Cowan Finch: Tips on protecting yourself when investing in a private company

Cowan Finch says demystifying jargon is essential as more New Zealanders start to invest in private companies. Photo/Supplied.

Investor protections are an important part of private equity investing. Investing in a company that fails can hurt. But investing in a company that succeeds as a business, and then fails to generate a return because you weren't adequately protected hurts more. Experienced investors like to see adequate investor protections so they can fully benefit from the companies in their portfolio that do succeed.

Investor protections in private investing are seldom talked about because legal terminology can seem intimidating. Demystifying the jargon is vital as more New Zealanders start to invest in private companies through online private equity marketplaces.

The most common way value of your investment can be eroded is through dilution. Dilution occurs when new shares are issued to other investors and your percentage ownership decreases. Dilution can be a good thing when new investors pay a higher share price than you paid, and you end up owning a smaller slice of a larger pie. However, if new shares are issued at a lower price than you paid, the value of your investment can decrease considerably.

Pre-emptive rights

In New Zealand, pre-emptive rights are the most common form of anti-dilution protection. If new shares are going to be issued, you have the right to invest before new investors to maintain your original ownership percentage in a company. This is like a waiter offering everyone coffee after dessert: you might not want coffee, but if one person gets to order coffee, then everyone should get the choice as well.

Drag-along and tag-along

If a company you have invested in has received an offer to be acquired, there may be some shareholders who wish to accept and some that do not. It's common for companies to allow the majority of shareholders to "drag-along" the minority and force them to sell. Sounds bad, but it's usually a good thing because it prevents small investors unnecessarily holding up the process. On the flip side, if the acquirer wants to just buy out the major shareholders and leave you behind, then you need to be able to "tag-along" with the large shareholders. Drag and tag rights help ensure all investors are treated equally. You can compare this to an agreement with your significant other to leave the party together, regardless if it's you or them that wants to leave.

Governance

One of the most subtle but powerful investor protections is having an independent person on the board of directors. An independent director can ask questions, participate in meetings and help gently guide the company. They should be independent enough to hold the management team accountable, and experienced enough to advise the company if things get tough. This is like having adult supervision at a school ball, the goal isn't to stop the fun, but to make sure people are being responsible so everyone can enjoy the event. Independent directors are particularly important for companies that haven't taken outside investment before.

Voting rights

Voting rights such as the right to elect directors, approve major transactions, and pass shareholders' resolutions is an important investor protection. Some companies offer non-voting shares to investors, so ensure the rights attaching to your shares are otherwise identical to any voting shares (in particular, the economic terms of those shares, such as the right to dividends). This is similar to small parties in parliament who may not have many votes, but can still have a share of voice.

Shareholder reporting

Most private equity offers include a description of what reports you can expect to receive as a shareholder. It's worth looking into the proposed frequency of, and level of detail in these reports. It's also good to know about problems with a company early, in case you (or another investor) can help the company out. For companies, this is like updating your parents on a regular basis so if you ever ask them for money, it's not the first time they've heard from you.

Private equity investing is an exciting new asset class for many Kiwi investors. Online private equity marketplaces have opened up investing to a range of new investors. Most reputable marketplaces have minimum standards of investor protections, but you should always ensure that the investor protections being offered are to your satisfaction. As the FMA's standard disclaimer says: "Ask questions, read all information carefully, and seek independent financial advice before committing yourself to any investment."

Cowan Finch is the head of private capital at Snowball Effect