Going for growth with private equity – the founder conundrum

For founders in Scotland’s STEM sector, securing funding to develop and grow their ideas is a critical challenge. While it’s possible to progress initially without external investment, there often comes a point where additional capital becomes necessary to reach the next level of growth.

Understanding the implications of different funding options, particularly private equity, is crucial for founders as it can significantly impact their roles and control over their businesses.

Dawn Robertson, an employment law specialist, and Michael Cox, an experienced M&A specialist explain what we mean.

The Entrepreneurial Drive for Growth

Founders are typically ambitious and forward-thinking individuals who aim to maximise the potential of their ideas. This often leads them to seek new investment, whether in the pre-revenue stage or when already generating revenue, to facilitate a substantial leap in business growth.

Equity Financing: Key Considerations

When raising capital in exchange for equity, founders should be aware that in exchange for the funds they will be forfeiting control over the business and entering into a new regime:

1. Ownership Dilution and Control

Offering equity inevitably dilutes the founders’ ownership stake, potentially altering the company’s control. As new investors join, founders will experience a reduction in their decision-making authority. It’s essential for founders to carefully evaluate how much of their company they’re willing to relinquish both by diluting their ownership but also by granting the investor specific control over issues in the Company’s constitutional documents.

2. Governance and Board Composition Changes

Equity investors, particularly those making substantial investments, often seek board representation. This can transform the governance structure from a founder-led model to a more diverse decision-making body. While this brings valuable expertise and networks, it may limit founders’ ability to make unilateral decisions. The introduction of new board members can lead to shifts in company strategy, operational focus, and even corporate culture.

3. Investor Expectations and Reporting Requirements

Bringing in equity investors introduces a new level of accountability and transparency. Investors typically expect regular, detailed reports on financial performance, operational metrics, and progress towards strategic goals. While this increased scrutiny can drive discipline and professionalism, it also requires significant time and resources to manage. Founders must be prepared to invest in robust reporting systems and dedicate time to investor relations.

4. Exit and forced exit

When raising equity, founders must consider potential exit scenarios for themselves and their investors. This includes considering scenario where the investor may be able to force the founders out of the company and trigger a forced acquisition of their shares via  Good Leaver or Bad Leaver provisions. Even in a harmonious relationship between founder and investor, it may well be that each has a different vision for when the company will be sold. Who has the power to trigger a share sale? This will be dictated by the constitutional documents. In some scenarios, we get involved in negotiations around the founder’s employment contract post-completion and wording around circumstances entitling the company (for which, read investor) to terminate the contract, as well as around the timing of any such termination, can become critical.

Debt Financing as an Alternative

Debt financing presents an alternative to equity funding, particularly suitable for profitable businesses seeking significant growth. Key points to consider include:

1. Ownership Retention and Control

Unlike equity financing, debt allows founders to retain full ownership and control of their business. However, lenders may still impose covenants or restrictions that could indirectly influence business decisions.

2. Financial Implications and Tax Considerations

While regular repayments can strain cash flow, interest payments on business loans are typically tax-deductible, potentially lowering the real cost of borrowing.

3. Collateral Requirements and Personal Guarantees

Lenders often require collateral or personal guarantees, which can put business or personal assets at risk. This increased personal risk can foster a high level of commitment and financial discipline among business owners.

4. Qualification Criteria and Credit Impact

Obtaining debt financing can be challenging, especially for new businesses, due to strict qualification criteria. The process can also impact a business’s credit rating, potentially affecting future borrowing capacity.

5. Long-term Financial Strategy

While debt can provide immediate capital for growth, it’s essential to consider how it fits into the long-term financial strategy of the business. Striking a balance between leveraging debt for growth and maintaining a healthy financial structure is crucial.

Conclusion

For founders in Scotland’s STEM sector, the decision to seek external funding presents both opportunities and challenges. Whether opting for equity or debt financing, it’s essential to carefully consider how different options will impact ownership, control, and the founder’s role within the company. A thorough evaluation of the pros and cons, aligned with the company’s long-term vision, will enable informed decisions that balance growth aspirations with governance considerations.