I’ve previously written about the steps that startups and emerging companies need to take to prepare for an angel or seed round, one of which is becoming familiar with the popular investment structures that are available. With the variety of funding options out there, it’s easy to feel confused or overwhelmed when deciding how to go about raising funds. In this post, I’ll explain more about the most common investment structures, to help you develop a customized funding strategy that works for your particular business.
Equity is an all-encompassing term for an ownership interest in a company. Holders of equity usually have rights to the company’s profits and to receive the proceeds of the liquidation of the company, after the company’s debts have been paid. Equity often, but not always, gives its holders voting rights. Selling equity to investors is the most common method of raising capital for startups. The equity in a corporation is called stock, but LLCs have equity as well, often referred to as membership interests. The two common forms of equity are common equity (or common stock) and preferred equity (or preferred stock). Each type carries with it certain privileges and rights that may be attractive to different kinds of investors.
- Common equity – This is the simplest form of equity and is the type of equity that’s typically held by the company’s founders. In an equity offering, since investors are receiving the same kind of equity as everyone else, no new class of equity needs to be created. Therefore, common equity offerings don’t create as much transaction costs as preferred equity offerings, but they also offer minimal investor protections, making them less attractive to sophisticated investors.
- Preferred equity – This form of equity has substantially higher transaction costs since the company’s governing documents must be reworked to create a new class of ownership, but it also comes with attractive terms and protections for investors. Preferred equity holders have a higher priority (called a “liquidation preference“) than common equity holders to receive proceeds from the liquidation or sale of the company (and often in the distribution of ongoing profits). The holder of preferred equity also receives additional governance rights (called “protective provisions“), such as the right to appoint board seats or the right to veto certain actions. The terms of preferred equity vary widely from deal to deal and can be complex to negotiate.
Deciding whether to issue common or preferred equity is generally a question of which side – the company versus the potential investor – has more leverage. From the perspective of founders, common equity is preferable to offer, because the preferred equity’s liquidation preference may mean that the founders receive a lower or no portion of the eventual proceeds of the company. For investors, preferred equity is the better option, as the preferred equity holders are paid first and the protective provisions give the investors a greater degree of control.
Also known as convertible debt, convertible notes convert into equity once the company raises a pre-agreed amount of financing. In essence, they’re short-term loans that are repaid in equity as opposed to a traditional loan repayment of principal plus interest.
One advantage of issuing convertible notes is that you’re not required to determine the value of your company at the time of the investment, which can be difficult for early-stage businesses. Valuation is determined in later financing rounds, at which point the notes will convert to equity at a price based upon the price used in the later round. Typically, convertible noteholders are offered the same price as that used in the subsequent financing round or at a discount, which is meant to compensate them for the increased risk associated with the initial investment.
Convertible notes also have the advantage of being simpler than a preferred equity offering (but not simpler than a common equity offering). However, they are only appropriate in situations where a company needs to raise a smaller amount of money now and intends to offer a larger amount of money in an equity raise at a later time (usually from a venture capital firm or other sophisticated investor). If your company doesn’t fit this profile, a convertible note is usually not the best route to go.
Designed as an alternative to convertible notes, convertible equity is a form of financing that offers investors the right to obtain preferred stock when a defined triggering event occurs. Convertible debt is seen by some as bad for startups because it requires the businesses to repay the amount borrowed plus interest if they don’t secure the anticipated amount of financing necessary to trigger the conversion of the notes to equity. An inability to repay the notes could force the company into bankruptcy.
Convertible equity, on the other hand, eliminates the repayment and interest aspects of convertible notes, allowing the company to avoid starting out with potential debt. Two popular forms of convertible equity are SAFEs and KISSes.
- SAFE – The simple agreement for future equity (SAFE) is not a form of debt, but rather a straightforward security. It allows the investor to convert the investment into equity whenever any amount of equity investment is raised in later funding rounds. Unlike convertible notes, there’s no maturity date, so it’s possible that the investment never becomes equity, and there’s no repayment required.
- KISS – The Keep It Simple Security (KISS) is a simple investment document designed to offer the flexibility of the SAFE, while also incorporating certain investor protections that are seen in convertible notes. Unlike SAFEs, KISSes provide for accrued interest at pre-agreed rates and set maturity dates after which the investor may convert the investment amount, plus accrued interest, into preferred stock. The KISS is often seen as a middle ground between the SAFE and convertible debt.
Exchangeable shares are an alternative to straightforward equity investing, meant to ensure that initial investors are treated fairly. As with traditional stock, the price of exchangeable shares is predetermined in the investment agreement. The difference, though, is that if the company later negotiates a more desirable form of shares in a subsequent round of financing, the early-stage investors are allowed to exchange their shares for the more desirable shares. This protects initial investors by offering them the same terms and conditions that are offered to later investors. The exchange is typically done on a one-for-one basis, preserving the initial pricing while adding the more desirable features.
It’s important to remember that there’s no one-size-fits-all answer for structuring your investments in the seed or angel rounds. Understanding the different investment forms will allow you to customize an investment strategy that best positions your startup or emerging company for success.
© 2017 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.