growth vs paying shareholders – the disconnect

Posted by in Investing, Opinions

Bit of a dry one this, my apologies. But super important. Basically the need to look at the entirety of the investment proposition and to consider the medium term impact of investment terms rather than just looking at the pure ‘what % am I giving away’.

I’m a little bit old-school when it comes to structuring growth capital investments. I tend to focus on the word “growth” in the definition of the investment type (i.e. requires capital to grow and the investment is being made because the company is growing in value) and that this therefore means the company should be doing everything it can with its’ day to day resources to do just that – to grow.

What then continually surprises me is when I meet people wanting to invest in growth businesses that have structured their investments to guarantee one of: paid yield (interest), structured redemption (payments) and/or dividends. Each of these simply put means cash coming out of the growth business and into the hands of the investors/shareholders. Leakage. Surely if a business is a true growth business then the imperative should be to deploy all available cash in priority to growing that company rather than to have it disappearing out of it? I underline the words ‘in priority’ because clearly if the business is growing and has free cash beyond this requirement then none of the above are, or ever should be, an issue. The problem arises more where the investment carries contractual obligations to any of the aforementioned payments that result in the payments to investors being given priority over the business’ requirements.

Now the compromise here is that in the above scenario investors are often covering some of their downside risk by getting an earlier return on their capital. This can result in a diminished equity ‘ask’ at the point of investment (i.e. the investor will accept lower equity ‘upside’ in return for some sort of earlier return of their capital invested) and lower % dilution for the shareholders/entrepreneur when the investment happens.

If you are a true growth business then giving away a smaller percentage on day one anchored to contractual obligations to pay cash out of the business is, in my book, less favourable than giving away more equity at the start. The short-term comfort on less percentage dilution does not balance the medium term hassle factor and distraction of paying obligations.

The best result for the business is therefore that investment is made entirely into equity. This however isn’t always realistic and/or acceptable to investors. As such, if loans are tabled as part of the investment proposal it is definitively worth exploring whether these can be loans that are only redeemed at an exit or have a long-stop redemption date and that, if there is any yield attached at all, the yield ‘rolls-up’ to be paid at either of these points.  This still gives the investor some priority on capital at redemption (a ‘preferred’ return) but guarantees that the growth business’ day to day cash remains in priority cash to grow the business. A decent compromise that protects the business, answers some of the investors downside protection requirements (or preferred return requirements) and mitigates some of the shareholder dilution.

How to strip all this reasonably jargonistic discourse down to the basics? Basically just consider the medium term implications of any investment on the company and look beyond the pure short-term benefit of the % dilution. An investment relationship is long-term, contractual obligations are very real and growth will, hopefully, be a long-standing feature of the business that should have cash prioritised against it! If you’re a true growth business then the majority of the returns for all parties should come through that growth in value of the company and giving away that little bit more equity or taking out that cash on the way through should be less important in the grand scheme of things. I know that peers of mine will shoot at this for being naive but I firmly believe in simplicity and, moreover, that it is the company’s needs that are the priority and that shareholders and investors will benefit more from a growing company than owning parts of a leaky one.

I’ve met too many young businesses contending with trying to re-finance expensive investor debt that made a deal in haste (gave away less) and then regretted at leisure.