‘SKIN IN THE GAME’

When you own a business, your savings at risk from failure.  This is known as having “skin in the game”. It implies that you will have a greater motivation for the firm to succeed than if you were an employee because an employee has none of their capital risk.

 

Experience and observations

Equity ownership is a much more complex decision than it appears on the surface.

 

What follows is a brief consideration of how much skin in the game different groups of investors might have. We do not cover all the scenarios that you will face when capital raising, nor all the available sources of capital and what each source of capital might demand from you and the business. We do not discuss here the competing interests that groups of shareholders might have and how to satisfy the often different expectations of each.

 

We can advise you from personal experience and observations and discussions with others about how to go about capital raising.

 

How much skin in the game?

Each employee shareholder should have equity in proportion to the capital they provided.

 

Many employees that want to also be shareholder will argue that they can’t afford to invest any savings, but they should have free or cheap equity because they are an important contributor to the business and or in the case of a startup, its potential success.

 

For example, we know of an boutique investment manager that hired a so call ‘gun marketeer’ who promised that he could win significant funds (because he “knew everyone”). The manager’s investment performance was top quartile and management fees relatively low. Thus, attractive to investors.

 

The marketeer was already being well paid by a bank and to leave, wanted at least the same salary and equity in the boutique business. But his life style didn’t allow him to buy equity at its value and he wasn’t willing to salary sacrifice in exchange for equity.

 

In the end, he was provided with equity at a fraction of its value. Which meant that he had little of his own savings at risk, a big discount to currently equity value.

 

As it came to pass, he hardly wrote any business in the two years he was there and when he was terminated, he received the then current value for his shares (which was much greater than the discount he had paid originally). Great outcome for him, bad outcome for the boutique and the other shareholders.

 

Ordinary shareholders

 

Startups

 

Passive investors (i.e. not going to be involved in the business), will need to understand your vision  and what your forecasts of success looks like. In particular they will want the founders to have significant savings at risk.

 

Then they will want to be protected against equity dilution from new shareholders including employee shareholders.

 

Established companies

 

Capital to expand the business

 

This is an easier sell that if you need capital to keep going (see below).

 

Previous successful execution of business plans make it relatively easy to raise new capital for expansion.

 

On the face of it, this would seen to be a happy circumstance to raise new capital. It won’t be.

 

Passive shareholders

They will want the opportunity to not be diluted, since it was there capital that provided the business start.

Employees

Employees will want to ‘jump on the band wagon’ by having an equity position in a business that has a bright future.

If you did decide to offer equity, it needs to be at a significant premium to previous capital raisings. Otherwise there is going to be a lot of discontent from other earlier shareholders.

 

New Capital to survive

For obvious reasons this is the weakest position to be in to raise capital.

 

It is very likely that you will have to find new investors. The existing shareholders will want to be projected from equity dilution if the new capital is sold at a significant discount to what they paid.

 

Institutional investors and their advisers

Institutional fund managers and their advisers (e.g. Industry funds and asset consultants/research houses) seem to almost universally think that Directors and employees having skin in the game is a good thing, seemly for two reasons.

 

Firstly, because it shows staff commitment to the business (because they have their own savings at risk) and

 

Secondly, business success is linked to good investment performance; an alignment of interests between the fund manager and the institutional client.

 

It is not important that there doesn’t appear to be any research showing a link between superior better investment performance and staff equity. What is important is that, Institutional fund managers and their adviser, think there is. To them, directors and employees having skin in the game is an indicator that there is a better chance of superior investment returns and that makes skin in the game an attraction.

 

Shareholder agreements

 

These are VERY important.

 

Foundation shareholders

It is common for large foundation shareholders to want an individual shareholder agreement as a condition of their equity investment.

 

A typical condition is sometimes know as “come along, go along”. Put simply it means that if you sell your equity, you have to sell my equity at least on the same terms (if they want to). The idea being that if an executive founder sells out, the passive shareholder does not get stranded with an equity position.

 

Be prepared for foundation shareholders to want individual terms and conditions. The tricky part is to make sure these don’t clash with the terms and conditions of other foundation shareholders.

 

Private equity, venture capital investors

 

These guys are professional investors in unlisted companies. It is not going to be easy to pass their due diligence without help from groups like Intrinsic AFSL Solutions.

 

They will demand stringent terms and conditions in their shareholder agreement. For example, should forecast profits not be achieved, then the private equity investor will want a greater role in the operations of the company. This may include increasing their voting power on the board of directors greater than their percentage of equity ownership. For instance, if they are entitled to 1 vote at board level, after failure to achieve the budget forecasts, they will be entitled to more votes (or more) at the board level.

 

Second round agreements

 

The terms and conditions of any second round capital raising will be based on the reasons for new capital being needed.

 

These shareholder agreements will need to take into account the terms and conditions of earlier agreements. This is usually not and easy thing to achieve and if not executed properly may result in litigation later.

 

Conclusion

Raising equity capital is sometimes a very complex process.

 

When you ‘sell’ another person your vision for greater wealth in the future in exchange for their savings, you have to provide realistic scenarios of the firm’s future.

 

There is a balance between foundation shareholders, employee shareholders and second round shareholders that must be considered and discussed before the first capital raising.

 

Foundation equity

Foundation equity positions for directors, executives and employee equity is very important for passive shareholders and for the success or otherwise of the business.

 

Second round equity

Other things being equal, hopefully you will not need to access this source of capital after the initial capital raising.

 

These shareholder agreements will need to take into account the terms and conditions of earlier agreements. This is usually not and easy thing to achieve and if not executed properly may result in litigation later.

 

Conclusion

Raising equity capital is sometimes a very complex process.

 

When you ‘sell’ another person your vision for greater wealth in the future in exchange for their savings, you have to provide realistic scenarios of the firm’s future.

 

There is a balance between foundation shareholders, employee shareholders and second round shareholders that must be considered and discussed before the first capital raising.

 

Foundation equity

Foundation equity positions for directors, executives and employee equity is very important for passive shareholders and for the success or otherwise of the business.

 

Second round equity

Other things being equal, hopefully you will not need to access this source of capital after the initial capital raising.

 

How we can help

Once we understand your personal and business objectives, we can advise you yours and other equity positions, on how to structure equity, and have safeguards to have in place.

 

There are lots of other considerations, such as keeping employees by ‘dangling the carrot’ through options on equity and how to link those to performance and employment contracts.

 

Shareholder votes in the event of a hostile bid for the company.

 

Shareholder protection in the event that a majority shareholder wants to sell their equity, perhaps because they have been taken over.

 

As you can see above, shareholder agreements for equity owned by non-passive investors (e.g. directors and employees) has many facets to consider before finalisation. Getting these right is important for the business and those who take an interest in the business. For example, institutional investors and their advisers, research houses and second round investors will scrutinize these agreements.