Business angels, venture capital and the financing challenge

4
2022
pharmacy

Business angels or angel investors are individuals who make equity investments in businesses. Many are successful entrepreneurs who want to help other entrepreneurs get their business off the ground. The unique thing is that the investment is not a loan but is made for equity (ownership). The business angel bears the risk of the business as the entrepreneur, hence the use of the term “risk-equity” financing to describe such investments.

In Nigeria, business angel investments were relatively popular before the stock market crash that hit the Nigerian Stock Exchange. Most were organised as angel-forums where individuals pooled funds to invest in public traded securities. Since the crunch, a few of such angel-forums have re-organised to focus on other investment platforms, other than the stock market. This could be due to the near absence of business management structures that are credible enough to handle such investments. However, wherever such management structures exist, finding investments has not been too hard a venture.

Venture capital, on the other hand, is a more organised investment made by venture capital firms for equity (about 30 per cent). The major difference between venture capital and angel investment is the degree of organisation and the amount of money involved.Both investments are “risk” and “equity” funding.

Let us say you developed your business from scratch (sweat equity) and, after one year,you have invested approximately N3 million. An angel investor comes in to make further investment for a 30 per cent stake in the firm. The angel investor brings not only money but experience and contacts to bear in the investment and the firm is valued, based on present and future potentials. These other contributions of the investor, such as expertise, contacts and influence should be considered in deciding if you should take the investment.

If need be, your business might still require a large amount to expand to three cities or go national and if the banks are not forthcoming with the money, a venture funding might be a good option with an exit strategy of either a debt exit or sell off at an IPO. Other exit strategies include franchising (used by UAC with the Mr Biggs franchise), trade acquisition, management buy-out and mergers.

Actis, a venture financing firm operating in Africa and Asia, has handled investments in Nigeria that involved projects like The Palms, Ikeja City Mall and Starcomms.It also currently has investments in Diamond Bank and Mouka, the mattress company.

Looking for investment?

Generally, investors are looking for the 3 M’s:

1. Mathematics

2. Market

3. Management

The risk-equity financing proposal should show these three and the exit strategy.

Mathematics

The mathematics of the proposal must be right. Mathematics refers to the returns on investment. It is usually the first thing the investor looks at. How much are the returns and how fast can they be obtained? The ideal venture financing proposal should give, at least, a hundred per cent return in the first two years and a potential of 300 per cent to 600 per cent returns in the third year.

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Market

This is the “how” of the matter.How do you hope to achieve these stunning figures? Note that a venture capitalist is not a novice to the business or he would not consider it. The idea and strategy has to sell sufficiently with him, regardless of the appeal of the mathematics. It should show the market opportunity, which must be wide enough. The ideal opportunity should not be limited to a very short window in time or restricted to a very narrow range of customers. There should be some characteristic unique to the company that is seeking the investment; something known by marketers as the unique selling point.

Management

It takes individuals to grow a business and the reputation of these individuals is the most important thing in evaluating an investment opportunity. In writing a proposal to a venture capitalist, it is usually recommended that the resume of the managers be attached first.

The management’s record of achievement in the resume, the quality of the business plan and the management’s ability to explain the opportunity to an outsider are key indices that give the investor an opinion of the management’s capacity to deliver.An investor will not commit money to a management whose integrity is in doubt, regardless of the enticements of the mathematics.

Structuring the deal

Note that, with the right financial instruments, a risk equity financing decision could be made to act as a loan. Typically, most business angels invest for ordinary shares.

The simplest of all financial instruments is the loan. A loan does not command an ownership structure and VCs (venture capitalists) will leave this arena for the banks.

Next are the ordinary shares. They command rights of ownership and are permanent. Ordinary shares live as long as the business does.They can be increased but not decreased.Most business angels would ask for ordinary shares, as they are not complicated.When more funding is required, more ordinary shares could be added, thereby diluting the voting power of existing shareholders.An investor could ask for an “anti-dilution” clause in the article of association, to prevent this from happening. Hence, the need for future financing should be considered in the deal structure and the terms spelt out.

Next are the preferred ordinary shares also known as preferred shares,which are generally preferred by institutional investors – venture capital firms–as they are entitled to a slice of the distributable profits before ordinary shares. They are “preferred” in the ranking of entitlements to dividend. Voting rights may or may not be the same, depending on what the article of association says.

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Nature of preferred ordinary shares

1.  They often do not have voting rights: this is to ensure management control, as the main use of preferred shares is to get finance without reducing management control or ownership.

2.  They could earn fixed interest over time: these are called participating preferred ordinary shares (PPO), also known as participating ordinary. They get a fixed percentage of the distributable profit, for instance, a 5 per cent PPO of the distributable profits. This gives the investor some fixed returns, regardless of how the business fares, as long as there are profits.

3.  The dividend could be cumulative; so we can have cumulative participating preferred ordinaries (CPPO). This implies that a dividend not paid for a particular financial season will be paid in the next once the money is available.

4.  Preferred shares could be callable or redeemable.Redeemable shares are a bit like loans but unlike loans there are no guarantees. These redeemable preferred shares have a predetermined value (par value) at which the issuing company (venture financed firm) can call them back. For instance, a million unit of shares at N5 each could be given at a  par value of N8 (60 per cent ROI profit) on or before one year of investment.  This implies that the company can pay out this investment even before the maturity date.

Since the number of units of a company share cannot be reduced, redeemable shares are redeemed either from distributable reserves or from a fresh issue of shares.

Redeemable shares have the advantage that they motivate the entrepreneur to perform and pay back quickly for greater ownership, while increasing the speed of returns for the investor.

Let us assume you have found an investor and he likes your M’s. The next challenge is how to structure the deal. It is always bestto have a good idea of what your business is worth and the degree of ownership you are willing to share. The best bet for really big investments is to use a mixture of ordinary and preferred shares, or to use preferred shares alone. The various characteristics of preferred shares allow both parties to agree on expectations.

You will however need to be flexible in the valuation, as it is quite unlikely that your valuation of your business and that of the venture capitalist will be the same. Valuation is not a precise science; it is only normal that two parties will see the same things differently.

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Also take into consideration the fact that you may need additional funding, as the investor may not want his shares diluted by an additional round of financing. This may require you to leave a “headroom” for this additional financing.

Ideally, investors would want to own about 30 to 40 per cent of the business, as they do not want to become full owners of the business. The use of preferred shares by venture funds allows them to provide the required amount of cash without owning the business outright. The use of preferred shares could allow an investor to contribute about 70per cent of the required sum and maintain about 30per cent ownership.

It is my own opinion that business angels, business angel networks and  venture firms do have a lot to contribute to the development of the Nigerian economy and the pharmaceutical industry in particular.

Provided the mathematics, market and management are right, risk-equity financing could be of help in scenarios  where loan is not available or is  deemed too risky. Research driven ventures have benefited immensely from risk equity financing.   Giants like facebook, Microsoft, Apple Computers, Research in Motion and Google are testimonies to the value of risk-equity financing.

In Nigeria, the following are important considerations:

1.  Entrepreneurs must learn how to pitch right.

2.  A thorough business plan is essential.

3.  Sweat equity should be present;  that is, the money and efforts of management.

4.  The plan should have an exit strategy for the investor.

5.  Real estate, telecommunication, Dot coms, pharmaceutical research, Nollywood, hospitality and consumer goods industries are potential ventures friendly industries.

6.  Venture equity entails a seat on the board of directors and the legal agreements would stipulate the degree of influence.

7.  Companies looking for venture money should have a corporate structure and appreciate its value.

8.  Entrepreneurs must also demonstrate why they can be trusted (not because they said so) but by providing strategies within the plan that assure the angel or venture firm of their investment.

9.  Most entrepreneurs do not want to share equity; you may have to resolve this bias first.

10.       The fear of manipulation by venture firms or angels is real; thus the need to find the right firm.

11.       A consultancy firm could go a long way in providing useful advice.

Risk equity financing will play a big role in the days to come, however, we muststart with proper education on how

things work. Regardless of the immense

challenges in the Nigerian business system, there are lots of untapped potentialities that risk equity financing offers.

We must prepare to harness these

potentialities.

 

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