Understanding capital investment

Capital investment is an alternative way of financing for the entrepreneur faced with the constraints and limitations of traditional sources.

At all critical stages in the life of a company, Capital investment offers it the means to achieve its ambitions by providing capital and strategic support.

Presentation of Capital investment

Definition and role of Capital investment

Definition of Capital investment

Capital investment is a very old form of investment by which an investor devotes part of his investment or capital under management to the development or takeover of a company (or a division) with growth, transmission or of recovery.

In return for his investment risk and the immobilization of his capital over a long period (opportunity cost), he expects a return on the capital invested, generally higher than that of the market for listed shares, taking into account the non-liquidity of his investment for sometimes several years.

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He does not just invest but generally supports the company in the portfolio with practical advice enabling it to accelerate its development and optimize its management.

capital investment results in an injection of funds into a company and the entry of the investment fund into the capital of companies that need equity capital. In some cases, there is no capital injection but redemption of the shares held by the historical shareholders.

It also happens that the investment is made in the form of convertible bonds and derivative products (options, new share subscription warrants in particular).

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The term capital investment generally relates to investing in unlisted companies (hence its name unlisted capital or capital investment in English as opposed to the term public). In French, this corresponds to the notions of closed capital as opposed to open capital.

Role and contribution of capital investment

For the company, capital investment is both a source of financing and a managerial support tool:

• A source of financing: a company confronted with the constraints and limits of traditional sources of financing (namely equity, bank financing, and the public call for savings) can solve its problems in capital thanks to Capital Investment, an actor essential in the business financing chain;
• A managerial support tool: in addition to responding to real financing needs, capital investment is a tremendous lever for improvement for the company. The intervention of the capital investor alongside the management teams results in a real transfer of know-how.

The company thus benefits from complementary skills for its long-term strategic management coupled with financial expertise. In addition, the capital investment activity:

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• Contributes to the creation of value for the managers, employees and shareholders of the company but also for the national economy;
• Accelerates business creation as well as the development and promotion of innovation and new technologies;
• Creates wealth and jobs while renewing the economic fabric.

The main players in a capital investment transaction

Capital investors are mainly insurance companies, pension funds, banks, large industrial groups and international development organizations that hold and manage long-term resources with the aim of making them grow.

Management companies are the intermediaries between investors and entrepreneurs. They prospect the target companies, study their projects and invest in them, through a fund, the capital entrusted to them by the investors.

Management companies have teams with high levels of skill and expertise to carry out in-depth preliminary studies before investing in the targeted companies.

Entrepreneurs are business leaders looking for equity or quasi-equity funds to ensure the start-up, growth or recapitalization of their business.

Buyers are the new entrants after capital investors exit. They may be industrialists, managers of the company, the financial market in the event of an IPO or even one or more other investment funds.

Type of capital investment

capital investment comes in several forms related to the development phase of the invested company:

• Seed capital
• Capital risk
• Development Capital
• Capital Transmission
• Turnaround Capital

Seed capital

Seed Capital investors bring capital as well as their networks and experience to entrepreneurial projects that are still at the Research & Development stage.

Example: Netpeas, a company specializing in new technologies and more specifically, in internet security.

Capital risk

Investors provide equity or quasi-equity financing in companies being created or in the start-up phase of the activity. Depending on the maturity of the project to be financed, Venture Capital is subdivided as follows:

• The Creation finances the start-up of the company’s activity
• Post-Creation occurs when the company has already completed the development of a product and needs capital to start production and marketing.

Examples: Tecmom, packaging manufacturing company and Sefcam, production of basic sheet metal parts and surface treatment for the aeronautics industry.

Development capital

Investors provide equity or quasi-equity financing, generally minority, intended to finance the development of a company or the buyout of shareholder positions. At this stage, the partner company is generally a mature company that has reached its break-even point and has significant growth prospects.

This operation aims to support the manager in financing the organic and external growth of the company with the objective of creating value and liquidity in the medium term.

Examples: Aixor, HPS, Webhelp, Labinal, Valyans, and others.

Transmission capital

Capital Transmission operations consist of acquiring the majority of the capital of a mature company through a combination of capital and bank financing (structured debt). The best-known operations are those with leverage or LBO (Leveraged Buy-Out).

They allow a manager associated with a capital investment fund to pass on his business or, more generally, to prepare his succession by selling his business in several stages.

Examples: Mobilia, distribution chain of interior furniture and Univers Motors, distributor of motor vehicles.

Turnaround capital

Investors provide equity financing to struggling companies. Thanks to this method of financing, the investor gives managers the opportunity and the means to put in place recovery measures for the activity allowing a return to profits.

Example: North Central Dairy Company, industrial production of dairy products.

The stages of capital investment financing

The preparation phase

Preparation of the business plan

The business plan (or business plan) is the document that summarizes the presentation of the company, its financial prospects and the investment proposal. It is prepared by the contractor, if necessary with the help of his adviser.

Typically, it deals with the following points:

• Products and services offered – originality/competitive advantage,
• Market dynamics and competitive positioning,
• Organization (human resources, logistics, sales; legal structure, etc.),
• Financial data and projections (income statement, balance sheet, cash flows),
• Proposed transaction (amount, legal form, etc.).

The business plan is necessarily a compromise, which must avoid certain pitfalls: both concise (which may have recourse to appendices to deal in more detail with certain technical points deemed important) and precise, it must sell without disguising reality or deny the difficulties.

Erroneous information, overly optimistic assertions such as the non-disclosure of important facts will lead to the immediate closure of the file by investors, who will retain a very negative image of the entrepreneur.

The section devoted to financial data and projections should not simply include tables with figures, but should provide comments on the key figures and present the main assumptions underlying the forecasts.

A significant part of the business plan should be devoted to management. Indeed, the success of a project is largely based on human capital. The experience of the team, its background and the value it brings to the project are key elements for investors.

The objectives of the leaders must be expressed, in order to ensure an alignment of interests with the investors.

Selection of cases by venture capitalists

• Deal flow processing

Venture capitalists each typically receive several hundred investment proposals per year. This deal-flow (or business flow) will give rise to some investments and reinvestments in companies already present in their equity portfolio.

This results in strong selectivity, which requires rapid sorting in order to concentrate the resources of the management team on the opportunities deemed the best and presenting a high probability of success.

• Selection criteria

Venture capitalists generally have an investment strategy that defines their scope of intervention.

Some criteria are directly related to the functioning of the investor:

• The maturity of the project: priming (seed), project in the launch phase (early stage) or development (later stage),
• The intervention capacity (100K Eur, 1M Eur, 10M Eur…),
• Sectoral strategy (biotechnology, ICT (information and communication technology), industry, new energies, etc.),
• The desired exit horizon,
• expected profitability. They can also be dictated by the regulatory constraints of the fund which influence:
  • The size of the target company (turnover, number of employees, level of equity, etc.),
  • The geographical area of investment
  • Certain sector exclusions

Each investor thus has a policy and investment capacities that condition his interest and his ability to finance a project. Also, it will be up to each project leader to identify the most suitable investor(s) to optimize their chances of being selected.

• Suitability of the project with venture capital financing

In the same way, the importance of the adequacy of the project for financing of the risk capital type will be underlined. Indeed, investors will seek value creation potential capable of remunerating the risk associated with their investment in a young company.

For their part, candidate companies will seek financing to build or accelerate their growth, which debt cannot provide.

From the first exchanges to the first meetings

• Intermediation by a fundraiser

Contact between the company and the investor is more and more often mediated by advisers (advisory banks, mergers and acquisitions « shops », fundraising specialists, etc.) mandated by the company for the assist in its fundraising. The use of a fundraiser can facilitate relevant contact between the promoters of a project and the appropriate venture capitalists.

• Exchange of documents and confidentiality

An initial selection can be made on the basis of an « executive summary », a 1 to 2-page summary of the business plan, which makes it possible to verify a priori the interest in principle of the investor, according to the main characteristics of the company and the operation envisaged (sector, maturity, location, amount sought, etc.).

This first document is frequently sent to the investor accompanied by a confidentiality agreement to be signed by the investor so that he can have access to a more complete information memorandum and protect the information on the business plan.

• How to get the most out of presentation meetings

The first meeting is an opportunity for the management team to introduce themselves, and to present the company and the project with which they wish to associate the investor. This presentation provides the common thread and includes the main elements of the business plan.

In the favorable case, other meetings will be organized which will allow the investor to familiarize himself with the company (at least one site visit is highly recommended) and with the members of the management team, to progress in his instruction in order to convince oneself of the advisability of an investment.

At the end of this first phase, if a common interest in continuing the project has been confirmed, we can move on to drawing up a financial proposal.

• Development of a funding proposal:

All these meetings will allow the fund manager to develop a specific financing proposal that will be presented to the company.

Negotiation stage

Before developing a financing proposal, the investor must assess the company in question and identify its true value. This is a crucial point to negotiate.

Valuation

Valuation methods are numerous, often weighted against each other, and they evolve with economic trends and phenomena.

The valuation used to value the shares of the company acquired by the investor will result from a compromise between the company and that of the investor.

If investors use various methods – multiples, discounted cash flows, asset valuation or the internal rate of return method

the price of the shares, in fine, will take into account objective parameters specific to the project (majority or minority shareholder, preferential rights of shareholders and others) but also subjective parameters (value of the company’s know-how, barriers to entry , market growth, company market share and others).

This price will be set after negotiations that are often delicate and likely to lead to the first differences between the parties. Discussing in a transparent and constructive manner, bearing in mind that capital investment is a partnership in which the interests of the parties coincide, is a necessity.

• Price adjustment mechanisms:

During negotiations, it may happen that the valuation proposed by the investor is too far from that resulting from the business plan. In this specific case, a collaboration can still be considered but under certain conditions.

The investor can then propose mechanisms for adjusting the price of his entry into the capital of the company which will allow him to subsequently correct his position in the capital in order to reduce the risk linked to an overvaluation of the shares of your company.

There are a multitude of adjustment clauses, whether for the benefit of the investor or the seller. There are also clauses of distribution of the price between the shareholders at the exit of the investment.

One of the most frequent clauses in favor of the investor is the ratchet clause, which makes the allocation of additional capital shares subject to the latter in the event of non-compliance with certain objectives previously set jointly.

The letter of intent

The letter of intent is a letter formalizing the investment proposal. It is sent by the investor to the company in which he proposes to invest.

This summary document highlights the main economic and legal terms and conditions of the proposal. It is a question of translating the perception of the investor and his knowledge of the company and its project, such as it was able to build during the first contacts between the managers and the investors and in view of the documents presented by the company (information memorandum, business plan).

The letter of intent can be more or less summary or detailed. In all cases, its purpose is to verify the existence of a common understanding of the bases of an agreement between the parties, before entering the phase of carrying out the operation.

A distinction can be made between letters of intent, containing in sufficiently precise terms an investment proposal remaining subject to conditions, and simple letters of interest which simply express an investor’s desire to continue discussions.

For entrepreneurs who have succeeded in arousing the interest of several investors, the letter of intent received from each of them will make it possible to compare the terms of the proposals and therefore to make a choice. It is an element of competition between investors. If necessary, it makes it possible to group around a lead investor the other investors who will complete the round table.

The selected letter of intent is countersigned by the company and, where applicable, by its main shareholders. If it has not been approved within the stipulated time, it lapses. Normally, the letter of intent does not have the value of a commitment by the parties for the final realization of the investment:

– It remains an expression of interest and the intention to continue negotiations with a view to finding a final agreement. It specifies the conditions that must be met in order to achieve the investment.

– It provides a secure framework for pre-contractual relations, specifying, where applicable, the conditions of exclusivity and confidentiality, the sharing of costs as well as the choice of applicable law and competent jurisdiction. French law simply recognizes that the parties having signed such a letter of intent have the obligation to negotiate in good faith in order to make the investment.

• Content of the letter of intent:

In the field of venture capital, where sometimes complex financial engineering has developed, the letter of intent must clearly present the proposed mechanisms (price adjustment, anti-dilution, preferential rights, etc.).

As this is an investment that will bring investors into the capital of the company, alongside the founders and existing shareholders, the letter should provide guidance on the governance of the company. Capital investors participate in the life of the company, but they are not intended to ensure its management, which remains the domain of the managers.

However, it is necessary to define how the management bodies will be composed, how strategic decisions will be made, and what information will be transmitted to investors. The letter of intent serves as a guide for the negotiation phase and the preparation of the final legal documentation.

This is where its more or less detailed nature is important: more complete, it takes longer to develop but makes it easier to move forward towards implementation; shorter, it can be issued more quickly but it necessarily leaves areas of uncertainty which must be clarified during the drafting

Signing the letter of intent allows you to move on to the next step. It sets the steps to be taken and their timetable: audits, prior authorizations, etc. A period of 4 to 8 weeks is usually necessary to go from the signing of the letter of intent to the completion of the investment.

• Syndication:

In some cases, the letter of intent is signed by one or more investors providing all of the amounts sought. But in other cases, it is on the basis of the letter signed by a first investor that we will seek investors to complete the round of funding up to the desired amount.

The fact of having defined the basic terms and conditions with a « lead investor » allows the investment to be syndicated with other investors, who will adhere to the letter of intent, if necessary by specifying certain terms. These new investors must receive the approval of the company and the other signatories of the letter of intent.

Once the desired minimum amount is reached, thanks to the contributions of existing and new shareholders, we can move on to the realization phase.

Due diligence work

After the first phase of discussion and the signing of the letter of intent, we enter a phase of in-depth due diligence, during which more in-depth investigations will be carried out on certain information presented in the first phase.

Traditionally, investors have reviews of the financial and legal situation of the company carried out by specialized auditors. Depending on the type of activity, it will also be necessary:

Analyze intellectual property rights, main contracts with customers and/or suppliers, stock status, etc.

Validating the skills and reputation of management, in particular by taking references from people who have worked with managers in their previous positions, is a necessary and important exercise.

Finally, in all cases, it will be necessary to check the capitalization table, that is to say the securities making up the capital and the rights of access to this capital.

In all these areas, it is not only a question of assessing the real situation of the company as closely as possible, but also of assessing the quality of the information provided and the transparency of the managers.

It may happen that the company does not yet have auditors (in the case of SARLs or SAS whose size is below certain thresholds). The entry of venture capitalists into the share capital will almost always be an opportunity to appoint an auditor, whose contribution in terms of shareholder security is essential. Audit results are usually shared and discussed with management.

The areas of weakness identified may sometimes be the subject of adjustments or action plans, to be carried out before or after the closing.

The most important point is that this situation is compatible with the objectives of the business plan.

The situation of the company and its possible subsidiaries will usually be the subject of declarations and guarantees for the benefit of new investors. Audits cannot replace these statements prepared by directors and founders, but their results will help clarify the statements to be made about the company.

Conditions precedent to the conclusion of the capital investment transaction

The letter of intent indicates the conditions that must be met before closing the transaction. The following conditions are often found:

– The signature by all the shareholders of the company and by the investors of the necessary legal documentation. (Shareholders’ agreement, definition of the rights attached to the shares or other securities subscribed, guarantees),

– The performance of audits, the conclusions of which must be satisfactory to the investors, in some cases the decision-making body of the investors will still have to give its final agreement on the realization of the investment.

– During the period between the signing of the letter of intent and the completion of the investment (closing), adverse events may occur that directly or indirectly affect the company in a substantial way. The adverse material change or MAC clauses indicate that in this case the investors will not be obliged to make the investment. This type of clause is consistent in the context of a letter of intent which, as we have seen, is not legally binding.

– To carry out any verification of the beneficial owner of the investment and generally of all the stakeholders (i.e. the company, the shareholders, natural and legal persons, the managers and, where applicable, the persons on whose behalf they act) in the context of the fight against money laundering and the financing of terrorism;

– Ensure the prevention and management of any potential conflict of interest between the management team and investors.

Signature of legal documents and closing

The legal advisors of the investor and the company share the work of drafting legal documents.

Often, the investors’ lawyer takes the pen for the part describing the terms and conditions of the investment (shareholders’ agreement, definition of the rights attached to the shares or other securities subscribed, guarantees), while the board of the company prepares the assemblies having to approve the operation.

Draft deeds are exchanged and finalized by lawyers and their clients. The technicality of the arrangements and the desired speed require lawyers accustomed to this type of operation.

It is also necessary to mobilize the auditor, who will have to prepare certain reports, and in certain cases special commissioners, appointed by the president of the commercial court, and who will have to write reports on the “special advantages” granted to new investors.

It is of primary importance that the shareholders of the company, who will have to approve the entry of new investors, have clear and precise information on the terms of the operation. Unanimity is sought to express everyone’s support for the new structure.

When the documents are ready, the old and new shareholders meet to vote on the resolutions of the general meeting, sign the contracts and proceed to the subscription of the capital securities. Funds are usually released the same day or in the following days.

The Closing is then carried out and the company can dispose of the funds raised. Following the fundraising, the investors become partners/shareholders of the company. As such, they participate in the general meetings of the company, and have the rights provided for by the articles of association and the agreement.

The collaboration ends when the investors leave, by partial resale (sale of the investors’ shares/shares) or total resale of the company (in the event of industrial transfer, the sale must generally be total, which obliges you to sell your units/shares).

The exit of the investor

The discussion on the terms and conditions of exit begins from the first contacts made with the investor. The interests, sometimes divergent between parties, make this preliminary discussion essential in order to find the right balance between, on the one hand, the profitability requirements of your investor and, on the other hand, the consideration of your strategic objectives.

The anticipation of the exit conditions leads the investor and the entrepreneur to decide on the following elements:

• The calendar
• The precise terms
• The search for buyers

In the shareholder agreement, the exit conditions are the subject of an “exit clause” which governs this precise moment of the phase of collaboration with the investor through, in particular, the prioritization of exit possibilities.

– The release schedule

The development of a timetable in consultation with the investor makes it possible to formalize, in the shareholders’ agreement, the date from which the exit efforts will be undertaken, which will relate to the valuation of the company, the exit procedures and the search for potential buyers.

– Exit conditions

The exit options discussed prior to the signing of the shareholders’ agreement are four in number:

• Initial Public Offering
• Transfer of the entire capital of the company to a third party
• Transfer of the participation of the financial partner to another financial investor.
• Redemption by the entrepreneur of the participation of his financial partner

– The search for buyers

This step is reflected in the shareholders’ agreement by a « best efforts » clause which specifies the date set for initiating the exit process. At this term, consultations with the investor are increasing to assess whether the exit criteria defined upstream have been met.

• The different output possibilities:

– Initial Public Offering

This mode of exit is often considered the royal road for various reasons:

Assurance of the liquidity of the shares for the shareholders  Reinforcement of the company’s equity as part of a capital increase operation associated with the introduction

Opening of the company’s capital to employees

Public recognition of the quality of management and the growth potential of the company

– Sale of the entire capital of the company

The sale of all the capital responds to a desire to maximize the value of the interests of the entrepreneur and the financial partner. This operation is carried out either with an industrialist or with another financial investor. This type of exit involves the participation of the company’s managers and, sometimes, the use of external skills to provide advice and management of the company by the new buyer.

– Transfer of the participation of the financial partner to another financial investor

This option allows the entrepreneur to maintain his share in the capital while renewing his experience of Capital Investment with another financial partner.

– Redemption by the entrepreneur of the participation of his financial partner

The purchase of the partner’s participation offers the entrepreneur the possibility of strengthening his participation in the capital of the company. Other investors may participate in this takeover operation by relying on legal and financial arrangements allowing them to resort to debt.

Conclusion

Business development: this is a subject at the heart of our concerns.

capital investment attracts institutional and private investors globally. In its simplest form, it refers to the purchase of stakes in unlisted companies. The capital raised by the company is then used to qualify its expansion through organic growth or acquisition.

Instead of investing directly in companies, institutions prefer to use structured funds that call on management specialists and make it possible to optimize the use of capital and diversify risks.