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.

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Antidilution Explained: Full-Ratchet and Weighted-Average Provisions

There are two principal ways to formulate antidilution provisions, capitalizing the terms to make it clear we are talking about the ones which have substantive bite—the “Full Ratchet” and the “Weighted Average.” Full Ratchet provisions are the real killers, at least from the founder’s point of view. They provide that, if one share of stock is issued at a lower price, or one right to purchase stock is issued at a lower aggregate price (exercise price plus what is paid, if anything, for the right), then the conversion price of the existing preferred shares [1] is automatically decreased, that is, it “ratchets down,” to the lower price. [2] Depending on how many shares (or rights) are included in the subsequent issue, this can be strong medicine. A brief example will illustrate.

Assume Newco, Inc. has one million common shares and one million convertible preferred shares outstanding, the founder owns all the common, and the investors own all the preferred, convertible into common at $1 per share. Newco then issues 50,000 shares of common at $ .50 per share because it desperately needs $25,000 in cash. To make the example as severe as possible, let us say the investors control the board and they make the decision to price the new round of financing at $.50. Suddenly the preferreds’ conversion price is $.50, the founder goes from 50 percent of the equity to under 33.3 percent, and all the company has gained in the bargain is $25,000. Indeed, a Full Ratchet would drop the founder from 50 percent of the equity to 33.3 percent if the company issued only one share at $.50. This is a harsh result, indeed. When a really dilutive financing occurs, say shares have to be sold at MO per share, the founder drops essentially out of sight. The company takes in $5,000 and the founder goes down under 9 percent, never to recover because he does not have the cash to protect himself in subsequent rounds. In the jargon of venture capital, he has been “burned out” of the opportunity. There is no other provision so capable of changing the initial bargain between the parties with the dramatic effect of Full Ratchet dilution. When venture capitalists are referred to as “vulture capitalists,” it is likely the wounded founders are talking about dilutive financings and a Full Ratchet provision. [3]

The more moderate position on this issue has to do with Weighted Average antidilution provisions. There are various ways of expressing the formula but it comes down to the same central idea: The investors’ conversion price is reduced to a lower number but one which takes into account how many shares (or rights) are issued in the dilutive financing. If only a share or two is issued; then the conversion price does not move much; if many shares are issued—that is, there is in fact, real dilution—then the price moves accordingly.

The object is to diminish the old conversion price to a number between itself and the price per share in the dilutive financing, taking into account how many new shares are issued. Thus, the starting point is the total number of common shares outstanding prior to the dilutive financing. The procedure to achieve the objective is tomultiply the old conversion price per share by some fraction, less than one, to arrive at a new conversion price; the latter being smaller than the former, the investors will get more shares on conversion and dilute the common shareholders (the founder) accordingly. The fraction is actually a combination of two relationships used to “weight” the computation equitably. The first relationship is driven by the number of shares outstanding, the weighting factor, meaning that the calculation should take into account not only the drop in price but the number of shares involved—the significance of the dilution, in other words. [Call the number of shares outstanding before the transaction—A.]

The fraction, then, takes into account the drop in price and expresses that drop in terms that can be mathematically manipulated with the first number to get a combined, weighted result. The relationship is between the shares which would have been issued for the total consideration paid if the old (i.e., higher) conversion price had been used versus the shares actually issued (i.e., the shares issued at the new price.) [Call these two numbers—C and D.]

The combination of these two relationships—number of shares outstanding and the comparative effect of the step down in price (expressed in number of shares)—is a formula:

((A + C) ÷ (A + D)) x Old Conversion Price

If the shares which would have been issued at the old (i.e., higher) price is (as indicated) the number in the numerator, the fraction or percentage will be less than one. This fraction (say 1/2 or .50) is multiplied by the existing (or initial) conversion price to obtain a lower conversion price, which means in turn that more shares will be issued because the conversion price produces the correct number of shares by being divided into a fixed number, usually the liquidation preference of the preferred stock.

It is open for theorists to argue about the fairness of that result, but the above formula has the advantage of economy of expression. If one wants to use a Weighted-Average antidilution formula, the above is one commonly used (albeit expressed in different terms).

There, are, of course, different ways of expressing the formula. In the case of warrants and options, for example, the contract is often expressed in terms of a specific number of shares obtained at a fixed exercise price. Simply adjusting the exercise price may mean that a holder gets the same number of shares but pays a little (or a lot) less. In such an instance, the trick is to continue the exercise price as is but to adjust upwards the number of shares resulting from exercise, which can easily be done by reversing the formula—(A plus D) divided by (A plus C).

The calculations get more complex, as rounds of financing multiply. If the investors in round one (holding series A preferred) enjoy a conversion price of $1, and the price for the round two (series B) investors is $1.50, and the round three (series C) preferred is convertible at $4 and there then occurs a dilutive financing at $.50, all the conversion prices are affected, but it takes a computer to figure out who is entitled to what number of shares, particularly since investors in the various rounds will tend to overlap. (In this connection, one occasionally encounters a formula which keys off accumulated dilution. Thus, in the example cited, and depending on the amount raised in each instance, only the series C preferred holders would get an adjustment in their conversion price; the earlier investors would hold fast because the Weighted Average price of all subsequent rounds, taken together, is above their price.)

There are a number of other confusions which can easily creep into the drafting of the section. For example, can the conversion price go up? The answer is ordinarily no, at least by virtue of cheap stock antidilution. Does the exercise price which is ratcheted down always mean the original conversion price or the conversion price immediately preceding the dilutive event? The answer can vary but usually the latter is meant. If the conversion price goes down from $10 to, say, $5, a subsequent round at $7 doesn’t budge it again. An adjustment in the conversion price is usually pegged to the issuance of cheap stock or the right to buy cheap stock, say another convertible or an option. If the option lapses, is the adjustment reversed? Ordinarily, no. Other dilutive events are referenced in conventional financing documents, including extraordinary dividends. Absent care in drafting, a distribution of cash or property can ratchet the conversion price down to a negative number.

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Stock Options and Their Effect on Capital Structure

Excerpt from Chapter 7 of VC Experts Encyclopedia of Private Equity & Venture Capital

Brief Overview

Competitive stock option programs are an integral part of a private or public organization’s compensation policy. As such, stock option programs are a significant part of a company’s capital structure and an important part of the valuation discussion and analysis that investors undergo.

As companies expand their headcount, their cash flow and, typically, capital needs increase for some period. Attendant with any increase in headcount presumably is the need to increase a company’s option pool. The need for any increase in capital not only places dilutive pressure on a company’s overall capital structure, but also erodes the percentage holding of employees who are members of a company’s stock option program.

Balancing Financing Needs with Competitive Best Practices

The extent to which an option pool can be a significant source of discussion and consternation is directly tied to cost of equity capital for a company. Options are dilutive to investors. Whereas founders and angel investors often hold important positions in the capital structure of any early-stage company, a company’s capital needs and the valuation tied to any equity investment assume significant needs in terms of options and compensation going forward. Few companies can run, scale, and generate handsome returns to investors without increasing their headcount and management team over time.

Companies that can point to compelling investment opportunities and command the interest of strong, established, and experienced equity investors should be able to agree to reasonable expectations on the part of prospective investors about the size of the future option pool and to what extent it will need to grow. The elements that any competent analysis of an option program need to have taken into account include defining the competitive market for compensation – specifically, the cash and equity components. Established accounting and law firms with a strong venture practice can be as strong a source of information as compensation consultants. Key to a company’s success in both generating financing and remaining competitive is a strong commitment to reviewing current equity holdings of key management and assessing them in the context of the competitive marketplace. Investors will want to see a stock option grant strategy in place and are likely to make some quite definitive assumptions of their own regarding the size and growth of the option pool during the life of their investment in the company.

It is important to note that some investors – and strategic investors, in particular – may not realize market norms for option grants in small, high-risk companies. In many cases, their more conservative assumptions can pose a real challenge for management teams that are not compensated well enough, but realize that only after precedents have been set. Employees, too, have a lot to learn about stock option levels, but a board should assume that eventually employees will have to be closely aligned with the marketplace or, otherwise, should be prepared to compensate managers mostly in cash.

Employee expectations with regard to the number of options vary significantly. Interestingly enough, many employees are satisfied with a specific number of shares in a company without placing value on how that number of shares may translate in percentage terms. It may seem logical enough for an employee to assume, if the most recent price of preferred stock was $1, the employee is awarded 250,000 shares of options, and investors expect to sell the company for $4 per share, that his or her shares could be worth $1 million. What employees often lose sight of is the amount of capital a company may require, as conditions change, to meet its goals and how many additional shares may need to be issued. Whereas astute investors protect themselves from dilution through the use of preferred stock, employees are diluted as additional stock is issued, unless they are awarded additional options along the way.

Some employees focus instead on percentage ownership. There are obvious pitfalls to emphasizing or agreeing to employment contracts that tie options grants to a fixed percentage ownership in a company. This becomes a significant liability and a continued drag on the options pool as a company seeks to raise additional capital. But it is appropriate to consider awards set against some percentage benchmark for senior levels of management. I have seen wide ranges in ownership in many companies that are not yet profitable. The range for CEOs, some of whom own founders shares, can vary from 3 percent to 13 percent and for CFOs from 1 percent to 2.5 percent. I have seen the range for key executives, including vice president and director level staff, from .5 percent to 1.5 percent. Often geographic regions will have their own unique profiles, and so it is appropriate to ask experienced executive search professionals, attorneys, and accountants for a sense of the local market when it comes to options.

Dilution and the Protections Investors May Require

Investors are fully aware of the dilutive effect of a financing on an option pool. VC investors especially are typically keenly aware of market parameters and standards regarding stock option compensation. Strategic investors may not be as up to date as they are more familiar with options plans in much larger companies. It is not uncommon, therefore, that strict expectations for the size and profile of a stock option pool will be set at the time of a financing, enumerated and outlined in a section titled “Reserved Shares.” Consider the passage below from a term sheet related to a financing:

Reserved Shares: The Company currently has or will have 3,000,000 shares of Common reserved for issuance to directors, officers, employees, and consultants upon the exercise of outstanding and future options (the “Reserved Shares”).


The Reserved Shares will be issued from time to time to directors, officers, employees and consultants of the Company under such arrangements, contracts or plans as are recommended by management and approved by the Board, provided that without the unanimous consent of the directors elected solely by the Preferred, the vesting of any such shares (or options therefore) issued to any such person shall not be at a rate in excess of 25% per annum from the date of issuance. Unless subsequently agreed to the contrary by the investors, any issuance of shares in excess of the Reserved Shares will be a dilutive event requiring adjustment of the conversion price as provided above and will be subject to the investors’ first offer right as described below. Holders of Reserved Shares will be required to execute stock restriction agreements with the Company providing for certain restrictions on transfer and for the Company’s right of first refusal.
Right of First Offer for Purchase of New Securities: So long as any of the Preferred is outstanding, if the Company proposes to offer any shares for the purpose of financing its business (other than Reserved Shares, shares issued in the acquisition of another company, or shares offered to the public pursuant to an underwritten public offering), the Company will first offer a portion of such shares to the holders of Preferred so as to enable them to maintain their percentage interest in the Company.


The purpose of the “Reserved Shares” clause in a term sheet is to set in place certain expectations that define exactly how large an option pool will grow before those preferred shareholders may benefit from any protection outlined in the clause. In the example above, the investors proposing the term sheet outlined that the financing would assume that up to 3,000,000 shares of common could be reserved “for issuance to directors, officers, employees, and consultants upon the exercise of outstanding and future options.” The clause clearly places a ceiling on the number of shares of common that can be issued upon exercise of options by these constituencies. The clause goes on to detail that unless the investors agree otherwise, any issuance of shares as a result of additional options will need to result in full anti-dilution protection and an adjustment to the conversion price of the shares held by the investors who propose this round of financing. The clause clearly states, “Unless subsequently agreed to the contrary by the investors, any issuance of shares in excess of the Reserved Shares will be a dilutive event requiring adjustment of the conversion price as provided above and will be subject to the investors’ first offer right as described below.” The “Right of First Offer for Purchase of New Securities” language that follows the “Reserved Shares” clause in effect proposes that the investors proposing the financing be allowed to maintain their ownership percentage and in effect purchase more shares in the company if additional options issued result in the need to issue more than 3,000,000 shares of common stock.

The full range of an investor’s potential tools in stock incentive planning includes the ability to require founders to bind some number of shares of common stock under a stock restriction agreement. In so doing, an existing ownership position can be treated as restricted stock that is earned over a period of years. This in effect resets the clock on the stock founders may own at the time of an early-stage financing. When market conditions and company progress indicate to investors that founders’ option packages are either too rich or are in line with the market but owned outright, requiring that these individuals agree to extend the time frame they will need to work to fully own stock is one mechanism that can keep employees motivated, but not require a company to issue more options to do so.


Top 10 Mistakes Companies Make During Acquisitions

Guest Post by: Don Keller (Partner, Emerging Companies Practice in Silicon Valley, Orrick, Herrington & Sutcliffe LLP)

It used to be that when entrepreneurs started their companies, the idea of going public and making it big was on top of every founder or CEO’s checklist.  Nowadays, it seems that startups are constantly looking to build a great product that will attract the most users and then cross their fingers that the Googles or Microsofts of the world will acquire the company (or the team).  I gave a presentation yesterday at RocketSpace, an accelerator for seed-funded technologies in San Francisco, about best practices and top mistakes companies make during acquisitions. So for those of you who are interested in going down that route, here are some things to note as you prepare your company and team for the road to acquisition-ville.

1.  Founder Equity – Make sure founder equity is held in the form of shares, not options.  Shares allow founders to get all of the appreciation taxed at capital gain rates, whereas options typically result in the appreciation being taxed at ordinary income rates.  This can make a huge difference in the amount of take home pay.

2.  Protect Your IP – One of the biggest mistakes companies make in the early stages of their development, is not dotting all their i’s and crossing their t’s when it comes to protecting their intellectual property.  Make sure that when IP is involved, you work with a good lawyer to ensure that your IP is not owned by a former employer and that all of the IP has been properly assigned to the company.  The last thing you want is for your company to take off and then get hit with a notice that your IP is not actually your IP.

3.  Keep Your Options Open – To maximize your price, companies should leave themselves with alternatives to the buyers they are targeting.  You want to make sure that you’re not selling yourself short and putting all your eggs in one basket.  This does not make for a good negotiation strategy and is less likely to get you the best price.  If a buyer knows that you have only one alternative, the price will fall like a rock.

4.  What to Avoid Selling – Avoid selling the company for private company shares in a transaction that is taxable.  There is typically no market for private company shares so getting someone else’s private shares in an acquisition and having to pay tax on those shares, leaves you with an out of pocket cost and nothing to show for it other than some shares you cannot sell.  If the transaction is properly structured, the receipt of the buyer’s shares can be nontaxable (at least until you sell those shares) which is what you want.

5.  The Art of Negotiating – When negotiating on price, make sure you understand all of the adjustments to the price such as escrows, legal fees, balance sheet adjustments, and special indemnities.  Once you sign the 60 or 90 days no shop agreement, the buyer has all the leverage.  You don’t want to learn at that point that the price they said they would pay is before massive deductions.  It’s important to negotiate the terms right out of the gate so there are no surprises when it comes time to seal the deal.

6.  Open Source – Make sure you understand open source and how it’s used in your product.  Always double check to make sure that you have complied with the open source license terms.  It doesn’t happen often, but every now and then, this can be a deal breaker for buyers.

7. Keep Up with the Kardashians…I mean Housekeeping – Do not, and I repeat, do not wait until the last minute to catch up on cleaning your minute books and stock option pricing (409A issues).  It is important that your documents are maintained and updated on a regular basis.  If you wait until the last minute, it can create unnecessary headaches and disorganization.  The last thing a buyer wants to see is a company that can’t keep their documents up to par.

8.  Don’t Wait Until the Last Minute – Rolling over from #7, another important thing to note is that you shouldn’t leave the negotiation of employment and non-compete agreements until the last minute.  These are things that should be brought up as soon as discussions begin.  Time and again, these agreements are negotiated at the last minute with lots of pressure on the founders to sign and be happy.  Don’t let that be your situation.

9. Be Wary of Earn-Outs – Earn outs are a lawyer’s dream.  They almost always end in disputes about whether the buyer tried hard enough to generate revenue to meet the earn out thresholds.  Don’t count on any earn out payments and negotiate accordingly.

10.  Pay Attention to Your Board Members and Investors – It’s very important to listen to what your board members and investors are saying during this time.  You want to keep an ear out for biases for or against a sale and also take heed to strategic investor reactions to a sale.

There is no full proof way of being certain that by following the advice above, the road to acquisition will be an easy route.  However, best practices can provide entrepreneurs a clearer path and hopefully increase the likelihood of your company’s success.

About Don Keller:  Don is a Partner in the Emerging Companies Practice at Orrick’s Silicon Valley office. He advises emerging companies, public companies, venture capital firms and investment banks and has represented clients on more than 60 public offerings, 75 acquisition transactions and several hundred venture financings.  Don has worked on transactions for companies including Apple, Google, Oracle, and Rambus and represents clients such as eHarmony, OPOWER, and LS9, among many others.  For more information, you can visit his full biography.

Fenwick & West LLP: Venture Capital Survey Silicon Valley Third Quarter 2015

Guest post by Barry J. Kramer and Michael J. Patrick of Fenwick & West LLP

We analyzed the terms of 175 venture financings closed in the third quarter of 2015 by companies headquartered in Silicon Valley.

Overview of Fenwick & West Results
Valuation results continued to be strong in 3Q15, but a little less strong overall than in 2Q15.

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Venture Capital Survey Silicon Valley Second Quarter 2015

Guest post by Barry J. Kramer and Michael J. Patrick of Fenwick & West LLP

Fenwick & West LLP analyzed the terms of 166 venture financings closed in the second quarter of 2015 by companies headquartered in Silicon Valley.

Overview of Fenwick & West Results
Valuation results continued to be strong in 2Q15.

  • Up rounds exceeded down rounds 83% to 8%, with 9% flat. This was essentially unchanged from 1Q15 when up rounds exceeded down rounds 83% to 9%, with 8% flat.
  • The 75 point difference between up and down rounds was the largest since we began calculating up/down rounds in 1Q02. The last two quarters have had the highest percentages of up rounds since 1Q02 as well.
  • The Fenwick & West Venture Capital BarometerTM showed an average price increase in 2Q15 of 107%, an increase over the 100% recorded in 1Q15.
  • Series B financings have generally had higher Barometer results than other series over the course of our survey, and in 2Q15 Series B exceeded the next closest series by 81 percentage points, the largest amount in two years.
  • The median price increase of financings in 2Q15 was 74%, an increase from the 62% registered in 1Q15.
  • The software industry again had a very strong performance in 2Q15 with 50% of all deals and generally the second highest valuation results. The internet/digital media industry, with the highest valuation results, and the life science industry, with the second highest percentage of deals and also strong valuation results, also had very strong quarters. The hardware industry had very solid results also in the quarter, but lagged the other industries.

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