Here are a few financing structure tips to keep in mind when you are looking to raise captial. There are are several preferred structures that private investors, private equity firms and hedge funds use when they give the green light to fund a company. The basic structures for private companies are convertible preferred stock and convertible debt. These structures usually contain an anti-dilution provision, so the lead investor doesn’t start out purchasing say 20% of your company for $500,000 and then end up with only 5% because you dilute his stock position with subsequent financing rounds.
A common stock structure is simple. The company and investor agree on a dollar amount to be funded and the percentage of stock, also called the equity position, the investor will receive. Most private companies, however, will find they have very little bargaining power with larger investors or private equity funds. Usually, it is the money that dictates the terms of the financing structure. Part of the reason is that if you don’t like the deal terms you don’t have to take the money. Another reason is that private equity firms know which structures work for them and which ones don’t. They are also extremely risk adverse.
Preferred Stock structures are used more often. Preferred stock is convertible into common stock, usually anytime at the option of the holder. The convertible preferred stock can be convertible into either a fixed number of shares of common stock or a certain percentage of the common stock outstanding on a future date. Most private equity financing structures are based on a preferred stock model and also have a built in dividend. The dividend could range from 4% to 12%. This allows the investor to receive some return on its investment before the exit strategy is used.
Another possible structure, if your company is already operating and close to break even without a high burn rate, is debt financing with an equity kicker. You might be able to get this kind of financing from Angel investors or maybe even family and friends if the amount is not too large. Say you feel $200,000 can get you over the hurdle and profitable. You could structure the $200,000 as a 3 to 5 year loan and give the investor 5% of your company in common stock as the equity kicker. The number of shares and percentage you give the investor/lender is based on the size of the loan and the value of your company, as well as the perceived risk.
Here are some tips to think about when structuring your financing to help level the playing field:
1. Voting Control. Giving up voting control is not a bad thing if you can further expand your business and ultimately the net profit so that your reduced percentage of ownership in the company will actually be worth more than it is now. For example, say there are 3 key management people in a company who currently own 20% each of a company that is valued at $10,000,000, but they will be reduced to 10% ownership once they are funded. If the company used the funds wisely and increased its value to say $30,000,000 then although management lost control, their value actually increased.
2. Super Preferred. If management has to give up the majority equity position in the company, see if the investor will let you maintain voting control. This way the investor does not have control over business or management decisions and management technically maintains control of the company. This can be accomplished through the use of what I call a “super preferred”. Super preferred stock can be structured in many different ways. Here’s one example. Lets say the company gets funded and management has 3,000,000 shares of common stock and all outside investors 7,000,000 shares of common. The management team, however, owns nonconvertible preferred stock that gives them additional voting rights for another 10,000,000 votes along with all common stockholders, so management still has voting control. That is, management has 13,000,000 votes while outside investors have 7,000,000 votes.
3. Long Term Employment Agreement. If the private equity firm won’t go along with the super preferred idea see if they will agree to 3 year employment agreements for management so management feels safe with the funding arrangement and not being replaced 6 months after funding (assuming you have given up voting control).
4. Pre-Qualify them as a Suitable Investor. Try to get as much information about their financing structure before you give them too much confidential information or spend too much time and effort with them. Just imagine spending four (4) months talking with a particular private equity firm to learn they don’t fund any companies unless they get at least 70% equity and voting control when your management team already agreed amongst themselves that they would never give up voting control.
5. Always ask for a “Clawback”. A clawback provision allows you to buyback shares from the investor at a minimum price if you achieve a certain milestone, thereby increasing your percentage of ownership and voting rights in the company. Here’s an example. If you reach $8,000,000 in gross revenues in the second year after funding, then your company may repurchase 10% of the shares from the private equity firm for a nominal value, like $.10 per share.
6. Subsequent Rounds of Financing. If they won’t fund you the full amount you are looking for see if they will fund you in a second and third round if you hit certain milestones based on gross revenues or net profits.
7. Get a Good Attorney. Get a good corporate attorney experienced in representing clients in these types of transactions. If you ask him what a “clawback” or “super preferred” is and he doesn’t know then look for another attorney. Spending a little more money for a good attorney may save you money in the long run. NOTE: I am available for consultation to review your business plan or help you structure financing terms with potential investors. I charge a reasonable fee based on the scope of work to be performed. You can reach me, Joseph B. LaRocco, Esq. at 475-244-5141.
8. Get a Good Accountant. Get a good tax accountant who may be able to make a few simple suggestions in the financing structure. It may help you tax wise if you get warrants or stock bonuses structured a certain way. Better to plan ahead and know the tax implications before you finalize the transaction.
Most Favored Nations and Anti-Dilution Clauses are used by sophisticated investors to protect their investment. They will likely insist upon use of these clauses in the funding documents.
Accounts Receivable Financing can be used if you have strong sales payable on a 30 to 90 day timeline.
Another possible structure, if your company is already operating and close to break even without a high burn rate, is debt financing with an equity kicker. You might be able to get this kind of financing from Angel investors or maybe even family and friends if the amount is not too large. Say you feel $200,000 can get you over the hurdle and profitable. You could structure the $200,000 as a 3 to 5 year loan and give the investor 5% of your company in common stock as the equity kicker. The number of shares and percentage you give the investor/lender is based on the size of the loan and the value of your company, as well as the perceived risk.
Here are some tips to think about when structuring your financing to help level the playing field:
1. Voting Control. Giving up voting control is not a bad thing if you can further expand your business and ultimately the net profit so that your reduced percentage of ownership in the company will actually be worth more than it is now. For example, say there are 3 key management people in a company who currently own 20% each of a company that is valued at $10,000,000, but they will be reduced to 10% ownership once they are funded. If the company used the funds wisely and increased its value to say $30,000,000 then although management lost control, their value actually increased.
2. Super Preferred. If management has to give up the majority equity position in the company, see if the investor will let you maintain voting control. This way the investor does not have control over business or management decisions and management technically maintains control of the company. This can be accomplished through the use of what I call a “super preferred”. Super preferred stock can be structured in many different ways. Here’s one example. Lets say the company gets funded and management has 3,000,000 shares of common stock and all outside investors 7,000,000 shares of common. The management team, however, owns nonconvertible preferred stock that gives them additional voting rights for another 10,000,000 votes along with all common stockholders, so management still has voting control. That is, management has 13,000,000 votes while outside investors have 7,000,000 votes.
3. Long Term Employment Agreement. If the private equity firm won’t go along with the super preferred idea see if they will agree to 3 year employment agreements for management so management feels safe with the funding arrangement and not being replaced 6 months after funding (assuming you have given up voting control).
4. Pre-Qualify them as a Suitable Investor. Try to get as much information about their financing structure before you give them too much confidential information or spend too much time and effort with them. Just imagine spending four (4) months talking with a particular private equity firm to learn they don’t fund any companies unless they get at least 70% equity and voting control when your management team already agreed amongst themselves that they would never give up voting control.
5. Always ask for a “Clawback”. A clawback provision allows you to buyback shares from the investor at a minimum price if you achieve a certain milestone, thereby increasing your percentage of ownership and voting rights in the company. Here’s an example. If you reach $8,000,000 in gross revenues in the second year after funding, then your company may repurchase 10% of the shares from the private equity firm for a nominal value, like $.10 per share.
6. Subsequent Rounds of Financing. If they won’t fund you the full amount you are looking for see if they will fund you in a second and third round if you hit certain milestones based on gross revenues or net profits.
7. Get a Good Attorney. Get a good corporate attorney experienced in representing clients in these types of transactions. If you ask him what a “clawback” or “super preferred” is and he doesn’t know then look for another attorney. Spending a little more money for a good attorney may save you money in the long run. NOTE: I am available for consultation to review your business plan or help you structure financing terms with potential investors. I charge a reasonable fee based on the scope of work to be performed. You can reach me, Joseph B. LaRocco, Esq. at 475-244-5141.
8. Get a Good Accountant. Get a good tax accountant who may be able to make a few simple suggestions in the financing structure. It may help you tax wise if you get warrants or stock bonuses structured a certain way. Better to plan ahead and know the tax implications before you finalize the transaction.
Most Favored Nations and Anti-Dilution Clauses are used by sophisticated investors to protect their investment. They will likely insist upon use of these clauses in the funding documents.
Accounts Receivable Financing can be used if you have strong sales payable on a 30 to 90 day timeline.
