No one needs me to add to the chorus that it is significantly more difficult to obtain funding for start-up companies. I fall into the camp that the late 90's was an aberration, and is unlikely to be revisited in the near future.
However, this is probably a good thing. There do not appear to be many pundits at this time professing that the technology stocks were properly valued. In fact, there are many experts who claim that the technology sector specifically, and NASDAQ and the S&P are still overvalued. Historically, the companies listed on the exchanges have traded at 14 to 15 times earnings. The exchanges are still trading at close to 20x earnings.
What this means for a start-up company is a return to fundamentals. The recent halcyon days of floating a business plan and attracting dollars are gone. Rather, for start-up companies to attract capital, then must offer something of value to their investors. That value can be something tangible. An invention, a product, a service-something that has or is poised to develop revenues. Proven management is another thing that a start-up can offer to prospective investors (if that in fact is the case).
The reason why having something or someone to offer to prospective investors is meaningful is it opens the door to the first round of financing. If the start-up has a product or service, then it has something that can be tested. There is no substitute for the market testing the product or service. Moreover, the market may even offer something in return. Revenues!
However, many start-ups require additional capital to get its product or services in a condition where it can be tested. In that case, the start-up must offer something else to the prospective investors. That often will be the management and founders of the new venture. I seasoned management team may be attractive to prospective investors for several reasons. First, an experienced executive may have prior experience in raising funds, and they may have the personal contacts to sources of capital. If that is not the case, then don't underestimate the importance of friends and family. It will likely always be easier to convince family and close friends that you have a great idea and the next big thing than it will be to convince any outside investor.
Close associates will also be more ready to address the other big concern when raising money, and that is control. The founders of a company need to go through some sort of valuation of their company in order to attract capital. They can look to other similarly situated companies, but this information is typically not available for privately held companies and public companies likely do not really provide a meaningful comparison. The reason why is the valuation of companies historically is so closely tied to revenues and profitability that a start-up cannot be closely analogized-revenues may not yet exist and the start-up may need the investment to have a product or services that can generate the revenues necessary for a meaningful valuation. Friends and family may be more willing to invest small amounts of money to help the start-up get into a position where it can attract meaningful dollars.
Getting back to control. There is an inherent tension between how much the founders keep versus how much of the company they sell to the investors. This is arms-length negotiations in its truest sense. If the initial $500,000 of investment is what it takes to get the product or service in a condition that the start-up can begin generating revenues or otherwise put itself in a position to attract additional funding, then the percentage of the company that is surrendered should not dictate the deal. My advice is get the money in today's environment. There has to be a fundamental belief that a bigger pie is in everyone's interest and that is how success will be defined.
Most of the venture capital transactions that I have done the past few years have been investments in preferred stock. This is in marked contrast to the some of the earlier transaction in my career where the investors were accepting common stock or a convertible instrument. I'm not sure why this is.
- Debentures. I think that you will see a return to convertible instruments as a favorable way of making investments in early stage companies. A convertible debenture is probably the most common form of a convertible instrument. A debenture is really just a fancy name for a note.
- Advantages. There are often advantages to using a convertible debenture. These include the following:
- A convertible debenture allows an investor to make less than a full commitment to the company. The debenture can convert to on several events and conditions. The debenture holder may have absolute discretion whether to convert the debenture to equity or to require that it be repaid. Alternatively, the debenture can automatically convert upon the corporation raising an equity investment in a threshold amount by a date certain or achieving certain revenue levels.
- Investors can use debentures to provide bridge financing that allows them to obtain equity on more favorable terms. For example, the debenture may convert to equity on a discount-the purchasers of stock may have to pay $1.00 for their shares but the debenture holders may be able to convert they instrument at $.90 a share. Alternatively, the debenture holders may convert at the same purchase price, but they get options to buy additional shares at a later date. You can get creative here.
- Since a debenture is a promissory not at heart, the company may be able to treat the debenture as a note for tax and accounting purposes.
- If structure as a note, then interest may be deductible, which will reduce the company's tax liability. However, in a start-up company, there may not be the revenues to offset the deduction, in which case they will have to stockpiled as NOLs.
- Tax tests/consequences
- Can give as many note like features as you'd like
- Interest payments. If the company and the investor want the debenture to be treated as debt, then the debenture should provide for interest and make some provision for paying the interest. The interest rate should be at least AFR to avoid imputed interest if the debt holder also taking equity. Payments don't have to be cash-can also use PIKs
- Default Provisions/Remedies. Another important feature to distinguish the debenture from equity is to provide proper remedies in the event of a default. An increase in the interest rate in proper, as are late fees. However, you can get creative-the conversion rate can change or control of the board can be surrendered.
- Security. To the extent that the start-up company has assets, then they can be used to secure to repayment of the debenture. This is more appropriate where the investor really wants to reflect on whether to convert the debenture or require repayment. This may also be a really bitter pill for the founders to accept. If they have a proprietary process, then a secured creditor can foreclose against the collateral and strip the company of the sweat equity that the founders have contributed. However, if the asset is truly proprietary, the investor may not know what to do with it. Often the intrinsic value of the assets is too closely associated with the founder/developer. It is very hard to perfect a security interest in know-howl
- Getting a lien in assets is problematic if there is existing bank debt because the bank's covenants likely prohibit junior liens.
- A start-up company, however, may not be sufficient mature to be able to get bank financing, but a security interest may effectively prevent the company from obtaining financing.
- I don't want to suggest that a secured debenture is the norm. However, if used, the company should get a commitment from the investor to enter into a subordination agreement. The better defined the terms, the less likely there will be a conflict in the future.
- Using debentures can also allow a corporation to preserve its Sub-S election. Sub-S rules allow a corporation to be taxed as a partnership, that is the corporation itself is not taxed but the owners are. This is a gross simplification, but this is the heart of the matter. This benefit allows the corporation and its shareholders to avoid double taxation and thereby save money. Sub-S rules, however, limit the number of shareholders and the types of shareholders. For a start-up company, the number of shareholders should not be a problem since it is pegged at 75 shareholders. (If the start-up has 75 shareholders, it may have a securities law problem.)
Sub-S shareholders must be individuals or certain permitted trusts. For a start-up company, this will prohibit it taking as an investor a venture capital fund which is typically organized as a limited partnership, limited liability limited partnership or LLC. It also may prevent taking a strategic partner as an investor since the company's strategic partner is unlikely to be an individual.
There are other rules on Sub-S corporations. The other trap for start-ups is Sub-S corporations cannot have more than one class of voting stock. That means that Sub-S corporations cannot have common and preferred stock. While debentures are not considered a second class of stock that violate Sub-S rules on prohibiting two classes of stock, debentures may convert into preferred stock.
- Disadvantages. While there are some advantages to debentures for investors, there are also disadvantages. The disadvantages include the following:
- Bridge financing by its nature is more risky. In the parlance of the industry, you need to make sure that you are funding a bridge round and not a pier. There may be a very good reason why the company cannot obtain full funding at this time. The company may have a very good reason, including valuation concerns. It may also just be the greater fool equation. In short, it is in both parties' interest to get a level of comfort that additional funds will be forthcoming and address the consequences of what happens if they don't.
- If investing in a troubled company, then may be dependent to new equity investors to provide the funds for your repayment
- As noted above, convertible debentures can be used by make an investment more attractive. The debenture holders can get more favorable terms by reason of putting its money up first. However, other investors and venture capital funds in particular can be a prickly lot, and they may not accept the discounts/benefits that you've negotiated for yourself. This may put the debenture holder in the unenviable situation of having accept less favorable terms or losing the entire investment.
- While a convertible debenture can expressly set forth the terms of the security into which it converts (price, common/preferred, etc.), this does not have to be the case. Convertible debenture can convert into the type of security that the corporation next offers. The debenture holder may not like the terms of the new round-the investor may have been expecting a valuation at a certain level, and it came in much higher because the company's new investors have a different view of the company's position and prospects.
- This risk can, however, be mitigated in several manners. The debenture holder in this situation may insist that it has the right to elect to convert the debenture or be repaid. If the investor does not like the terms of the security into which the debenture converts, then it elects to receive back its money. The debenture holder can also attach conditions, like a conversion price not to exceed a certain amount.
- As the holder of a debenture, the investor is just a creditor of the company. The directors of the corporation do not owe the same fiduciary duties to the creditors of the corporation that they do to the shareholders. Moreover, debenture holders do not have the statutory rights of a shareholder. They cannot vote under any circumstance. They do not have the right to inspect corporate records. While this right can be give under the terms of the debenture, the remedies are different. Under Colorado law, if a stockholder's proper request to inspect the books and records is denied, then there are theoretically penalties available (C.R.S. § 7-116-104(3).) The damages to the debenture holders are they get their money back.
- Advantages. There are often advantages to using a convertible debenture. These include the following:
- Preferred Stock. Preferred stock does not mean that investors prefer it, rather it is a reference to the preferences associated with the stock. Under Colorado Business Corporations Act, a Colorado corporation's articles of incorporation may provide for more than one class of stock (C.R.S. § 7-106-101(1).
If more than one class of shares is authorized, the articles of incorporation shall prescribe a distinguishing designation for each class, and, before the issuance of shares of any class, the preferences, limitations, and relative rights of that class shall be described in the articles of incorporation. (C.R.S. § 7-106-101(1) (emphasis added).
If permitted by the articles of incorporation, the authority to assign the preferences, limitations and relative rights may be delegated to the corporation's board of directors. C.R.S. § 7-106-102(1).
- Dividends. Preferred stock can have an associated dividend preference. The dividend can be established: (i) the corporation will commit to pay a dividend of $.10 per year for each share of preferred stock; or (ii) the corporation will pay a dividend equal to 5% of the purchase price for each share of preferred stock. Often the dividend preference is not mandatory. Rather, it is characterized as if the board of directors declares a dividend, it will be in the amount . This provides the corporation and the board of directors with a lot of flexibility.
The dividends can be on a cumulative or noncumulative basis. The dividends also do not need to be payable in cash. The dividend can be payable in additional shares of the same class of stock or another class of stock. (Some explanation of the tax consequences here is probably in order .) The dividends can also have a preference. They may expressly provide that the dividends are payable to the preferred stockholders ahead of the common stockholders or ahead of other classes of preferred stock. They may also provide that declared but unpaid dividends be added to the liquidation preference.
- Liquidation. One of the preferences commonly provided with preferred stock is a liquidation preference ahead of the common stock. Often the liquidation preference is the original purchase price plus any accrued but unpaid dividends. This does not, however, need to be the case. The liquidation preference can be for a greater or lesser amount.
A threshold question with respect to the liquidation preference is whether it is participating or nonparticipating. If the preferred stock is participating, then the preferred stockholders get their liquidation preference, and they get to share in the liquidation proceeds, typically on an as converted basis. This may be perceived as double dipping, but it is becoming increasingly common as it becomes harder and harder for companies to raise funds. The participation, however, does not have to be unqualified. The liquidation preference can be capped at a multiple or a dollar amount. - Voting. Preferred stock does not have to be voting stock. Historically it was not uncommon for preferred stock to nonvoting-it simply provided a set dividend preference that was attractive to some investors. One should bear in mind that the Colorado statute authorizing different classes of stock addresses not only the preferences and rights associated with the new class of stock but also the restrictions.
Nowadays it is common for preferred stock to have voting rights. Often the voting rights are as extensive as the voting rights associated with the common stock. Moreover, the voting rights associated with the preferred stock do not even have to be on a share for share basis as they are for the common stock. The preferred stock can be voted by the holders on an as-converted basis (if the stock is convertible to common), or the preferred stock shareholders can be given five or some other multiple of votes for each share of stock. As with the other rights and preferences, it is all a matter of negotiation.
It is also increasingly common for the preferred stockholders to get special voting rights. Rather than serving as a restriction, the voting rights associated with preferred stock are often a special right. The preferred stockholders often hold fewer shares than the common stockholders, so they feel that they need additional protections to protect them from majority rule. The preferred stockholders may ask for a separate vote on significant corporate matters or events. Examples include:
- Approving any increase in the compensation of any employee who is a stockholder or an affiliate of a stockholder of the company
- Approving the award any stock options, other than awards under a company's existing Stock Option Plan, to employees or consultants to the company
- Authorizing the creation or issuance of a security that is senior or pari passu in rights, preferences or privileges to the applicable class of preferred stock
- Authorizing a merger, sale of substantially all the assets of the portfolio company or a recapitalization or reorganization of the portfolio company
- Creating or issuing additional shares of or increase the authorized number of shares of applicable class of preferred stock
- Redeeming, purchasing or otherwise acquiring any shares of the company's own stock; note however that certain exceptions to the prohibition on redemption rights may be appropriate (e.g., redeeming the stock of a former employee, consultant or director at agreed upon or formula value pursuant to a pre-existing Shareholders' Agreement or similar agreement)
- Approving any capital expenditures in excess of an established amount or outside of a budget
There will also be some issues in which the preferred stock shareholders will have mandatory voting rights. Under C.R.S. § , altering or changing the rights, preferences or privileges of the applicable class of preferred stock requires the consent of the holders of that class. Under the Colorado Business Corporation Act, any class of preferred stock will be a "voting group" for some purposes, which may require the consent of the preferred stock holders. Finally, preferred stock may carry with it the right to designate one or more directors. This may be accomplished separately by a voting agreement, or it can be incorporated directly into the articles of incorporation. (Can the directors delegate this if they are simply given blank check preferred stock?) Conversion. Preferred stock may also convert into other classes of stock. Typically, preferred shares convert into common stock, but this is not statutorily required. The key concepts are basis of the conversion and the timing of the conversion. Each will be discussed in turn.
- Conversion. It is necessary to define the basis for converting the preferred stock into common. A basic basis is simply to provide that one share of preferred stock converts into one share of common stock. The conversion does not have to be on a one-for-one basis. The preferred stock can convert on a two for one, or one for two, and any other ratio as the corporation and the investors may agree.
- Adjustments. Even with a basic conversion formula, there are certain adjustments that both the corporation and the investor will want to address. For example, the conversion ratio should automatically adjust in the event of any reorganization or reclassification of the corporation's common stock. If the corporation undertakes a ten for one split on its common stock, the convertible preferred stock should automatically convert into ten times the number of common shares than initially provided for in the documents creating the preferred stock. Another issue frequently addressed is to give the preferred stockholders additional shares of common stock to account for any stock dividend that may have be issued to the common stockholders prior to the conversion of the preferred stock.
- Anti-Dilution Protection. Preferred stock now often carries anti-dilution protections to protect the preferred stockholders in the event that the corporation sells stock or other convertible securities for a less than the purchase price paid by the preferred stock investors. If the corporation sells shares for less than the original purchase price, then conversion ratio adjusts.
There are two common adjustment formula-a full ratchet adjustment and a weighted average adjustment. The difference between the two is a full ratchet adjustment does not take into account the amount of funds received by or the number of shares sold the corporation. This can be more readily explained by example:
Assumptions. A corporation has 2,000 shares of common stock issued and outstanding. The corporation sells 1,000 shares of preferred stock at a purchase price of $1.00 per share. The preferred stock converts to common stock on a one-for-one basis, subject to adjustments. The corporation subsequently sells 500 shares of common stock for $.50 a share.
Full Ratchet. With a full ratchet anti-dilution clause, the conversion ratio based upon the lower price at which the corporation sold stock. The original purchase price ($1.00 per share) is divided by the new purchase price ($0.50 per share) to determine the new conversion ratio ($1.00/$0.50 = 2). Accordingly, with a full ratchet anti-dilution clause, each share of the hypothetical preferred stock would now convert into two shares of common stock.
Weighted Average. With a weighted average anti-dilution clause, the conversion ration not only takes into account the lower price at which the corporation sold its stock, but also the amount of funds that it raised. With a weighted average adjustment, the original conversion ratio is adjusted by a fraction, the numerator of which is.
There are several transactions commonly excluded from triggering the anti-dilution rights. These include:
- common stock issued pursuant to stock splits, stock dividends and like transactions
- setting aside a pool of common stock issuable or issued to employees, consultants or directors of the portfolio company directly or pursuant to a stock option plan or restricted stock plan approved by the Board of Directors of the company,
- capital stock, or options or warrants to purchase capital stock, issued to financial institutions or lessors in connection with commercial credit arrangements, equipment financings or similar transactions, which issuances are primarily for other than equity financing purposes
- capital stock or warrants or options to purchase capital stock issued in connection with bona fide acquisitions, mergers or similar transactions, the terms of which are approved by the Board of Directors of the company
- shares of common stock issued or issuable in a public offering.
- shares of common stock issued or issuable upon conversion of the preferred stock
- shares of common stock issued or issuable upon the conversion of a debenture or other convertible security
- Timing of Conversion. Typically the preferred stockholders have the right to convert their preferred stock voluntarily. The only question is whether each preferred stockholder holds this right individually or if a simple or super-majority of the preferred stockholders can force the conversion of the entire class of preferred stock.
The preferred stock may also be automatically converted upon the satisfaction of certain conditions. These conditions often include specific situations where having a class of preferred stock can be problematic. For example, sometimes the preferred stock automatically converts upon an IPO or the sale or merger of the corporation. The automatic conversion rights, however, can be conditional upon the preferred stock holders receiving a minimum return.
The conversion formula can also work as a club against the preferred stockholders. For example, the corporation may know that it requires additional funding. The investors may be willing to fund a portion of their investment now, but they want to wait until later to pay the balance. The preferred stock can provide that it automatically converts to common if the stockholder fails to fund the balance if its commitment.