BUSINESS CAPITAL BASICS: ISSUING SECURITIES
September 16, 2014
By Jeff Wolfe
In the first three installments of our Business Capital Basics Series for startups and small businesses, we’ve explored some interesting topics like the different types of financing available (equity, debt, and crowdfunding), different types of investors (friends, family, angels, and venture capital firms), and legal considerations of fundraising (securities law and tax code). In this post, let’s take a closer look at the specific types of securities that may be offered.
There are four general types of securities germane to startups and small businesses: common stock, preferred stock, corporate debt, and convertible securities (either debt or preferred stock).
Common stock is the most basic form of ownership in a corporation. The rights, preferences, and privileges of holders of common stock are generally the same from company to company. For instance, holders of common stock traditionally have voting rights to exert power over the company, including through the election of the board of directors, thereby influencing corporate policy at the highest level. However, when companies must declare bankruptcy, holders of common stock are last in line behind preferred shareholders and creditors. Common stock is typically offered in the early stages of a company to founders and other insiders and in later stages of a company if the company pursues an initial public offering (IPO).
As with common stock, preferred stock is also an instrument that confers ownership shares in a corporation, albeit with more a more complicated set of rights, preferences, and privileges (e.g., dividends, voting rights, liquidation preference, redemption rights, anti-dilution provisions). And unlike common stock, the terms of preferred stock vary widely from company to company (and even from series to series within the same company). However, there are some standard market terms to expect for an early stage (e.g., Series A) preferred stock round, which may vary slightly depending on the industry and investor group.
Preferred shareholders have a much stronger position in terms of dividends, typically with guaranteed periodic dividend payments as a reward for their investment. And, unlike their counterpart common shareholders, owners of preferred stock, as their name alludes, have a greater claim to corporate assets should the company sell itself, liquidate, or declare bankruptcy. When startups raise money from outsiders, preferred stock is a popular vehicle since it allows the investors to differentiate themselves from the founders and gain certain protections. If preferred stock is not convertible into common stock (which we will discuss below), a preferred stock offering may often be combined with common stock or warrants to purchase common stock at a later date as an additional incentive to the investors.
If current shareholders of a company (or the investors themselves) are not interested in selling (or buying) an ownership stake of the company, corporate debt may be used as alternative to raise money. In a corporate debt offering, companies guarantee repayment of the principal plus interest over a certain term of years through a corporate debt instrument (e.g., promissory note). This is different than corporate equity discussed above and also loans from a bank or other traditional lenders.
Compared to corporate equity, corporate debt may be favorable to the company since it is simpler (i.e., less expensive) and interest payments may be tax deductible. And by avoiding the question of what percentage of a company the investor will receive, corporate debt allows companies and investors to avoid the difficult process of agreeing to a company value. However, investors will typically not put their investment at risk unless the company shows a strong ability to repay the debt securities, common stock warrants or other incentives are offered, or the investor has the opportunity to convert the debt into equity as discussed in the next section.
A fourth type of security, which is basically a more specific type of preferred stock or corporate debt summarized above, is a convertible security. By including a conversion feature, both companies and investors are given greater flexibility. For the company, there is flexibility if the company does not have the ability to pay dividends on preferred stock or the principal and interest on corporate debt. For an investor, there is flexibility if the company grows or raises additional capital.
In these cases, convertible securities may solve both the short-term needs and long-term wants of both the investors and the company. The company raises the capital it needs, while the investor gains short term protection with the option to convert preferred stock or corporate debt, as applicable, to common stock by certain dates and at a set price. In startup financing, convertible securities are typically in the form of convertible notes rather than convertible stock and are often used as a “bridge” between equity rounds.
Understanding options for issuing securities can help businesses make critical decisions on appropriate measures for raising capital at different stages of their life cycles. At the Forrest Firm, we help hundreds of North Carolina businesses think through the risks and rewards of many business challenges, fundraising included. Please consult with one of our business attorneys to gain a better understanding of your options when raising capital.