Investment: The Challenges of Managing Investor Syndication as Part Of Scale-Up Deals

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This past year was not easy for investors. With inflation in the United Kingdom came raises in interest rates and investors were clutching at capital as insurance for the needs of their existing investments. In effect, investors witnessed the strain of the economic situation on businesses, which undoubtedly played a contributing factor to the re-shaping of investors’ risk tolerance.

All things considered, the economy in the country carries on reacting and adapting to what has taken place in view of the geopolitical and macroeconomic challenges, profoundly influencing the financial decisions and tactics of investors.

Investment Activity

For the most part, London leads the investing landscape. However, uncertainty due to the upcoming general election has weathered the confidence of VCs that a recovery is looming. Figures provided by KPMG show that investors remain cautious as a total of only $4.8bn (circa £3.78bn) was invested into businesses in the United Kingdom during the last quarter in 2023 (with 454 deals completed in that period). VC deal value and volumes fell significantly from the previous quarter from $6.1bn (circa £4.81bn), with 630 deals completed.[1] It is important to keep in mind that later-stage VC was the most typical deal type in 2023, comprising of 40% of all deals completed and 46% of total funds invested last year.[2] To compare, in 2022 later-stage VC accounted for 34% of deals completed and 40% of funds invested.[3] This shows that companies with a proven track record were more appealing to investors in 2023 in contrast with early-stage ones.[4]

It appears that VC is moving from a “growth at all costs” approach to directing their focus on innovative companies with sound unit economics.[5] In other words, “this new focus on strong gross margins and effective customer acquisition strategies underscores a balanced approach in risk management and value creation, favouring sustainable growth and financial stability over rapid cash burn and scale.”[6] As such, companies which are keen to raise capital will need to make certain they have solid business models and management teams to be investment worthy.

Scale-Up

The United Kingdom is an incubator for start-ups. More people in the country take part in start-ups than any other substantial European economy.[7] But although the United Kingdom is successful at rearing start-ups, it is less fruitful at scaling them to be highly productive/sizeable companies.[8] Otherwise said, the transition from start-up to scale-up has proven to be a challenge for many founders in the country, which in turn limits overall economic success (especially if start-ups fail to grow or relocate if successful). In the United Kingdom, only 1% of SMEs are deemed “scale-ups” - this percentage contributing however to over 1/5 of total SME turnover (amounting to £497bn).[9] For that reason, a slowdown in deal volume and value amongst investors could lead to significant economic consequences.

Companies Looking to Grow – “Syndicated Investing”

Companies seek capital for their growth initiatives, aiming to scale their operations and enter emerging markets. Nonetheless, accessing debt can be difficult on the one hand, while other scale-up financing would constitute equity finance - which not only injects capital, but brings expertise, connections in the industry, and support for growth to the company. This is through, perhaps, multiple investors facilitating access. For this reason, investor syndication appears to be a means of providing some ease when navigating the economic obstacles in the wake of 2023.

It has become apparent, throughout the years, that a cooperative investment approach could result in more profitability in general. As such, syndicated investment is a means of pooling resources, expertise, etc together. Syndication allows access to broader expertise and knowledge, as each member of the syndicate has the ability to bring their own skills and experiences to the table. In effect, syndication is about unity.

More specifically, syndication allows individuals to spread their capital across multiple investments, and therefore mitigating the impact of any losses through diversification (i.e., the failure of one being offset). This could prove particularly welcoming in times of financial unpredictability. What is more, syndication can result in a boost in deal flow for investors through wider investment opportunities (and to potentially more profitable ones), which may not be feasible for individual investors (i.e., otherwise inaccessible as a result of individual investors having limited resources to gauge deals on their own).

All things considered, syndicated investment offers portfolio diversification, greater access to knowledge and increased deal flow, principally presenting opportunities to amplify the chances of success and empowering investors to circumnavigate investment opportunities and economic obstacles more successfully.

Challenges of Syndicated Investing

In order to be efficient, syndicated investors are well advised to appoint a “lead investor” who will negotiate and raise funds (especially where the interests of investors may not be aligned). Each individual investor in the syndicate may also want certain rights, resulting in the board of directors not functioning as it should (especially if the list of reserved matters becomes too lengthy). Companies should therefore keep the list of reserved matters to a minimum. Rather, for example, the syndicate should have the right to appoint a sole director. But syndicates will generally invest through a nominee entity or special purpose vehicle, which should have its own rules and agreements between the investors.

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Deal Terms and Negotiating

It is usually the case that trends in the terms of a deal are dependent on the maturity of the company and the investors’ dispositions (which will need to be negotiated by the “lead investor”). In addition to this, the terms of a deal will mirror the economic climate.

At present, the market is leaning to term sheets becoming increasingly less company-friendly, and consequently more investor-friendly. This also means that executing term sheets, and deals more generally, are taking more time. Negotiations have also become more complicated, especially around the protections given to investors. This is particularly the case if the deal relates to down or rescue rounds where those who are investing in the company are no longer keen to put their capital on the line and are basically giving a timescale for the company to achieve an exit.

Some of the protections given to investors at the moment include, for example:

  • full anti-dilution ratchets;
  • greater participating liquidation preferences (with a higher multiple also being used);
  • by only taking a preferred class of share;
  • swamping rights in the company’s articles of association allowing enhanced voting rights for investors in certain default situations; and
  • an increase in down and rescue rounds (i.e., less tranching occurring).

On the whole, this means that investors are treading much more cautiously - making sure that they are protected in the current market. As such, there is a real possibility for novel investing approaches, from a term sheet perspective, to be taken by investors and more generally by syndicates.

Completion

As discussed above, deals are taking longer to complete because more time is being spent on the term sheet/negotiations stage. In its simplicity, this may reflect the new standard of the deal process, as deals are becoming more complex in structure, with greater due diligence being done beforehand. So, investors are spending more time considering the potential benefits of making the investment (i.e., due diligence to conclude whether to invest or not). It is also possible that as a result of the present economic challenges there is a greater deal abort rate.

Government Involvement and Support

On the whole, the government would like to accelerate the growth of innovation outside of London. As such, through the “Innovation Accelerators” programme, the government plans to invest £100m into 26 R&D projects in Glasgow City Region, Greater Manchester and West Midlands.[10] The government is also aiming to raise investment in R&D to 2.4% of UK GDP by 2027.[11]

Modifications have also been made to make simpler the process of granting share options under the Enterprise Management Incentives (“EMI”) scheme, in addition to increasing the reach of the Company Share Option Plan (“CSOP”). It is hoped that this will enable companies that have outgrown the schemes to better incentivise employees on the whole. Further, the Seed Enterprise Investment Scheme (“SEIS”) has been broadened, also increasing its funding limits. This will hopefully foster further investment and support the scaling of companies at the early stage.

It is also the case that the government is on a “scaleup policy sprint” to grow the number of domestic unicorns.[12] The government wants the United Kingdom to become a driving force for scale-ups (particularly in relation to the science and technology sectors). In this way, the government aims “to match the US levels of VC investment as a share of GDP by 2030.”[13] Furthermore, Michelle Donelan (the Secretary of State for Science, Innovation and Technology) announced a new scale-up forum in January of this year.[14] The forum will also provide a scale-up support service, with directed government support, for up to 20 science and technology businesses seeking to scale-up with the intention of helping them overcome barriers to their high-growth ambitions.[15]

Conclusion

As the United Kingdom adapts to the present economic conditions, new trends are seen to emerge. Undoubtably, some of them will shape how investments will be made in 2024 and the general investor-investee relationship. Nevertheless, and as discussed above, investors may want or need co-investors, by means of a syndicated investment route, in order to leverage their investments.

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