The Two Most Popular Deal Structures for Start-Ups

  1. The Seed Capital Convertible Bridge Note™. This security was created specifically to meet an unusual demand by our portfolio company candidates. On occasion, some of these folks would call and say, “I have these investors standing around my office trying to invest in my company, but I don’t know what to do; how much of the company to give them; and how to legally take their checks. Can you help?” One Wall St. rule of thumb: “Take the Money.” (But do it legally so you don’t have to give it back.)

 

In General:

 

From both the entrepreneur’s and investor’s viewpoint, a Seed Capital Convertible Bridge Note comes as close to a perfect security as one can create. This structure works well for seed, as well as first-stage development-capital, especially if your new company or project is not bankable. The structure is effective, especially for a Start-Up, because the Notes are convertible into common equity, which benefits investors if and when the company becomes successful, but commands a first lien position against the assets of the company if liquidation were to occur—forced through bankruptcy or otherwise—that senior-secured bank debt would normally command, while they wait. If your Company or project is bankable (i.e., the plan includes the purchase of real estate and/or real property, machinery and equipment, or your Company has current receivables and marketable inventory), you could still use the Seed Capital Convertible Bridge Note structure for a seed capital offering, but it would need to be subordinated to the bank debt. If so, it would have, not a first lien on assets, but a forward lien.

 

No bank, we know of, will allow any sharing of the first lien position against assets with any previous or joint creditors (Noteholders). So, if you felt you needed to keep the Seed Capital Convertible Bridge Note in a first lien position, just keep in mind that you would eventually need to use the newly acquired bank debt to pay off the seed capital investors (Noteholders). This would work well if the investors do not mind taking a second position on liquidation rights. It may be wise to illustrate the Note pay-off with the use of bank debt or equity trough a subsequent securities-offering, within the Seed Capital Convertible Bridge Note documents to further strengthen your exit strategy for the Noteholders. Offering convertible preferred equity, with a stated and participative dividend, to the Noteholders through a subsequent securities-offering, may enable you to keep them in the deal by recycling the Notes proceeds into the preferred equity. The Noteholders could simply redeem their Note principal, with or without accrued interest, to the purchase of convertible preferred equity.  They can re-invest their Note proceeds (at any time prior to or on the Note maturity date), which essentially pays off the Notes with preferred equity securities, as opposed to cash. Typically, to obtain a substantial amount of bank financing, you would need to provide a substantial amount of equity as a pre-requisite to bank financing. You could raise equity capital through the issuance of common or preferred stock first, but remember you need to disclose the bank debt as the 1st lien position on assets. Then you would have the minimum amount of equity required to secure the debt component through bank loans.

 

In general, Seed Capital through the issuance of debt, should be kept at a minimum. Too much debt could be detrimental to a new company. (The inability to make the interest and/or principle payments in a timely fashion could force a young Company into liquidation.)

 

Seed capital should only be used to cover your Company’s overhead expenses associated with initiating the overall organizational design and capitalization structure—as well as any other important action items to further protect your investor’s capital contribution, such as securing patents on previously developed intellectual property. Most importantly, seed capital should be employed to cover the costs associated with raising “Development Capital.”

 

Seed Capital Convertible Bridge Notes™ may not be the appropriate deal structure for a development-capital round of financing if you have already secured bank debt or any other debt with the first-lien position against the company’s assets and/or you have already raised capital from friends and family. If so, it may be appropriate for a development-capital round of financing with the use of preferred equity.

 

The interest rate and maturity are the only attributes of any type of debt that you can legally advertise. The interest rate is the only attribute that can be advertise to illustrate the expected return though.

 

No Dilution.

 

Issuing Seed Capital Convertible Bridge Notes does not create immediate dilution of the price of the security owned by the investor or dilution of votes (control) for the entrepreneur until and unless the Notes are converted into common equity.

 

  1. Convertible, Participating, Cumulative, Callable Preferred Equity. A preferred stock for C corporations or preferred membership unit for an LLC, with the additional features listed below, becomes as close to a perfect security as one can create—from both the entrepreneur’s and investor’s viewpoint. It’s truly a win-win deal structure, as you will shortly realize. Actually, the default deal structure within Financial Architect® is engineered for—and termed as—a “Convertible, Participating, Cumulative, and Callable Preferred Stock.” For simplicity’s sake—and for this explanation—we’ll keep it termed as Preferred Stock.

 

In General:

 

The preferred stock, as a deal structure, works well for seed, first, second and third-stage development—or expansion capital securities offerings—especially if your new Company or project is bankable. From an accounting perspective, preferred stock is considered equity and is reflected that way on your Company’s balance sheet, which further enables you to acquire bank debt, if necessary. However, preferred equity is considered a hybrid security resting between common equity and debt.

 

It is always wise to replace one first lien holder with other first lien holders, in a rolling forward fashion. For instance, Seed Capital Convertible Bridge Notes™ (original first lien holders) upon Note maturity date, are replaced by Convertible, Participating, Cumulative, and Callable Preferred shareholders (next first lien holders) upon the Call Date, are then replaced by traditional Bank Debt (final first lien holders).

 

In regards to liquidation preference—in the case of selling, unwinding, or bankruptcy of a company—a preferred stock is a hybrid security, which is placed between common-stock equity and debt in the form of bank loans, notes, or bonds. Upon liquidation, before common-stock shares receive any payment, preferred-stock shares are paid off only up to their par value or original issue price—same thing—plus any accrued dividends/cash distributions held in arrears. But preferred shares are subordinate to any debtors. This means they hold a liquidation position behind general creditors—i.e., note-holders, bond-holders, vendors, and banks are paid first. For simple valuation purposes, preferred-stock shares are valued at “par value” or at “conversion value” (the value they would be if fully converted into common stock)—whichever is higher. Most start-up and early stage companies should seriously consider issuing enough preferred stock to eliminate all current debt and remain debt free, thereby making this security a first-lien position on the company’s assets. By doing so, you increase the probability of funding.

 

More importantly, one can attach different attributes or “provisions” to create different “types” of preferred stock to form a “series” if needed. One can easily engineer a preferred stock to meet all the individual-investor-market demands while maintaining the maximum common equity ownership and voting control.

 

No Value Dilution.

 

Issuing preferred stock does not create immediate dilution of the price of the security owned for the investor or dilution of votes (control) for the entrepreneur until conversion into common equity.

 

By its very nature, preferred stock holds a forward position on liquidation rights (first lien in the absence of secured debt) over any common stock. Hence, there is no dilution of assets for the preferred shareholders. For instance, if one were to sell 30% of the company’s common-equity ownership to investors for $1 million, with little or no tangible assets prior to its issuance—including cash—the investors’ net assets per share would be diluted by 70% or the balance between 100% ownership and the 30% they do own. In other words, they invest $1 million and end up with only 30% of the company with current assets of essentially only $1 million, which would mean they now own only 30% ($300,000) of the $1 million in cash they just invested. They immediately lose $700,000 or 70% of their assets—not so if those investors purchase preferred stock. Because the preferred shareholders’ assets are forward to common stock on liquidation, in the absence of secured debt, the preferred shareholders inherently still retain $1 million in net-asset value on their preferred shares.

 

No Voting Dilution.

 

Another benefit for companies issuing a preferred stock is preferred stockholders generally have no “operational” voting rights, so control of the company can further remain in the founding principals’ hands.

 

Within a Corp.’s By-laws and Articles of Incorporation and an LLC’s Articles of Organization or Operating Agreement, you may create a Class B non-voting stock or membership interest—termed “Preferred Unit”—to serve the same functions for an LLC as a preferred stock does for corporations.  You must originally style the preferred equity, with various attributes, within the Corp.’s By-laws or Operating Agreement. Editable Operating Agreement & By-law templates are available in the Corporate Engineering Conservatory™ to help you style preferred equity for your LLC or corporation.

 

Cumulative Stated Dividends.

 

Preferred stock not only has limited voting rights and a forward-lien position ahead of your Company’s common stock on assets, it generally has a stated dividend. What that means is the preferred stock may “state” a dividend, as opposed to common stock, which must be “declared” by the company’s Board of Directors. For example, a preferred stock could “state” in its indenture—the language on the actual preferred-stock certificate—that the preferred stock carries a seven-dollar-per-year dividend ($7.00) on a par value preferred stock of $100 per share. That stated dividend represents a 7% annual yield or return—normally paid quarterly—and is due and payable whether the company has net earnings or not. If there are no earnings or cash flow sufficient to be declared by management, if cumulative, the stated dividend amounts will accumulate until paid.

 

We suggest the stated dividend for any participating-preferred shares be cumulative. That means that preferred dividends that are not paid in cash or re-invested into preferred equity cumulate until paid. In such a case, no dividends can be paid to the common stockholders until all stated dividends, held in arrears (past dividends that are due but not yet paid) are paid to the preferred stockholders, first. The dividends accumulate—accrue as a liability on the balance sheet—if not paid on schedule. Actually, your capitalization plan can illustrate accumulating the dividend for one or two years before payments begin. This would help your Company’s cash flow stay as positive as possible during the early years of its existence. However, most preferred stockholders want their dividend payments, so if your Company’s operational plan will not be able to provide enough cash flow to pay the stated dividends in the early year(s), it may be wise to over capitalize your Company to pay those dividends out of principal on a timely basis. As long as it’s properly disclosed within the securities offering documents, it’s legal.

 

The stated dividend, participation & conversion rates and call date are the only attribute of any type of equity that you can legally advertise. The stated dividend is the only attribute that can be advertise to illustrate the expected return though.

 

In addition, unlike general creditors—e.g., banks, noteholders, or bondholders—preferred stockholders cannot force your Company into bankruptcy or liquidation for defaulting on dividend payments, especially if those payments are cumulative.

 

 Cumulative Participating Dividends

 

A participating preferred stock has more return potential because it “participates” in a small percentage of net earnings. For instance, a $5 million preferred equity offering, as an aggregate amount, may participate in 10%, 15%, 20%, 25%—or possibly as high as 50% of net earnings of a company.

 

In the early stages, the participation rate can become expensive if you’re not careful. For instance, if your Company’s capitalization plan requires that you raise a large amount of equity—e.g., $10 million you may need to provide a 50% participation rate to make the offer attractive.  But if the $10 million can be spread over a few years, we would suggest running the numbers on two consecutive $5 million preferred equity offerings with different participation rates.  One would issue a Series A $5 million preferred equity offering then a subsequent Series B $5 million preferred equity offering to accomplish the following strategy.

 

For instance, in the 1st tranche, we would engineer a higher stated dividend of 9% with a higher participation of 20% of the company’s net earnings, than for the 2nd tranche. For the second scenario, we would engineer a lower stated dividend of 7% with a participation rate on the company’s net earnings of 10% because that later round of $5 million in capital will have less risk, a lot less risk, than the original $5 million.  The total participation rate for the $10 million spread out over time with 2 tranches would only be 30% as opposed to 50%.

 

In addition, the IRRs on the 2nd $5 million may be slightly larger than the 1st $5 million even with a lower stated and participative dividend, because the cash flow that determines the IRRs on the 1st $5 million will be spread over 5 years—one or two additional years more than the 2nd $5 million. Proper engineering would bring the IRRs for both tranches closer together. You want the 1st set of IRRs to be slightly larger than the 2nd set of IRRs for the 2nd tranche because the 1st tranche investors are taking on more risk.

 

We suggest the participating dividend for your participating preferred shares be cumulative as well.

 

The “Call-protection” feature.

 

The preferred stock can, and normally does, include what is termed a “Call” feature.  This feature allows you to “Call” or buy back the preferred shares from those preferred-stock shareholders after a certain period of time (The Call-protection Date) and at a pre-determined price (The Call Price). It’s generally at a slight premium (The Call Premium – 10% in this case) above its par value or issued price and expressed as a percentage of par value ($100)—e.g., 110% (The pre-set Call Price).  The Preferred Equity’s Par Value plus the Call Premium equals the Call Price.

 

You can “Call” the preferred shares any time after the Call Date, as the Call provision is at the pleasure of the issuing company. The “Call provision” with preferred equity, allows you to replace expensive financing with less-expensive financing, such as bank debt or another series of preferred stock with a lower-stated dividend and/or participation rate.

 

Technically speaking, the Call Date is known as the “call-protection date.” The call-protection date protects the investor from being forced to sell his/her preferred shares back to the company. This would be the case of falling-interest rates in the general economy—whereby the issuer could re-finance with low interest rate bank debt to lower the cost of capital and eliminate any participation or conversion rights. If the Call Date is five years out, the investors know they have locked in a certain rate-of-return expectation for five years, because the issuing company cannot force the investor to sell back their preferred shares to the company for five years. Therefore, the issuing company can Call the stock any time after the call-protection date. By stating a Call Date, as the issuer, your Company has the option to make the preferred stock temporary or permanent equity as opposed to only permanent equity. The preferred stock becomes temporary if Called, any time after the Call Date, it stays permanent equity if never Called or if converted into common equity.

 

Let’s say in year four, your net-ending cash balances are projected to be $1.4 million. You would then be able to formulate a Call of your preferred-stock shares to coincide with a Call Date at the end of year four to be called at 110% of par or face value. Let’s say you sold $5 million worth of the Series A preferred stock. To Call the Series A preferred stock at the end of year 5, you would need to pay $5.5 million (110% of par) to the preferred shareholders. You would need to either borrow the $5.5 million from a bank and/or raise additional equity (common stock or a Series B preferred stock) to pay off the Series A preferred stock plus enough capital for a sufficient net-ending cash balance for the end of the 5th year.

 

You will also need to predict net-ending cash balances (consolidated statement of cash flows) conservatively before you set the Call Date and the Call Price for the issuance of those preferred shares, so that your Company can illustrate its ability to afford the exercise of the Call feature. However, you can illustrate in your pro formas obtaining bank debt to call the preferred shares as well.

 

The Conversion Option.

 

The preferred stock may include a conversion right, giving the preferred shareholders the right to convert anytime up to the Conversion Expiration Date. Normally the Conversion Expiration Date coincides with and is the same date as the Call Date. Although one can set the Conversion Expiration Date to be any date, when it coincides with and is the same date as the Call Date. It tends to force conversion into the Common Class A voting or Common Class B non-voting stock —priced right a very good thing. Remember, the investor has the option (but not the obligation) to convert into a pre-determined number or amount of Common Class A voting or Common Class B non-voting stock, which ever you choose prior to issuance.

 

The participating preferred stock may be convertible but does not necessarily need to be. The participating preferred stock, without the conversion feature, is generally attractive enough for investors when dealing with start-up, early stage, and seasoned companies; however, with conversion feature it’s especially attractive to investors if there is a real possibility of an aggressive buyout of the issuing company through merger or acquisition. If the company were to receive an unusually high buyout offer, without the conversion feature, the preferred stockholders would simply receive the par value or original purchase price and any accumulated dividends for their preferred stock. If, on the other hand, there is a conversion option as part of that preferred stock issuance, the preferred stockholders could elect to convert their preferred stock principal and any accruing preferred dividends, into the company’s common-stock. Obviously, in this scenario, the buyout price would need to be high enough to warrant conversion into the pre-determined common-shares amount.

 

Tax Advantages.

 

Currently, 50%–65% (depending on the amount of investment and percentage of ownership stake purchased) of any dividend payments from any form of stock, including the preferred stock’s stated and participating dividends, made to C corporations (as corporate or strategic investors) from other C corporations (your C Corp. if you have one) are excluded from the preferred shareholder’s taxable income. This is known as the “Dividend Exclusion Allowance.” This tax advantage encourages larger companies to invest in smaller companies. Both the stated and participating dividends should qualify for the tax exemption. Tax laws can change, so be sure to double check with your accountant before making that claim—if at all. (It may be wise to verbalize it in a sales presentation, rather than writing it on a securities-offering document.) Keep the Dividend Exclusion Allowance in mind when seeking a strategic alliance (other corporations) to invest in your start-up or early stage “C” corporation. Always be sure to check with your tax advisor before making any such claims in your securities-offering documents.

 

Legal Preparation.

 

Before issuing any preferred shares, you must amend your corporation’s Articles of Incorporation or LLC’s Articles of Organization, to reflect the total amount of preferred stock that you want authorized and the provisions to be included in the preferred shares. Be sure to conduct a shareholders’ or directors’ meeting to approve the issuance of any security before its issuance. Even if you own a controlling interest—51% or more of the voting equity—you need to have a meeting in accordance with your corporation’s By-laws or LLC’s Operating Agreement with yourself and enter it in the minutes. It may be wise to have a shareholders’ meeting and discuss the deal structure(s) you’re considering, for two reasons: (1) to get feedback, which may be helpful as a preliminary testing of the waters and (2) to get political support—i.e., referrals from your current investors, if any.

 

Remember, preferred stockholders generally have no “operational” voting rights, so voting control can further remain in the hands of the founding principals. However, according to many states’ laws, preferred stockholders generally have a “provisional” voting right. This means any preferred shareholder could possibly change the original provisions of the preferred shares—i.e., its “attributes.” Such radical changes generally require a unanimous vote of existing preferred shareholders. Individual state statutes mandate this rule for entities organized in their given state. You will need to check with your legal counsel before even considering a change to any preferred-stock attributes after its issuance. To easily block any attempt to change the above attributes or provisions issued by unanimous vote, it may be wise to personally purchase at least one share of the preferred stock if the unanimous-vote rule exists in the state where your organization filed its Articles of Incorporation or Organization.

 

Why issue preferred shares? Most start-up and early stage companies would do well by choosing to issue Preferred Stock/Units, with all the aforementioned attributes for their equity capitalization needs prior to an initial public offering. When properly engineered, preferred stock will sell better than any other type of security.

 

The trick to deal structuring with preferred equity is to arrive at the “sweet spot” by using all the attributes of the preferred equity to arrive at a 3 tier scenario or ascending IRRs, as illustrated below.

 

 

As the last comment to be made, the participating preferred stock is probably the most valuable tool for your start-up, early stage, or even for seasoned companies—because it fulfills the demands and expectations of both the entrepreneur and the investor.