Emerging companies looking to raise capital from outside investors most commonly do so via one of three different structures: preferred stock, convertible debt, or other convertible instruments.
The most common form of financing structure for venture capital investors, especially for larger financing transactions, involves the issuance of preferred stock by startups. Companies typically create a new series of preferred stock for an initial equity financing transaction and for each subsequent equity financing.
Preferred stock typically carries special rights with respect to preferential payments in a liquidity transaction; voting; and protection from dilution. Issuing preferred stock may also require a startup to forgo some degree of control from a corporate governance perspective by allowing the preferred stockholders to elect directors or have special approval rights over certain company actions.
One of the key substantive differences between a preferred stock financing and the alternative structures discussed below is that the parties to a preferred stock financing typically agree on a fixed valuation of the company that is used for determining the price per share and number of shares acquired by the investors.
From a process perspective, drafting and negotiating the legal agreements for a preferred stock financing is more complicated and time consuming than the alternative structures discussed below, but the more comprehensive provisions in these documents leave less work to be done later, and greater predictability for entrepreneurs and investors as they plan for future capital-raising or sale transactions.
Emerging companies may also agree to issue “light” preferred stock to investors, pursuant to a set of streamlined documents with a narrower set of investor rights. In such instances, investors generally receive stock having a liquidation preference, but without the more comprehensive governance rights or investor protections that are ordinarily associated with preferred stock.
Traditional Preferred Stock Financing
“Light” Preferred Stock Financing
Convertible Debt Financing
|Stock Purchase Agreement||Stock Purchase Agreement||Note Purchase Agreement||SAFE|
|Restated Certificate of Incorporation||Restated Certificate of Incorporation||Convertible Promissory Note|
|Investors’ Rights Agreement||Investors’ Rights Agreement|
|Right of First Refusal and Co-Sale Agreement|
|Management Rights Letter|
Figure 1: Representative list of documents required for various types of early-stage financing transactions.
When companies and investors cannot agree on a valuation for the company’s stock, or simply prefer not to issue equity securities for another reason, there are alternative structures by which companies can raise funds.
One such option is for the company to borrow money from lenders. But early-stage companies that have not previously raised capital may find it difficult to find a lender that is willing to extend credit on reasonable terms due to the perceived high degree of credit risk. Those willing to lend money to early-stage companies will seek to be compensated for taking that risk, and the form of compensation frequently sought by such lenders is the ability to participate in the company’s later growth by having the ability to convert the credit extended to the company into equity securities so that the lender becomes a stockholder of the company. In the case of a company that experiences rapid or exponential growth, that equity stake may be worth significantly more than the amount originally lent to the company.
As with traditional loans, convertible debt is typically evidenced by a promissory note, has a maturity date, bears interest at a fixed rate or based on a specified formula, and, in the event of an acquisition, is repaid before any acquisition proceeds are received by stockholders. Unlike traditional loans, however, convertible debt may be converted into equity securities, either automatically upon the occurrence of a specified event (such as an equity financing) or, in some cases, at the lender’s election. When a lender extends convertible debt to an early-stage company, the lender is, in effect, making a prepaid investment in a subsequent equity financing.
To compensate convertible debt investors for investing early and in the absence of a valuation, convertible promissory notes often convert at a discount relative to the price paid by new investors in an equity financing. The discount rate may be calculated in a number of ways, including as a percentage discount (i.e., the notes convert into equity at a price per share that is a certain percentage less than the price paid by new investors) or a valuation cap (i.e., the notes convert into equity based on an assumed pre-money valuation). Convertible promissory notes also often include terms addressing the treatment of the notes in the event of an acquisition. Although these provisions may seem boilerplate, conversion and repayment formulas include important nuances that ought to be discussed and reviewed early in the process with investors to ensure all parties are aligned on how the notes will be treated in the event of a financing or acquisition.
One advantage offered by convertible debt financings is that the documentation can be simpler and less cumbersome to negotiate than the documentation required to complete a preferred stock financing. The simplicity arises in part from the fact that purchasers of convertible debt are willing to invest without agreeing on a fixed valuation and without negotiating complex governance and investor rights. Instead, convertible debt investors rely on later investors to negotiate those terms.
Convertible debt does have a number of corresponding disadvantages. First, issuing convertible debt in lieu of equity merely delays the negotiation of key investment terms, and could make those later negotiations more difficult. This is particularly true if the interests of the terms of the equity investment cause the interests of the new investors and existing noteholders to diverge, in which case the company may end up serving as an intermediary between those two groups. Second, the issuance of convertible debt by an emerging company may raise accounting and legal concerns regarding the company’s solvency, as the issuance may cause a company’s liabilities to exceed its assets. Finally, the accrual of interest and investor-favorable conversion formulas can also dilute founders’ ownership beyond that which founders may have expected at the time notes were originally issued.
Other Convertible Instruments
In addition to preferred stock and convertible debt, a number of alternative forms of convertible securities have gained popularity in recent years. These include the Simple Agreement for Future Equity (SAFE) developed by Y Combinator, Keep It Simple Security (KISS) developed by 500 Startups, and bespoke instruments prepared to address special situations.
The terms of these instruments differ from each other, but all are designed to offer investors some of the key advantages of convertible notes — including discounted conversion rates and the ability to delay agreement on the company’s valuation — without some of the key disadvantages. In particular, because most of these instruments are not styled as debt, they do not accrue interest and do not raise the same solvency concerns as convertible debt.
Properly structured, a successful early-stage financing will set the stage for subsequent financing and strategic transactions, including public offerings or acquisitions. Hastily structured, an early-stage financing transaction can discourage future investment or cause founders to suffer more substantial ownership dilution than expected or desired. Emerging companies, particularly those that have not previously raised outside financing, should therefore carefully evaluate these various options in close consultation with their counsel and other advisers before launching their fundraising efforts.