The Three Most Important Types of Equity In Your Business Pt. 1

Entrepreneurs are not always aware of the various financing structures that may be available to them when raising new capital to finance their growth. And, even if they are, they are not always sure what fair terms look like when receiving term sheets from investors.

“Entrepreneurs are not always aware of the various financing structures that may be available to them when raising new capital to finance their growth.”

Equity

Issuing stock in your company is the route most entrepreneurs pursue, especially for growth companies where cash flow is difficult to predict, hence making it tough to forecast repaying debts. Equity is typically secured from angel investors or venture capital firms.

Representative Terms: A typical Series A (first institutional round) investor is looking for 25% to 35% of the company, in exchange for its investment. So, if you are worth $4MM pre-money, an investor would likely give you $2MM for a 33% stake, as an example. Most professional investors will be seeking equity in the form of preferred stock, not common stock, where they get a 6% to 8% interest and a liquidation preference of one times their money back before the common shareholders begin to participate in any sale proceeds for the business.

There are a number of types preferred – including participating preferred, where investors “double dip” on their interest and liquidation preference and also get their equity upside pro rata with common, however, if this structure is used there is frequently a limit of two to four times the liquidation preference before the participating feature goes away. The other type of preferred is straight convertible preferred where an investor will get their 6% to 8% interest rate plus money back or they can convert and get the equity upside of their stock pro rata with common.

The security will include some form of anti-dilution protection for the investor, typically a weighted-average rachet in the event of a subsequent financing at a lower valuation. The investor will also be looking for protective provisions, in terms of their rights as a shareholder to block certain major actions (e.g. change of control, modification of the board size, changing the charter so as to adversely affect their security, etc).Typically all employees will be required to enter into invention assignment, non-disclosure, non-solicitation and non-compete agreements.In addition, an investor may ask the founder to vest some portion of their shares, in case they need to make an executive change or if the founder quits.As an example, a founder may be asked to vest 50% of their ownership over a two to three year period, a pro rata portion “earned” each month.

• Advantages: Does not have to be repaid, like debt does. Gives certainty of valuation for your company which can also be a disadvantage if the value is too low (for diluting founders’ stake) or too high (which can impact interest from next round investors who do not like to price downrounds from the round before, to avoid legal risks from diluted shareholders).
• Disadvantages: The most complex to structure (highest legal bills, longest time to close). Usually involves giving some level of board control to investors.