fairly complicated, and you have to be a trading business in order to qualify, we don't want to get into the detail of that here but it is absolutely worthwhile just making 100% sure that your company's going to qualify, and that the investor's not asking for some share right that's going to push it outside of the regime, and also there are also limits on the amount of cash you can raise, so it's £5 million a year for EIS, up to a maximum of £12 million, and there are slightly different rules if you're R&D heavy, if you're a research and development heavy company, or 'knowledge intensive' is the phrase used.

Ed

So this all gets across the need for someone who understands this, and Guy

and I see this from the other side because we're organising for individual investors and so forth, and we're very aware of how important those tax breaks are, and the difference it makes when you're looking at a potential private investment and sometimes they'll have started out life with whichever, say accountancy or law firm they could afford, which might be a small little local outfit and so forth and the problem there, that I presume you've seen from your end Alex as well, is you might end up with the wrong starting position, then when you're trying to scale up and grow it's actually hard to do that because you've inhibited yourself in the way you've begun life, is that fair from your point of view?

Alex

That's fair and there's always going to be a trade-off.

 

Financial resources are constrained, time's restrained, you want to build the business itself, you don't want to be spending time on your legals, and I understand that and that's why we created our Bscale product really, to give some basic operational documents and some really, really early fundraising documents away for free, the idea being at least you've got there a platform from which to build, but recognise these companies are not going to be absolutely perfect in their legal work at this point, they won't have the money to spend thousands and thousands on every single contract, but you do have to get the basics right and you do come across mistakes quite a lot and the obvious stuff is you've got a cap table, you've got a list of shareholders, that's confused, you've offered someone some equity without documenting it properly, you've got a convertible loan that doesn't actually work because you've got it off the shelf but then tried to make it bespoke yourself, or you've given away shares to people on a promise without actually writing it down and all these things sound a bit silly but they're absolutely half true, or you offer an employee some options in the company but you haven't documented the option scheme properly, it doesn't quite qualify for the tax advantage that you think it should, that's the cap table. And think about IP, you've got a critical piece of IP, it's not actually owned by the business. An investor comes in to look at it, and says this IP isn't invested in the company that I'm investing in, so you've got to then sort that out. You've got a business critical contract and the contract's poorly documented and that contract is underpinning the valuation of the business.

 

And then the one which everyone's going to get wrong a little bit is your data protection policy is not quite right. You haven't registered with the information commissioner's office, you haven't sorted out your border enrolment quite right on your pensions, your health and safety policy, all those sort of compliance elements and they're not going to be perfect, but it's a bit of a red flag for investors if they're completely askew or off the mark. So I'm afraid at some point, when you're looking to take some money, you've got to get your house in order. It's on that basic level and you do see mistakes all the time.

Guy

And inevitably when there's mistakes you might find that that's where disputes arise. I've seen it before where business owners have given some shares to a sibling, understanding that the sibling would make further equity investments or indeed possibly give those shares back to his brother at some point in time, that doesn't happen, the business has grown significantly, the shares that have been given away have significant value and that's not been documented properly, and that's where disputes can arise. And ultimately it's value destructive, Alex.

Alex

Yes absolutely, that's the whole point isn't it, from all of this, you're limiting the amount of cash you can raise and also the valuation of the company, because if there are mistakes they're either going to need to be remedied or you're going to put off potential investors and drive down your own valuation, so all of that is true. Having a nice clean set of legal documents you can present to an investor when they're doing their due diligence makes the whole process easier. I'm not saying these things can't be fixed, by the way.

Ed

A great job of setting out the minefield that is starting out.

Alex

I've made it sound too bad haven't Ed?

Ed

Well should we walk through, in a really basic way, how our Bscale offering is there to guide you through that, and try and manage that tension that you can see between being a really small business that doesn't have the resources at the outset and doesn't have the time, frankly, to spend it on legals, to suddenly find yourself a position where you're going to need your legals in order and how we can help a bit in that place and be there for the bigger events later down the line.

Alex

Yes sure I can Ed. First of all, the point of it really is to invest a bit of time, our time and therefore our money I suppose, in the really early stage companies. And it's all about recognizing that problem that we've just talked about, no cash but need to get some basic legal documentation in place. So the system is totally free for a start, that's the main point, there's no strings attached to it, you just give an email address and you can download a set of documents. At the moment those documents are a shareholders agreement and subscript and articles, that's for a really early stage fundraising, So the idea being, you're raising a small amount of money, the legal fees would be disproportionate but you can have a solid set of documents that you can use as a starting point for that raise. Those are the main ones, and then you've got a set of operational documents for your day to day, just to try and give you a base level of documentation that's workable, usable and be recognisable to investors down the line. And there's an employment contract in there, there's a confidentiality agreement, there are website terms, there are privacy policies, so this gives you just a basic set of documents that you can use free of charge, that's the idea.

Ed

We're building a foundation, that's my understanding. We're giving you that foundation, it's not perfect necessarily, but it'll give you all the key stuff and give you a foundation that by the time you need to be, as a client, thinking about these things in more detail, you're hopefully then tweaking around the edges and finessing rather than ripping up and starting again because everything's just a complete mess, is that a fair summary of what we're trying to achieve with that?

Alex

That's the point and it gets you through, because there'll come a point where you're raising enough money that that fundraising means that it's now proportionate to seek proper legal advice and then this has bridged the gap and got you to that point, that's the hope, and then once you're at that point, there's still an issue with funding and legal costs because if you're raising a small amount of capital, spending a huge amount on a top law firm's a very difficult thing to swallow, and also  the investor won't be expecting the company to swallow a huge level of legal fees, so you've got a choice then.

 

You can go to bigger, significant law firms and pay the fees, or you can go to a smaller high street firm and pay a smaller fee but perhaps don't quite get the expertise because you want to be starting a relationship, there's value in starting a relationship with a firm that can then support you through your regulatory work, your commercial contracts, that has some sector knowledge, if you're a clean tech business it's great to know a law firm that knows all the cleantech investors say in the landscape well. So you want to be building that relationship. So we feel there's a bit of a gap where bigger law firms, law firms like us, need to invest in those early stage rounds. So you've used up the Bscale piece, you're now raising some proper money and we'll come in with a really low fee for that initial fundraising, the idea being that we're investing time and we're investing time to build a long-term relationship and end up in that Embark situation that we just talked about.

Guy

So Alex, if you've grown the business out of that initial stage and in the fortunate position to take on external investments, I guess the question is who are you going to speak to and who do you want as your investors in your company?

 

Yes thanks Guy, well it depends on the nature of the business and what you're looking for out of the fundraising, but let's talk about it in broad terms and about the mistakes that people make.

 

I seem to be harking on about the negative here but I think it's instructive to point out the mistakes that so people get it right when they do it. The first obvious error that you see, or problem that you see, is that founders have given away a hell of a lot of equity in the early days of the business, too much equity, and then a VC comes in, we've seen this multiple times, the VC comes in, they look at the cap tab and they're like well hang on the two or three people that are going to drive the business and deliver the returns for me, they haven't got a big enough stake in this company anymore to be properly incentivized, and you've got a whole bunch of other people who are going to make money out of this who aren't driving the business, so this is an obvious early fault, which is obviously painful for the fans because they've just given away too much, but also, strangely enough, painful for the investors especially if they're professional investors, they'll see that as a gap. So that's point one, try to avoid over diluting yourself, clearly it's dependent on the situation and the need at the time, but that's one.

 

Second is, you often get these cap tables that are really confused, there's a huge number of people on there with really small investment amounts, and that can become unwieldy because you've got a big shareholder base, you've got to communicate with and deal with, get consent from and when it comes to exit you've got all these people with all these differing views in your shareholder base, so unwieldy cap tables can be a problem as well.

 

Then you've got to think about what are the investors going to bring to the table. So if we think about a venture capital fund, first of all it's great to have a good name on your cap table in one sense, if there's been a legitimate and

well-known VC has invested, gives you some credibility so that's one thing to think about. Secondly, a lot of them are now offering more than just cash, so they'll offer you access to support and they'll help you to build your business as well, so there'll be soft benefits alongside hard money with venture capital funds, quite often, Then you've got strategic investors, so is there a corporate out there that could add a lot to the business by investing. Can they do it through access to their network, are there contracts to be made with that corporate. So there's a strategic element if you're looking at corporate venturing.

 

Then you've got your angels. Some of those angels will bring with them a hell of a lot of knowledge as well, if you've got someone who's experienced in the sector coming on board as an angel investor will they sit on the board, will they share some of their expertise with you. So there's that.

 

What can the investors bring, it's an obvious bit. And the next one which we see quite a bit, is varying expectations between UK investors saying US investors, or foreign investors of any type, because remember going back to what we were saying earlier about tax advantage schemes being very important in early stage fundraisings in the UK, so as I also said before, if you're looking for EIS tax reliefs you've got to take ordinary shares effectively, and there's a limit to the number of contractual protections you can have, so if you're raising generally from those investors they're going to get a sort of plain vanilla situation they're going to be on risk and then you're looking at taking money from a, we've got it at the moment actually with one who was looking to raise money from a Russian investor which has caused all sorts of problems now given the situation in Ukraine for a start but even before that, that Russian investor was expecting all sorts of anti-dilution protections and preferential share rights and it was putting them on a very different plane to the UK angels who were looking for EIS treatment, so you can imagine you can create tension just because of the different expectations of the different investors, maybe by jurisdiction or just by type of investor or just by their attitude, and I suppose it's worth saying as well there's a geopolitical element to it and there's a reputational element to it.

 

That Russian investor six months ago looked like a great addition to the cap table, now looks like we're worrisome addition to the cap table and other shareholders express concerns about it.

Ed

It is interesting isn't it? The way I think about it is the way you divide up the pie almost has a surprising impact on the value of the pie, because you can do the best job in the world of growing your business and actually having strong fundamentals and the economics of what you're doing, and it's such a shame if shareholders are undermining all that

Alex

You do see that Ed, you see conflict, but as between them they're very different priorities. So you come to an exit, you've got a company that's

been going quite a while at this point, you've got some high net worth who came in really early at a really low valuation, they were already looking to turn, they're already going to make a big return on this on an exit, you've then got somebody who's come in years down the line, they come in at a much different valuation and exit for them at this point doesn't look so attractive, the money hasn't been in for very long, they had in mind that they would be a longer hold, looking for a bigger exit or an IPO later down the line, and suddenly you've got two sets of shareholders with very competing interests, these want to get out because they've already made a good return, these just came in so they're not pushing for an exit and you can have them then be going back to your shareholders agreement and working out who does and doesn't control the ability to sell the company for example, or float the company.

 

So yes, the shareholder base and having a consistent shareholder base that's happy is crucial.

Ed

And there are some areas with crossover isn't there between you and us, in terms of the corporate side and the product line is the death of a shareholder and how if you haven't really planned that out, that can cause all sorts of mayhem both for the company and for the individual's family.

Alex

Yes there are loads of crossovers actually, which we should probably get into a little bit shouldn't we, so yes you do often see clients come to us and they'll say well I'm in business with my partner what happens if he or she dies, I don't particularly want to be in business then with whoever's going to inherit the shares under their will, be it their wife or their kids, and there are insurance solutions to deal with that, you can end up with a shareholder protection style insurance arrangement whereby the policy pays out and the company can buy the shares back or it pays out to the other shareholder giving them the cash to acquire the shares from the estate, and my part my role in that would be to draft some put and call options, so the ability for one or the other to force the sale or the acquisition of those shares. There's that piece and I suppose the other crossover Ed, is where quite often founders and investors want the ability to transfer their shares to family trusts or to spouses or as part of their estate and tax planning generally, so there's often a bit of a trade-off there, as between that flexibility versus the investors or the other founders don't necessarily want shares ending up left, right and centre, they want some level of control over that.

 

So there's this fair bit of crossover as it comes to chairs as assets in somebody's estate or somebody's will.

Ed

Absolutely.

Guy

So Alex, from what you're saying it's clearly important that the founders consider what should happen on the death of one of the founders and how that's dealt with as between them in the articles of the company etc. In terms of raising finance and fundraising, that would be one part of on the list of so-called founder risks that will need to be dealt with as part of the agreement going forward, but what are the other types of founder risks that you see and what are the other key terms that need to be dealt with as part of any fundraising?

Alex

Yes so key risks for founders personally, so when you raise this money the funny thing is it becomes very emotive right because you're raising money, this is your baby, this company, and suddenly someone's coming in and trying to impose some terms onto you and the ones that go to the heart of the founder are, if you think about it from the investor's point of view, they're coming in and they're saying to you we're backing you as individuals to deliver a business plan that ultimately is going to deliver some returns for us as investors, we can't have you leave the business because that's just destroying the value in our investment, so you end up with these good and bad lever provisions, meaning there's usually a compulsory transfer of your shares if you leave the business and the manner of your leaving determines the amount of money you get as part of that compulsory transfer, so that's founder risk one, get those right.

 

Founder risk two, think about non-compare restrictive covenants and non-competes, non-solicitation of employees and customers, really it's all about your ability as a founder to work once you've left this business, so if something goes wrong and you leave the business for whatever reason you don't want to be locked out of the market for too long so you've got to make sure those restrictive covenants aren't too restrictive and don't last for too long, you quite often see them drafted in such a way that they potentially stop people from earning a living. Then you've got the obvious one which is you're going to give some warranties to these people who are investing, they're saying to you we're putting our money in we want you to make some contractual promises about this business and that'll give rise to personal liability for the founders.

 

Key concept to take away there is the investors really don't want to be suing you because if they sue you as the founder, the very person's going to deliver value,  it's fairly destructive for the investor, so it's a last resort option for them, which gives you a good reason to say well in that case the limit of my liability should be enough to be painful but not to ruin me because that's not the point, this isn't about you recovering, it's about you focusing my mind and you set the level accordingly. And then you've got economic rights in general, so if you've got an investor with a class of shares that ranks so far above your class of shares that on an exit, or on a return of capital of any kind, you're so far down the waterfall you don't get the money out, that's another key, so those are the crux of the ones that really go to the heart of the founders.

 

Probably rabbiting on a bit here but very quickly, the other issue is governance and control of the business, so you've been running it your own way, you've been doing it successfully, you've got a business plan, they're backing that business plan, the other risk is that they then come in impose enough controls on you that you're certainly hamstrung into how you can move the business and if it's a young business you may need to be able to pivot and to change direction and to move in whichever way the market tells you to move, so there's those operational freedoms, veto rights, board control etc.

Ed

Great that all makes a lot of sense, and is it fair to say those early rounds of fundraising, a key part of that is just setting the bar in the right place so you know where your business is going and people who follow on afterwards have a precedent that they're happy with?

Alex

Yes exactly Ed. If you think about, it an investor coming in later, they're hardly going to reverse the gains that previous investors have made in the documents and lighten them in your favour, so exactly, you start off with a solid foundation and that's what Bscale is about, it's getting that foundation for that really, really early stage.

 

Then you come to your next round, we'll help and we'll help at a reduced rate to recognise that the tension between the need for advice and the finances that are available, and then you build from there, so the way that I'd like to see it is a really long-term relationship between the company and the law firm, the same law firm that advised on that investment round, is then advising on the commercial contracts as you go through, is then a great place to advise you on the next fundraising and then eventually your CVC and then your exit and if you've got that continuity I think there is real value in that, but it requires something from the law firm, it requires the law firm to acknowledge that they've got to invest some time in the early stages, but I'm not saying you couldn't swap or have multiple law firms acting for you, but there's got to be a benefit in having that continuity and that's what we're looking to achieve.

Ed

Great stuff and then hopefully you get to the end, your business is worth whatever your successful exit will allow you to make on it, and it happens that on season one of Death and Taxes we had an episode covering exactly that eventuality, so please do feel free to look up 'Selling your business - how to make a successful exit', and that would, in an ideal world, complete the journey with your team, Alex, but then Guy and I often step in with clients at that point and help them with that value they've created and the new liquidity for the family, advising them what to do with that, what kind of estate planning they can use and whether there are new business ventures they want to put that back into and how to do that, so another point to make just more generally is Burges Salmon's well set up with the corporate expertise and the private client expertise to cover all bases on that and actually be able to help families with that, the journey both for the business and their personal journey alongside it.

 

Well Alex, it's been great talking to you, thank you very much for all your help today, I think it was very insightful and something that all our listeners will appreciate enormously, anything else you want to add or is that enough for today?

Alex

No that's great, it's been a pleasure chaps, thanks very much Ed and Guy, it's been good to be on. Great to have you.

Guy

Thanks again for listening to Death and Taxes, a Private Client podcast from Burges Salmon, you can find out more about Burges Salmon and our team at burges-salmon.com, or on our LinkedIn page.

 

This is the final episode of season two of Death and Taxes and we hope you've enjoyed listening to the private wealth content from Burges Salmon.

 

Keep an eye out for details of an upcoming special interview, featuring our long-standing Burges Salmon client, and in the meantime don't forget to subscribe to all episodes from season 1 and 2.

 

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