Four Things to Note in Equity Financing
Equity financing generally means raising capital through the sale of shares, a stake of ownership in a company, in return for upfront funding, which is one of the common ways for a company to raise funds from investors. Based on our first-hand experience, this article intends to help founders and investors understand four key issues in equity financing.
1. Types of Equity Financing
Before raising funds, founders may wish to consider what types of equity-based financing they would like to use in its financing round. There are three options for founders to consider, i.e., Simple Agreement for Future Equity (“SAFE”), convertible notes and direct share issuance.
SAFE is conventionally suitable for startup companies to raise funds as it may be difficult to value the business at the early stage. A SAFE is an investment contract between a company and an investor that gives the investor the right to receive equity of the company in the future on certain triggering events, such as a qualifying equity financing round or a liquidity event. Upon the triggering event, the company will issue shares to investors based on the investment amount initially given by SAFE investors.
SAFE is viewed by some as a more founder-friendly instrument to raise funds. First of all, SAFE is not recorded as debts in the company’s accounting book, and thus the company creates no debt by issuing a SAFE. Second, contrary to convertible notes (which will be introduced below), SAFE has no maturity date; SAFE will remain outstanding indefinitely until the conversion event is triggered, and thus the startup company can focus more on its business development without concerning about any significant immediate obligations to investors (such as repayment). Third, SAFE has no accruing interest, and investors only receive the right to convert their SAFE into equity at a lower price than subsequent investors.
In the interests of the investors, SAFE might not be a good option. SAFE investors do not have creditor rights. As previously said, SAFE has no maturity date. If the events for triggering the rights to receive shares of the company do not occur and the company is going to be wound-up or in liquidation, the investor may receive up to their original investment amount back, which is however only available if the company still has enough assets to liquidate after distributing those assets to the company’s secured and even unsecured creditors.
A convertible note is a short-term debt that can be converted into shares of the company. In effect, the investor is loaning money to a company, but instead of a return in the form of principal plus interest, the investor may receive shares of the company at a maturity date or in a future financing round.
A convertible note is a quite attractive fundraising tool for founders as well as investors. When investors inject cash into the company, investors are still not shareholders and founders can retain control of the company until the loan is converted into shares. Further, the company may have the right to repay the loan if the founders do not wish the investors become shareholders of the company. For investors, convertible notes could ensure that the investors will gain something ultimately, either principal amount plus interest or shares. Most importantly, noteholders have creditors’ rights prior to the conversion, which means that investors will have a higher priority claim against the assets of the company than the shareholders if the company is in liquidation.
The company may directly issue shares to investors in exchange for funds. The company will not need to repay the investment amount and investors are buying a percentage of the company from the founders. As the company grows and structurally becomes more sophisticated, direct share issuance will generally be favoured, since the company’s valuation is more easily to be assessed.
2. Classes of Shares to be Issued
Founders are advised to consider what class of shares will be allotted and issued to investors. This is important because the rights attaching to different classes of shares may vary. The rights attaching to the shares include voting rights, dividend entitlement, repayment of capital and participation in surplus assets upon liquidation.
There are four common classes of shares: ordinary shares, preference shares, non-voting shares and redeemable shares.
Holders of ordinary shares have equal rights: one share one vote. Voting and receiving dividends or distributions in liquidation will be on a pro rata basis depending on the number of shares owned by the shareholders. In the event of liquidation, ordinary shareholders have the right to the company’s assets only after the creditors and preference shareholders have been paid in full.
Preference shares (also known as preferred shares) carry a preferential right to dividends and a right to receive distributions in a liquidation ranking ahead of ordinary shareholders. Further, preference shareholder may have the right to receive a fixed amount or fixed rate of dividends every year, and the right to dividends sometimes can be cumulative (that is, if no dividend is declared in any year, the arrears can be carried forward). Generally, there is no voting right for preference shareholders.
Non-voting ordinary shares have most of the rights that are attached to ordinary shares except that the holders of these shares are not entitled to vote at a general meeting.
Redeemable shares are shares that are to be redeemed, or are liable to be redeemed, at the option of the company or the shareholder, according to the mechanism set out in the terms of the agreements or Articles of Association.
The above are typical classes of shares and not intended to be exhaustive. Under Hong Kong company laws, private companies limited by shares can create, define and name their class(es) of shares flexibly, designing its share structure based on the investors’ expectations and the company’s needs, provided that the Articles of Association allow the creation and issuance of different classes of shares.
3. Management Control
Some investors may request special approval rights with respect to certain matters of particular significance to their investment. For instance, if the matters are about the amendment of Articles of Association, increasing/decreasing share capital, liquidation, dissolution or winding-up, merger, acquisition or sale of substantial assets, dividends and distributions, the investors may require the company to obtain their prior consent.
If founders want to retain the control of the company, they should pay attention to the clauses in relation to matters requiring investors’ consent. It is essential to avoid the possibility of even the most ordinary day-to-day business operational decisions requiring the approval of the investors which may be too demanding for the founders.
Both investors and founders generally would wish to work towards a successful exit of their company by selling their shares of the company in the market after the company becomes relatively mature. A typical exit period is five to seven years, but five years from the closing of a series A round may be a short time and seven years is more preferable.
IPO is the most ideal way of exit. Through listing in the securities market, the investment can achieve value-addedness and withdrawal.
Mergers and acquisitions can also achieve the exit purpose. When the company is going to be acquired by another company through the purchase of all or part of its equity, the founders or the investors would have the chance to sell their shares to the purchasers.
Though IPO and mergers and acquisitions are the more desired ways to exit the company, they may not occur easily. Some investors may take an aggressive approach to ensure their success in exit. For instance, the investors may require a right to force the company or founders to buy back the investors’ shares at a specified price based on the fair market value (“Put Option”). A Put Option in an investment agreement is an important mechanism to reduce the risk of loss of capital for the investors and provides a convenient device for withdrawing investment in a business. The Put Option clause should be precise to set out the conditions, time and manner of the exercise of the Put Option. It should be noted that requiring the founders to buy out investors’ shares is essentially a personal guarantee, and it is advisable for the founders to consider thoroughly if there is such an obligation for the founders in the investment agreement.
Before starting equity fundraising, founders should first structure the type of equity financing that they are going to use and the class(es) of shares that the company will issue to investors. It is inequitable that the founders may lose part of their control over the company in exchange for investment, but in any event, it is important for founders to retain the control over day-to-day business operation so as to avoid excessive interference by investors. IPO and mergers and acquisitions may not be easily achieved; investors may consider the Put Option as an alternative way for the exit, while the founders should be careful when dealing with the Put Option, not making it personally liable to pay the investors.
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