Buying into a very small, unlisted, startup.

[BT63]

I have a friend who, I believe, has a good 'invention' that could really go places. It is also an 'invention' that I have a good understanding of.

His very small business has only a handful of employees and is severely constrained by lack of financing options and lack of understanding of what could soon be a rapidly expanding market for the 'invention'.
I also sense that just as his 'invention' is approaching perfection, he's running low on cash and reaching borrowing limits.
He has 'pitched' to professional investors but ended up coming a few places behind the startups that were chosen.

Although my friend is unaware, I could offer significant financial backing to (hopefully) help get things moving at a faster pace.

I'm not so much concerned about the risk of the 'invention' turning out to be a dud, but I am concerned about not knowing a great deal about the complexities of offering to buy-into/finance a startup.

Can any experts educate me on important points to consider?

Thanks.

[Slarti]

I'm no expert, but there are a few points that come to mind

1) Is it a limited company? It should be. And it should own the rights to the invention.
2) If you buy in, the issued share capital should be increased so that you can buy shares without upsetting the current shareholder(s). This could be done by way of part paid shares to allow a further injection of cash later, or by fully paid shares. Existing shareholders would usually also gain additional shares, especially if there is just the one.
3) There needs to be a shareholder's agreement covering people getting out having to allow the other shareholders first refusal on their shares. There are formulas relating to this, but I haven't seen one in over 35 years.
4) Is there Key Man insurance in place on your friend?
5) Is there a business plan?


I'm sure that there are more, but that should get you started.

Cheers
Slarti

[Wizard]

If you want to buy shares in the company, rather than just make a loan, surely the company needs to be valued. Only then can you and your friend agree what injection of capital would give you what proportion of the business? I would imagine that such a valuation of an early stage company would be subjective, or to put it another way based on a large number of assumptions about development costs, growth rates, etc.

It does make me think of Dragons' Den somewhat. Those pitching usually go in with a view of the worth of their company than cannot be supported, but I also feel some people desperate for the investment and profile a dragon can bring allow themselves to be beaten down too far. The Dragon will frequently say something along the lines of "do you want 100% of nothing or 50% of a successful business" to put pressure on the business owner.

Finally, have you considered what this may do to your friendship if things go wrong. Are you buying to hel out a friend or are you buying because you see a way to make some money?

Hope that is in someway helpful.

Terry.

[PaulBullet]

When he pitched it at other groups what was offered?

Paul

[gryffron]

It isn't a simple task. Company law works well for big companies with many shareholders, but works very poorly when a single shareholder owns the majority. A 51% shareholder can force through almost anything to suit himself. As the minority owner of a ltd company you are in a very poor position.

Consider this: You buy 49% of Company A. The director then sells all its IP to Company B (100% owned by himself) for £1, leaving himself with all the goodies and you with 49p.

Even if this is a good friend you trust implicitly, you could end up falling out over a lot of money. Maybe five years down the line he feels he deserves a bigger slice of the cash for his years of hard work when all you have done is provided a bit of cash and sat on your backside.

Venture Capital companies go to a lot of trouble, employing lawyers to write cast iron contracts that tie in both key staff and IP rights to the company they are investing in. If we are talking any amount of money at all you should be talking to a specialist lawyer. Explain to your friend that you want to keep your friendship friendly and your business business-like.

Who will decide directors' remuneration?

Also, you should consider a shareholders agreement that allows other shareholders first refusal of any share sale at a price set by some pre-agreed formula.

Also agree under what circumstances you will allow further share issues for future funding. This may still be necessary, to scale up production for example. The company's constitution should require a significant majority of shareholders voting to allow this. Certainly not just 50%.

Sorry if I've put you off. There are a lot of rewards in this type of investment. But there are also a lot of risks.

gryff

[BT63]

Thanks for the replies, folks.

Answering the many questions:

It is a limited company.
It owns the rights/patent for the 'invention'.
Not sure about Key Man insurance. However, I know a lot about the 'invention' and the industry it relates to.
There is a business plan and I can see plenty of opportunities if there's enough funding.
I was expecting that any 'deal' would involve creation of new shares in the company in exchange for money, with dilution of existing holder, somewhat similar to a rights issue.
Valuing the company will probably be difficult and I'm not sure what was offered by the professional investors he pitched to. I don't think the company could ever become a global giant - best case scenario, if successful and after several years, it mature to might reach a market a point where sales reach a few tens of millions of pounds and bottom line profits might reach a few million pounds.
Regarding our friendship: we live a good hour away from each other, we're not in each others closest circle of friends and neither of us share any friends, so if a falling out occurred it would not have significant knock-on effects.
The existing owner setting up another company and selling the rights is a risk.
Regarding my friend not thinking I'm making a fair contribution in several years time: I've assisted him with design/development/advice and would expect to continue to do so.

[BT63]

......A 51% shareholder can force through almost anything to suit himself. As the minority owner of a ltd company you are in a very poor position.
Consider this: You buy 49% of Company A. The director then sells all its IP to Company B (100% owned by himself) for £1, leaving himself with all the goodies and you with 49p.

Yes, that thought had crossed my mind. I had been pondering whether if I get involved, a third shareholder - even if a small one - would be beneficial and the original owner holds no more than 49% so he can't win a vote without at least one of the other shareholders.

I haven't discussed anything with my friend yet because I'm not sure whether I want to make an approach - hence seeking the 'foolish' advice from the knowledge base here.

[gryffron]

if I get involved, a third shareholder - even if a small one - would be beneficial and the original owner holds no more than 49% so he can't win a vote without at least one of the other shareholders.

Even with 3 or 4, they can gang up to force a minority stakeholder out. It works much better once there are a dozen or more, as such contrived agreements then become very difficult. But obviously that isn't an option for most small companies.

You could reward the staff with a few shares. To hopefully retain their loyalty. Obviously depends how important or easy to replace they are.

gryff

[dspp]

I have been involved with technology start-ups that had external funding. It is a minefield. Often it does not end well. Often = about 90% of the time.

In this situation you may well find it simplest to organise a loan that is secured against the title to the invention or some other item that, if it goes missing, won't affect his ability to run his business and live - or just make it unsecured (and uncallable). It will give you less upside, but hey ho. You might also agree that a condition of the loan is a small royalty from any sales so as to give you upside access.

If you go into equity (or option) financing of either the existing ltd co, or of a special purpose ltd co that exists only for the invention, then you are into shareholder agreements territory with all sorts of valuation, tag & drag, and etc etc clauses. To get a 'deal' properly done with lawyers who know what they are talking about is likely to be £50k of legal fees. In contrast you ought to be able to draw up a simple loan note with a royalty clause yourselves on one page of paper.

By all means PM me off board but it may be a while before I can respond if you do.

regards, dspp

[UncleEbenezer]

What you describe is a similar situation to both angel investors and crowdfunding campaigns. Sites about those might have some highly-relevant insights.

......A 51% shareholder can force through almost anything to suit himself. As the minority owner of a ltd company you are in a very poor position.
Consider this: You buy 49% of Company A. The director then sells all its IP to Company B (100% owned by himself) for £1, leaving himself with all the goodies and you with 49p.

Yes, that thought had crossed my mind. I had been pondering whether if I get involved, a third shareholder - even if a small one - would be beneficial and the original owner holds no more than 49% so he can't win a vote without at least one of the other shareholders.

I haven't discussed anything with my friend yet because I'm not sure whether I want to make an approach - hence seeking the 'foolish' advice from the knowledge base here.

A big listed company can shaft its shareholders too!

Food for thought. You might for example consider holding preference shares, or a non-voting share class. That keeps you out of the way of management, but your share class can hold special rights triggered by particular events, such as a proposed disposal of a key asset. Set up the triggers and rights to protect both sides, with the assumption that nothing will ever be triggered provided everyone acts in good faith.

Caveat: I have no expertise here!

[dionaeamuscipula]

agree with most of what dspp says.

"tag" = a tag along clause. If the main shareholder sells, you have the right to sell too at the same price.

"drag" = a drag along clause. If the main shareholder wants to sell, you are required to sell too at the same price.

Both of these clauses are standard terms in shareholder agreements. A shareholder agreement can set out how decisions are made too.

Even for a one page loan agreement, you should employ a competent solicitor to make sure that the terms are clearly drafted. In my experience (though ClitheroeKid may disagree) high street solicitors do not have the experience or knowledge to handle this sort of commercial work, hire a firm which does.

Again in my experience, ideas are ten a penny. Good ideas are about one a penny. You don't often come across someone with no ideas but lots of money. You often come across someone with a good idea and no money. You are in an excellent position, therefore, to dictate terms - compromise on things if you want to, but don't feel cowed or railroaded because the invention is someone elses.

Finally, if you are going to invest in just this one project, you should anticipate that your investment will most likely be a complete loss. If you make a return then brilliant, but don't underestimate how high the risk of failure is. It is enormous - think 90% or higher. Business angels generally invest alongside others in a number of projects in order to spread the risk of loss.

DM

[rthak]

Hi BT63

I'm a solicitor in London that deals with a lot of this type of investment on behalf of the investor.

Just to add to the above:

1. Typically these types of investments would be structured as loans which are convertible into shares within a certain timeframe and at a certain price. This gives you the certainty of ranking higher in the repayment order than the equity but if the company takes of as expected you still see some of the upside.

2. You should have a shareholders' agreement in place. This is designed to give you certain protections that you would not ordinarily have under general Company Law. For example, the right to appoint a director (so you have some oversight as to what is going on in the Company) and the right to veto certain key decisions (such as a sale of the company or its assets and the issue of new shares to ensure you are not diluted regardless of any right of first refusal you might have).

3. To sit alongside the shareholders' agreement one would usually expect bespoke articles of association. These are the company's constitutional documents and include certain other protections (such as relating to prohibitions on the transfers of shares).

4. Some of the other things you might think about are:
a) How well do you know the company you are investing in? Would you want to do some basic due diligence to ensure that for example it owns the IP which is critical to the business and does not have some ongoing material litigation that could easily eat up your investment.
b) Does the founder have an employment contract in place to regulate his rights and responsibilities (no 3 months holidays!) and how much he gets paid?
c) Does the Company have a business plan with targets to achieve? That is a good way to measure performance and avoid disputes about how the company has performed in the future.
d) Will further investment be required in the future and if so, how will you deal with that in terms of dilution?

Clearly how much of the above is actually relevant will depend on the level of investment. You might be willing to take a view on much of the above if you are say investing £20,000 as opposed to £200,000!

Send me a PM if you have any further questions.

[BT63]

Thanks to everyone for the replies.

I've gently touched on the subject with the business owner and I think there are some differences of opinion that can't be overcome until he gets more desperate for cash. I think that may partly be why he has so far failed to attract investment from his pitches to potential investors.

I think he wants to retain 100% of the shares in his business. He gives the impression of wanting to take on debt via online fundraising websites.
My suspicion is that the amount of additional debt - several hundred thousand Pounds - that he wants to take on for aggressive expansion could leave the company in a very weak position, up to its neck in debts.

I have a suspicion that the 'going for the moonshot' that he appears to want to do will be too much too soon without heavyweight professionals involved, therefore I fear that his company will need a second round of funding in a couple of years time, but at that time the business will be indebted up to its neck and borrowing options will be severely limited or simply unavailable, at which time he'll then have to issue additional shares to raise funds and dilute his holding.

So I'm going to let this one pass for now, but I greatly appreciate all the replies. If things change I'll revive this topic.