What Will VC’s Want For A Security: Common Stock? Preferred Stock? Debt? Warrants?

Written by: Joseph W. Bartlett/VC Experts Founder

As one programs any financing, as in corporate finance generally, the objective is to make 2 + 2 = 5; that is to obtain added value for the issuer. In the course of a financing, the insiders are attempting to raise the maximum amount of money for the minimum amount of equity (“equity” meaning claims on the residual values of the firm after its creditors have been satisfied). A corporation will issue at least one class of common stock because it must; many firms stop there; they pursue the simplest capital structure possible in accordance with the KISS principle (“Keep it Simple, Stupid”). However, in so doing, the corporation may close down its chances to pursue the added-value equation (2 + 2 = 5) because that equation involves matching a custom-tailored security to the taste of a given investor. The top line of the term sheet will ordinarily specify the security the VCs opt to own; the following discussion takes up the most common possibilities.

Different investors have differing appetites for various combinations of risk and reward. If a given investor has a special liking for upside potential leavened with some downside protection, the investor may “pay up” for a convertible debt instrument. An investor indifferent to current returns prefers common stock. The tax law drives some preferences, since corporate investors must pay tax at full rates on interest but almost no tax on dividends. On the other hand, the issuer of the security can deduct interest payments for tax purposes–interest is paid in pre-tax dollars–but not dividends. The sum of varying preferences, according to the plan, should be such that the issuer will get more for less–more money for less equity–by playing to the varying tastes of the investing population, and, in the process, putting together specially crafted instruments, custom made as it were. A potential investor interested in “locking in” a return will want a fixed rate on debt securities instead of a variable rate; the ultimate “lock-in” occurs in a zero coupon bond, which pays, albeit not until maturity, not only interest at a fixed rate but interest on interest at a fixed rate.

As the practice of tailoring or “hybridizing” securities has become more familiar and frequent, the traditional categories can become homogenized. Preferred stock may come to look very much like common stock and debt resembles equity. In fact, the draftsmen of the Revised Model Business Corporation Act no longer distinguish between common and preferred stock. Moreover, it may be advantageous (again with a view to making 2 + 2 = 5) to work with units or bundles of securities, meaning that an investor will be offered a group of securities, one share of preferred, one debenture, one share of common, and a warrant, all in one package.

Indeed, creativity by sponsors has spawned a variety of novel “securities,” equity and debt, which have played a role in venture capital, the underlying notion being to maximize values by crafting instruments to fit the tastes of each buyer and to capture current fashions in the market. The use of “junk” or “fluffy debt has been the focus of popular attention of late; however, junk bonds debt securities which are less than investment grade and, therefore, unrated are only one species of the complex phyla of hybrid securities invented by imaginative planners. Thus, a given issuer‘s financial structure can perhaps be best envisioned by thinking in terms of layers of securities. The top layer is the most senior: usually secured debt, “true” debt in the sense that the holder is opting for security of investment and “buying” that security by accepting a conservative rate of return, a fixed interest rate, or a variable rate tied to an objective index. The bottom layer is the most junior: common stock (and if the common stock is divided into different series, the most junior series); on occasion, this level is referred to as the “high-speed equity.” The risk of a total wipeout is the greatest, but, because of the effects of leverage, so is the reward. In between are hybrids, layers of securities with differing positions, meaning differing claims on Newco‘s current cash flows and the proceeds of a sale or liquidation of the entire enterprise.

The variables open to the planners include the following:

  • a security can be denominated either debt or equity with different tax consequences to both the issuer and the holders;
  • a security may be senior, or subordinated, or both, as in senior to one level and subordinate to another (the term “subordinated” opens, in and of itself, a variety of possibilities);
  • a security may be convertible into another at a fixed or variable rate of exchange (and convertible over again, as in debt convertible into preferred stock, in turn convertible into common);
  • an equity security may contemplate some form of fixed recoupment of principal, perhaps expressed in terms of a redemption right;

Redemption can be at the option of the issuer, the holder, or both; and the issuer‘s obligations to make periodic payments with respect to a debt security can range from the simple to the exotic–monthly interest payments at a fixed rate to so-called PIK payments (payment in kind, meaning in stock versus cash) tied to the performance of a particular business segment (as in “alphabet stock”). The utility of this structure is that it gives Newco time to fulfill the promises in its pitch book.

All that said, in today’s universe, the market standard is common stock to the founder founders, plus the friends and family. The next round, with the exception noted, is convertible preferred stock. The jump balls are participating versus non-participating, cumulative dividends, etc. But the security is convertible preferred, even in the angel round, which used to be common. The exception is a convertible note in the bridge round, next round pricing. See the Buzz article, The Next Round Pricing Strategy.

For more information on Venture Capital and Private Equity, please visit VC Experts.

Effectively Connected Income and Penny Warrants

Guest post by Nicholas Jacobus and Sung Hwang – Venable LLP

There is a case currently proceeding in the U.S. Tax Court (TELOS CLO 2006-1, Ltd. v. Commissioner, T.C., No. 6786-17, petitions filed 3/22/17) that deals with the question of whether non-U.S. investors inadvertently realized “ECI” from the sale of “penny warrants” (a/k/a “hope notes”).  This is a reminder that careful deal structuring is crucial for funds that have a significant non-U.S. investor base or otherwise have a covenant to avoid income that is “effectively connected” with the conduct of a U.S. trade or business (ECI). 

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Reverse Mergers Hinge on Due Diligence and Cleaning Up Public Shells

Guest Post by Laura Anthony, Esq – Legal & Compliance, LLC

When a publicly traded company “goes dark” and becomes delinquent in its filing requirements, it generally becomes a public shell and is no longer quoted on the Over the Counter Bulletin Board Exchange (OTCBB). However, with the assistance of an experienced securities attorney, the shell company can be restored so that a merger candidate can be introduced.

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Going Public Transactions For Smaller Companies: Direct Public Offering And Reverse Merger

Guest Post by Laura Anthony, Esq – Legal & Compliance, LLC

Introduction

One of the largest areas of my firms practice involves going public transactions.  I have written extensively on the various going public methods, including IPO/DPOs and reverse mergers.  The topic never loses relevancy, and those considering a transaction always ask about the differences between, and advantages and disadvantages of, both reverse mergers and direct and initial public offerings.  This blog is an updated new edition of past articles on the topic.

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Completing A Name Change Without Shareholder Approval

Guest Post by Laura Anthony, Esq – Legal & Compliance, LLC

Generally a name change is completed through an amendment to a company’s articles of incorporation.  Moreover, amendments to articles of incorporation generally require shareholder consent, which can be time-consuming and expensive and become even more so if the company is subject to the reporting requirements of the Securities Exchange Act of 1934.

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The Business Plan And Private Placement Memo

Since a private placement memorandum, usually abbreviated as the PPM, is the norm in most deals, the founder should familiarize himself with the standards for memorandum preparation, keeping in mind that, like any legal document, there are various audiences. The audience composed of potential plaintiffs (and, theoretically at least, the SEC enforcement staff) will read the document against the requirements contained in the cases imposing liability. The audience composed of investors will read the document for its substantive content: “What are the terms of the deal?” To professional investors interested enough to become potential buyers, the private placement memorandum is a handy collection of only some of the information they are interested in, plus a lot of surplus verbiage (the empty language about suitability standards, for example). To the issuer, it is a sales document, putting the best face possible on the company and its prospects. To the managers, the memorandum is a summary of the business plan. Indeed, it may incorporate the business plan as an exhibit or be “wrapped around” the plan itself—a memorialization of how the business is to be conducted.

The first page of the PPM, the cover page, contains some of the information one might see on the front of a statutory prospectus: name of the issuer, summary description of the securities to be sold, whether the issue is primary (proceeds to the issuer) and/or secondary (proceeds to selling shareholders), the price per share, the gross and net proceeds (minus selling commissions and expenses), and a risk factor or two (that is, the offering is “highly speculative” and the securities will not be liquid). Some would argue a date is important, because, legally, the document speaks as of a certain date. However, if the memo becomes substantively stale between the offer and the closing, it is critical that the issuer update and circulate it; omission of material information as of the closing is not excusable on the theory that the memo displays an earlier date. Moreover, a dated memorandum will appear just that—dated—if a few months elapse and the issue is still unsold. A related issue is whether to specify a minimum amount of proceeds that must be subscribed if the offering is to go forward. If the financing is subject to a “minimum,” a reference belongs on the cover page. It makes common sense that there be a critical mass in most placements; however, a stated requirement that X dollars be raised or all subscriptions returned inhibits an early-closing strategy—the ability to “close,” if only in escrow—with the most eager of the issuer‘s potential investors. Such “closings ” may not be substantively meaningful; the deal may be that the “closing” will be revisited if more money is not raised. However, a first closing can have a salubrious shock effect on the overall financing; it can bring to a halt ongoing (sometimes interminable) negotiations on the terms of the deal and create a bandwagon effect.

The cover page should be notated, a handwritten number inscribed to help record the destination of each private placement memorandum. It is also customary to reflect self-serving, exculpatory language (of varying effectiveness in protecting the issuer), that is:

1. The offer is only an offer in jurisdictions where it can be legally made and then only to persons meeting suitability standards imposed by state and federal law. (The offer is, in fact, an “offer” whenever and to whomsoever a court designates.)

2. The memorandum is not to be reproduced (about the same effectiveness as stamping Department of Defense papers “Eyes Only,” a legend understood in bureaucratese to mean, “may be important … make several copies”).

3. No person is authorized to give out any information other than that contained in the memo. (Since the frequent practice is for selling agents to expand liberally on the memo’s contents, it would be extraordinary if extraneous statements by an authorized agent of the issuer were not allowed in evidence against the issuer, unless perhaps they are expressly inconsistent with the language of the memo.)

4. The private placement memorandum contains summaries of important documents (a statement of the obvious), and the summaries are “qualified by reference” to the full documentation. (A materially inaccurate summary is unlikely to be excused simply because investors were cautioned to read the entire instrument.)

5. Each investor is urged to consult his own attorney and accountant. (No one knows what this means; if the legally expertised portions of the private placement memorandum are otherwise actionably false, it would take an unusually forgiving judge to decide the plaintiff should have obeyed the command and hired personal counsel.)

6. The offering has not been registered under the ’33 Act and the SEC has not approved it.

The foregoing is not meant as an exercise in fine legal writing and the avoidance of excess verbiage. Certain legends are mandatory as a matter of good lawyering—a summary of the “risk factors”; a statement that investors may ask questions and review answers and obtain additional information (an imperative of Reg. D); and, of course, the language required by various state securities administrators. A recitation tipping investors that they will be required in the subscription documents to make representations about their wealth and experience is generally desirable, particularly in light of cases finding against plaintiffs who falsified their representation. However, in my opinion, a cover page loaded with superfluous exculpations may cheapen a venture financing, signaling to readers that the deal is borderline, in a league with “double write-off” offerings in the real estate and tax-shelter areas.

A well-written private placement memorandum will follow the cover page with a summary of the offering. This section corresponds to a term sheet, except that the language is usually spelled out, not abbreviated. The important points are covered briefly: a description of the terms of the offering, the company’s business, risk factors, additional terms (i.e., anti-dilution protection, registration rights, control features), expenses of the transaction and summary financial information. The purpose of the summary is to make the offering easy to read and understand. As stated, suppliers of capital are inundated with business plans and private placement memoranda; the sales-conscious issuer must get all the salient facts in as conspicuous a position as possible if he hopes to have them noticed.

At this juncture, it is customary to reproduce investor suitability standards, identifying and flagging the principal requirements for a Reg. D offering, that is, the definition of “accredited investor.”

Issuers should approach offerings that have stated maximums and minimums with caution. The SEC has made its position clear. If the issuer elects to increase or decrease the size of the offering above the stated maximum/minimum, each of the investors who have signed subscription agreements must consent to the change in writing. It is not open to the issuer to send out a notice to the effect that “We are raising or lowering the minimum and, if we do not hear from you, we assume you consent.” The issuer must obtain the affirmative consent of each investor, which may be a bit difficult if the investor is, at that point, somewhere in Katmandu.

Investors should be aware that issuers sometimes do not want the investors to know certain information. For example, some issuers elect to code the numbers on the private placement memorandum so that no investor knows he is receiving, say, number 140; he is, instead, receiving “14-G.”

Finally, the current trend is to prepare both a full placement memo as well as a brief summary, such as the so-called “elevator pitch”, a concise summary that can be read while riding in an elevator. Venture capitalists are chronically short on time and a 40-page document is likely to be left unread if this is the only pitch material available.