alignment of interests

A difficult and abstract subject to blog about, however the requirement for alignment of interests between investor and entrepreneur in growth capital situations is a firm belief of mine. This alignment is driven by the structure of investment agreed between entrepreneur and investor. Please bear with me!

At it’s most basic, I am a fan of simple investment structures that everyone understands and where everyone’s shareholding ‘moves’ in the same direction at once.

What I mean by this is that as a company develops the value in each party’s investment is affected in the same way, and at the same time, such that when the investor is making a gain, the managers/entrepreneur is making a gain but, most importantly, when one party is facing a loss on their stake in the business, then all parties face a loss. Ideally all parties move from loss to profit (and vice versa) at exactly the same moment and in the same proportions.

The critical part to this is that all stakeholders in the business will therefore have a much higher chance of being totally aligned in both motivation and decision making processes as they will have equal interest in either continuing to drive profit or managing and defending their losses. This means that you should have a greater chance of consensus of opinion on corrective or growth strategies.

Where this does not happen is where one party has a ‘preferred’ position of some sort over the other party such that one party can be in profit whilst the other is in a loss situation – e.g. preference shares that attribute value ahead of ordinary shares, preferred yields and/or dividends, loans that sit ahead of equity……

Lets take the example of a business (X) that is theoretically worth £4m pre-money that is seeking a £1m investment. Here on a straight equity deal an investor would get 20% of X for their £1m (based on a £5m post-money valuation)

The sub-optimal scenario:

Because management want to protect their ‘upside’, instead of negotiating a straight equity deal, they give the investor a 10% stake in preferred shares such that the investor receives a preferential return of £1m on sale. However, in this situation, should value diminish for whatever reason then the investor can end up sitting on a profit whilst management are seeing their value diminish. Specifically here if the business is then worth £3m in the future due to unforeseen circumstance, the investor has £1.2m of value (£1m preferred and 10% equity) whilst management have seen their stake diminish from £4m to £1.8m (90% of the remaining £2m equity value). The investor has a 20% profit whilst the management have a 55% paper loss.

In this ‘bad’ scenario the investors motivation and the management’s motivation may differ due to the profit vs (paper) loss scenario and resulting decisions will be influenced by this.

Ironically, the same thing can also happen on the upside. When the business is worth £20m, management may be much more aggressive in the decision making than the investor would want to be as management are seeing a disproportionately higher percentage gain on the equity upside due to their ‘accelerated position’ in the equity. Management will have a paper gain of 327% whilst the investor has a gain of 190% (£17.1m of value for management vs £4m at start and £2.9m for investor vs £1m at start). Great for both parties but management may be more ‘pro-risk’ (or theoretically ante-risk) than the investor.

The better scenario:

If, for the same business, a straight equity deal had been agreed (i.e. 20% of X for a £1m investment) when value diminishes to £3m the investors stake would be worth £0.6m and the management’s stake £2.4m. In each case both parties sitting on a (real/paper) 40% loss on their initial investment. Whilst this isn’t an ideal position, both will be feeling pain in the same way and both will be making decisions in the same manner.

On the upside when the business is worth £20m, both will have made proportionately the same gains (£4m to £16m for management and £1m to £4m for investor = 300% profit each). Decision making aligned.

Whilst sometimes these types of investment are required (mainly due to management not wanting to take the full dilution required by an all equity deal) and are even appropriate (for example in much larger MBOs), in a growth capital situation I think that a straight equity investment with all participants in the same economic class of share makes more sense.

Profit/Loss ratios are aligned, motivation is aligned and hopefully decision making is aligned. Oft mentioned, but entirely true, the one absolute is that a business plan will not be hit and there’ll be both ups and downs on any investment journey. The value of long-term alignment is huge and making consensual decisions from the same place and for the same reasons will reap dividends in all situations.

 

1 Comment

  1. Preparation Capital Limited » keeping control
    January 29, 2016

    […] end value of a stake rather than the emotional ‘percentage’ when capital raising (for example alignment of interests). However in a recent blog post (I doubt it’ll be a majority stake)  I made the point that […]