Counsel & Conversation | S2 E3 | Raising Capital: Equity vs Secured Lending | Swinburne Maddison

Caroline Smith 0:02
Welcome to Swinburne Maddison’s Counsel & Conversation, where our experts talk about everyday legal scenarios. Today, I’m pleased to have with me Alex Wilby, who is a Partner in our Corporate Department. Alex has an M&A background and specialises in VC and PE investments. Welcome, good to have you here, Alex. Thank you. I’ve also got Gillian Moir, good to have you back, Gillian. And Gillian is a Partner in our Commercial Property department. So, welcome to you both, and thanks for giving up your time today. I’m going to read a scenario, a legal scenario, and obviously it’d be great to get your view on how that scenario might play out, and how you’d advise the client. So, I’ll read the scenario, and then Alex, I’m going to come to you to kick things off. Ok, so a growing business is seeking capital for expansion. One investor offers equity, another option is a secured loan. The founders are unsure which route to take and want to understand the legal implications of each. So, Alex, over to you.

Alex Wilby 1:10
Excellent. Well, no. Thank you for the question. It’s one of those where those considerations should perhaps come to the founder’s mind a little bit earlier than prior to receiving an offer. If it’s at the stage of receiving an offer, then there really are two quite stark choices to make, two very distinct choices. What we’d always recommend is that it’s our role to advise on the legal implications, but the client, the founder, can take specialist advice from an accountant, particularly a corporate finance accountant, as to which fundraising option may suit them the best. In respect of debt finance, debt finance is typically advanced to businesses taken by founders who have established businesses, are generating revenues, are generating profits, and whose business is able to support the repayment of the debt, whereas equity can be a little bit more flexible, so equity might be pre revenue, it might be some investors effectively taking a punt on a business that might have high-risk, high-returns. There are tax advantages associated with equity investment, and then there’s a whole host of options in the middle. So, mezzanine finance is a term for quite often debt that can become equity, or vice versa.

Caroline Smith 2:15
So, almost going back to this scenario to start with, the suggestion being that actually they’re so distinct, either lending or getting investment into the business, that the scenario itself perhaps wouldn’t quite play out like that.

Alex Wilby 2:29
No, I don’t think so. I don’t think so. I think ultimately, if I was advising a founder, my first question would be, what is your aim as a result of the capital raise? You know, what are you looking to do with this money, if it’s a relatively nominal amount to cover a short-term fix, then that may well be appropriate just to take a quick and easy debt facility from somebody, whereas if it’s a more substantial sum of money that perhaps has an extended payment profile, then they really will be tied into that arrangement, and that may or may not be the best thing for them to do. Similarly, with equity investment, founders can find themselves giving away too much too quickly, losing control of the business, not necessarily having same ownership, or the ownership levels they’re looking to maintain. So, there are a whole host of considerations here.

Caroline Smith 3:14
And would you say, then, also on the back of that, that depending on the sophistication of the business, how long it’s been trading that actually that varies. I imagine you see quite a gambit of very big businesses through to smaller sort of startups, and again, presumably that their requirements and the advice would be different.

Alex Wilby 3:34
Yeah, absolutely. It’s difficult to generalise, but I think it’s fair to say that smaller scale businesses will be pushed more towards equity investments and larger businesses, perhaps debt, or, you know, as I say, some creative solution in between, and that really does come back to the point that an equity investment does see you seeding ownership to your investors, whereas a debt investment can put a strain on cash flow, so it’s ultimately getting that sweet spot between where you want to be in respect of ownership percent percentages and what your business can support in respect of debt repayment.

Caroline Smith 4:08
Okay, that’s really interesting. So, maybe if we talk a little bit more about the lending, this is obviously Gillian, this, this is your area, can you give some examples perhaps where a business has taken lending into into their business, and why they might have done that.

Gillian Moir 4:24
Certainly, yes, I mean, in terms of secured lending, if a business, there’s a lot of considerations to sort of take into account, really, in terms of the assets of that business, and whether the business actually already has assets that can be secured by way of a charge in favour of a lender if they have already got property, real property on their books, that can be a way of raising capital. They can effectively take a loan from either a high street lender or any other type of lender, really, and have that secure by way of legal charge against the property. Often, if they’re purchasing new property or taking a new sort of long lease of property, then if that’s funded by way of loan, the lender will often want to take a legal charge over that, that property is security for their own loan, which is a fairly common process, really, and that’s what we, and we do see a lot of. As I say, if that company is proposing to take a loan, not for the purpose of actually purchasing a property, but for other business purposes. Then, if they have existing long leases or existing freehold and property interests, then the lender can take security over those as well. So, it often depends on what the purpose of the loan is for, and the existing assets of the business, really, as to whether it’s, it’s something they can consider,

Caroline Smith 6:10
so effectively is saying that in order to lend a business to want to borrow money, it’s generally a specific purpose, it might be for something like machinery or what sort of things might they want to borrow money for?

Gillian Moir 6:27
A lot of different reasons really as you say machinery equipment a business expansion and sometimes it’s as simple as they’re actually purchasing the premises that they actually trade from. There can be a lot of different reasons why, and why a business would want to raise capital, but it’s really how they then secure that against the property where we tend to come in.

Caroline Smith 6:58
So, what type of clients Alex might come and seek advice from you.

Alex Wilby 7:03
There’s a range, Caroline, so we act for owner-managed businesses who are looking for their options in respect of what’s available to them, whether that’s debt, whether that’s equity. There’s variations on each, different types of debt, different types of equity, or much larger businesses, some of the largest companies in the North East, who will have teams of people, finance departments, finance directors with multiple people reporting to them, who have plans that span many years, and they really know what it is they’re doing, and just require us to implement it. In respect of the debt options that are available, I think the classic example is lending that’s secured on property, you obviously have invoice finance, you have asset finance, you have primary lenders, you have the secondary market who might be looking for second charges on the property. I don’t know what Gillian’s experience may be in respect of secured lending, and how often that you’ll see people requiring first charges, second charges.

Gillian Moir 7:57
Again, we act for a wide range of clients, and in terms of the lending from the actual banks, from high street banks, and more smaller banks, we can often be instructed on the purchase of a property, the refinances on behalf of both the lender themselves and the borrower company. There’s sort of two ways that we can sort of deal with it, really. We can act on what we call a dual representation basis, where we act on behalf of both the borrower and the lender. We can also act just for either the lender or just for the borrower, with another firm of solicitors acting on behalf of the other party, so there’s a little bit of flexibility there, but in terms of the actual sort of borrower clients that that we see, again, there’s a wide range, we’ve done refinances of theme parks, water parks, office blocks, subject to quite a number of leases, which obviously then are all to be reviewed as part of the sort of package for the for the lender, really. So there’s never a dull minute, put it that way.

Caroline Smith 9:11
So actually you’re you’re saying on occasion you’re acting on behalf of the lender?

Gillian Moir 9:16
Yes

Caroline Smith 9:17
But then also the borrowers, so you’re seeing that across both ways?

Gillian Moir 9:21
We are used to seeing more of a trend of the what we call the dual representation transactions, where we acted on behalf of both lender and the borrower, but often a borrower will have their own solicitor that’s familiar with the property that they’re actually dealing with, in which case we can, we can act for the lender, or vice versa.

Alex Wilby 9:46
We quite often see that, don’t we, when we’re working together on deals where we’re acting for the lender in respect of share acquisitions, so you know, being an M&A lawyer, a lot of the work that I do is acting for buyers and sellers of companies, and then we work quite closely with our Corporate Property team. When the buyer is separately represented by an independent lawyer, we’re acting on behalf of the lender, who are funding the purchase of the entire issued share capital of a company, and it’s our role to advise the lender that the SPA that the buyer has negotiated basically is a good one, that it protects their position, and we take matters forward on that basis, because there’s a common interest, isn’t there, where, if it’s good for the buyer, it’s generally good for the lender, because the buyer needs to have an asset that stands up to scrutiny and is capable of performing in such a way as to allow the buyer and the borrower to repay sums that are owed to the lender.

Caroline Smith 10:35
So, Gillian, what security package may a lender request, and what should your considerations be as borrower?

Gillian Moir 10:42
In terms of secured lending, which is my bag. The main document that a lender would ask to be given by the borrower is the legal charge. That’s effectively the document that secures the funding, secures the charge against the property. That’s the document that we registered at Companies House, it would go to the land registry to actually charge the titles to the particular property that’s being, that’s been security for the loan. So that’s really the main, the main one in terms of other documentation that a lender can request. There’s a bit of a wide range, really, if it’s a company that is the borrower, then the lender can request a debenture, put in place effectively a floating charge over their assets. They can also request cross-company guarantees from other companies, depending on the size of the, the borrower’s sort of group, and potentially personal guarantees from individual directors as well,

Caroline Smith 11:41
So Gillian, how do lenders assess risk in structure deals?

Gillian Moir 11:46
The main thing for a lender to be to be concerned about is the balance sheet of the borrower. Ideally, they really want to just make sure that the borrower is able to repay the loan at the end of the day, so that’s one of the main things they will look at. The next thing is the valuation report, for if the property is going to be charged as security for the loan, effectively the valuation report will indicate whether that property has sufficient equity in it to be good security for the lenders lending that money at the end of the day,

Caroline Smith 12:25
So what happens if the borrower defaults on the loan?

Gillian Moir 12:29
The ultimate remedy for a lender, really, if a borrower defaults on a loan that’s secured against that property, is that the lender can take in possession of that property, and then sell it, and the sale proceeds will then repay the loan. Now, obviously, that’s sort of worst-case scenario, really. Other options available to them, if they’ve got things like personal guarantees, they can look to the guarantors to repay the repayments for the loan. Similarly, if they’ve got intercompany guarantees as security, they can look to other companies to sort of fund those repayments. Another option to a lender is to appoint an LPA receiver, Law of Property Act receiver, who can actually manage the property, they often do that when a property is subject to a letting, so they can appoint somebody who will effectively collect the rent and manage the property, and then those rental payments can then be paid to the lender as in repayment of the loan, effectively.

Alex Wilby 13:39
I think it’s important, as well, Gillian, isn’t it to appreciate that when Caroline asked the question about what the remedies are on the on a on an event of default, a default doesn’t simply mean failing to make the loan repayments, you know, in more complex lending arrangements, an event of default could well be failure to comply with financial covenants, so lenders will be looking for protections that crystallise prior to the actual non-payment event, so you know, on a complicated loan, a lender might say, you know, you require to have this level of income to service your interest payments, and if you dip below this level, we suspect an event of non-payment will be coming later down the track, so that event of default can occur relatively early in the process, certainly before payment is defaulted upon, and then those same remedies that Gillian’s just covered can apply in those circumstances as well.

Caroline Smith 14:25
Okay, so Alex, I’m going to turn to you now, and my question is, How can founders retain control while attracting capital?

Alex Wilby 14:34
Excellent. Well, there’s lots of considerations, I think, as a, again, as a general rule of thumb, a founder will have more control if they raise capital through debt finance, you know, primarily a lender is going to be concerned about being repaid the sums that are owed to it in the loan agreements, or whatever the documentation is that creates those responsibilities. There may well be further obligations on the founder, on the borrower, such as, you know. Obligation to have your accounts audited, so if you are not of the size to have your accounts audited, you could raise capital through debt finance, and that requirement is imposed upon you by the lender, so you are effectively losing a little bit of control in that. In that way, similarly, there can be financial covenants that require you to run the business and maintain capital in the business in a certain manner, otherwise an event of default could be triggered, but as a general rule of thumb, debt finance will allow the founder to retain a significant level of control. When a founder is considering equity investment, then almost always an equity investor, a significant equity investor, will expect a, if not a level of input, certainly a level of consent regime. So, ultimately, they’d be saying, if you are looking to make these key decisions, you require our consent. You have to give us your business plan, you have to make your proposal to us, and we can approve or decline that request, or just talk to you about it, and establish what it is you’re looking to do, and whether we’re comfortable that the company moves in that direction. That may come across as a negative, but there are certainly circumstances in which equity investors bring with them an awful amount of experience and expertise. So, if you take back to a dragon’s den scenario, it isn’t just about getting the money in the business, it’s about having the value that the dragon can bring, and lots of equity investors will make pictures to businesses on that basis to say these are our commercial terms of investment and these are the extra value services we can provide to you that will allow your business to grow further and faster than it would without us.

Caroline Smith 16:32
That’s really interesting. So, effectively, although there might on the surface appear to be a loss of control, there could be value add by actually having these experts with incredible knowledge coming into the business.

Alex Wilby 16:42
Yeah, absolutely, absolutely. And there can even be an argument to say that the loss of control can just be the imposition of good corporate governance, to say that you know, if you were running this business in such a manner that, as an owner manager would, in a relatively informal way, and bootstrapping certain decision making, if an investor comes in and says that that’s great for a smaller business, but as your business grows, we need to put in place policies, procedures, and controls that require our consent, require our approval that may well simply result in better corporate governance, better operational decision making in a more robust business,

Caroline Smith 17:17
right. So, Alex, I’ve got another question for you. How should investment agreements be structured in equity agreement deals?

Alex Wilby 17:26
There are a few different ways. Caroline, an investment agreement is a private contract, so it’s not a document that gets filed on public record. It’s prepared by the investor, and it’s primarily designed to ensure that the investor is comfortable putting their money into the company on the terms that that they require, so there is variability as different investors will have different approaches, but it’s perhaps fair to say that there are three main sections that an investment agreement would typically cover. The first is in respect of the historical activities of the company, so the company and or the founder may be warranting to the investor as to decisions and matters that apply to the company prior to the date of investment, so for example, the investor will almost certainly have completed the investment based on financial information that’s been provided to them. So the company and the founder will warrant to the investor that the information they have given them is accurate and has been appropriately prepared. This ensures that the investor isn’t misled, it ensures that there are no skeletons in the closet. The last thing an investor will want is to invest a significant sum in the company, only for there to be a liability that the investor wasn’t aware of that devalues their investment. So that’s effectively backwards looking. There’s then the element of simply doing the transaction, which is, which is a legal process, so you know the process for issuing and allotting shares is a technical legal process that has to be followed correctly. So, ultimately, that will be the investor is paying an agreed sum of money for an agreed percentage of equity ownership of the company, and it’s the role of the lawyers to make sure that the legal processes are followed, to make sure that those shares are issued correctly, and that the funds flow is handled correctly, so that the money ends up with the company and doesn’t get delayed due to banking defaults or anything similar to that, and the third aspect of an investment agreement that we typically see is post-completion decision making. So, once the investment has taken place, and once the investor is on board, the investor may well require information to be provided to them at certain intervals, that may well be management accounts, it may be audited statutory accounts, it may well be reports as to ESG. You know, we’re seeing that as an increasing, as an increasing issue, where investors are looking to push companies in the direction of ensuring that the following best practice in that regard, and also in respect to the consent regime. So, if the company, if the founder wants to make any key business decisions, quite often they’ll need to go to the investor and ask for their consent, ask for their approval, and the investor may well have thoughts to share at that point, and those thoughts could be based upon the investor’s experience, background, and specialism to allow the company to make the best decisions.

Caroline Smith 19:55
Thank you. Yeah, thanks for that. So, a sort of quick question, really, it. Is it possible for you to summarise the common pitfalls of early stage investment?

Alex Wilby 20:05
Common pitfalls would be, I think, most importantly, is to commercially assess the deal. It’s to make sure that you aren’t giving away too much of your equity too soon, and there’s obviously a balancing act there. If you’re not putting enough equity on the table, you’re not going to attract investment. If you’re giving too much equity up, then you are diluting your ownership position, you are losing control of the company, and what we’d also say is a common pitfall of not just necessarily looking at the transaction at hand, but looking at the next decade of plans for the company. You know, quite often companies seeking equity investment will do so in various different tranches, so there’s an equity investment now, there may well be another planned equity investment in a couple of years’ time, so you have to plan and map your dilution to take you over the life cycle of envisaged equity investment. Outside of that, the common pitfalls are really understanding personal liability, so if you have an established company, you may well be pushed more towards taking a debt deal, because your company’s established is capable of servicing the debt, but there are there are times where you have an established company with a significant balance sheet. The company has to give warranties in the investment agreement, and if those warranties are incorrect, it’s the company’s liability. A common pitfall would be proceeding with a deal of that nature, the investor seeking personal liability for those warranties, that those warranties are given by the company and the founder, and where that is the case, the founder is personally liable for those warranties. That puts the founder’s personal assets at risk, it puts the home at risk, it puts any savings they have at risk. So it would be our role to make sure that the founder fully appreciates that, that that’s the terms of the deal that they’ve signed up to, and also to mitigate that risk by introducing limitations of liability, so that may well be that the founder carries a degree of liability, but only up to an agreed sum. So, quite often that might be associated with the salary. So, if the, if the founder is taken out x amount per year, then their liability is limited to one time, two times, whatever their salary is, and that protects their position and allows them to enter into the deal, appreciating where they stand,

Caroline Smith 22:04
so I mean it sounds like the implications of investment are considerable, but then likewise the risk of lending, there’s huge considerations there. So, how, how would you begin to help a client understand that, you know, when, when should they seek advice?

Alex Wilby 22:22
I always enjoy engaging with clients as early as possible, not just necessarily in the investment process, but over their life cycle. You know, we have strong commercial teams that allow clients to put in place robust contractual arrangements that can withstand due diligence processes and complete the investment smoother than if those weren’t in place, investors will complete due diligence, and that due diligence will heavily centre on your legal compliance. So, if we can work with the client over their entire life cycle to make sure that they are as legally compliant as possible, that will present the best picture to an investor and allow the actual process of completing that investment to sail through as smooth as possible.

Caroline Smith 23:01
Gillian, what about from your point of view? If a client is looking to lend money, at what point should they seek advice?

Gillian Moir 23:08
As early as possible, really. I suppose the answer is, if you know it’s a case of talking to us, finding out what if they’re looking at secured lending, we can sort of talk them through what a lender’s requirements normally are in terms of the property itself, making sure that the house is in order in terms of obtaining all of the sort of compliance documents that a lender would usually sort of ask to see things like your energy performance certificates, asbestos reports, fire risk assessments, that type of thing, and just making the property as attractive to and to a lender as possible, and hopefully that will make the process more smooth as

Caroline Smith 23:53
well. Yeah, so effectively you’re saying have the conversation almost before you speak to your lenders, get advice, get to understand what might be required.

Gillian Moir 24:03
It, it’s often useful. Absolutely.

Caroline Smith 24:06
So, Alex, in summary, I mean, what, what, what would you say to somebody that was considering investment into their business,

Alex Wilby 24:13
just to come and see us? Really, Caroline, we’re more than happy to meet with people, have a coffee, talk through their options, make any introductions, steer them in the right direction, and just help them get from where they are to where they need to be. Yeah,

Caroline Smith 24:22
it makes sense. Have a conversation. Gillian, what’s your thoughts if somebody was looking for lending?

Gillian Moir 24:29
And just to reiterate what Alex has said, really just come speak to us. We’re more than happy to have a conversation and certainly point you in the right direction.

Caroline Smith 24:36
Yeah, the doors open, the coffee machines are. Yeah, thank you so much. Honestly, what’s come across to me today is your knowledge, as ever. I’m always blown away when I have these conversations. So, thank you for giving up your time, and I look forward to chatting to you again. Thank you.