FINANCING 101 FOR STARTUPS: PART 3 - EQUITY FINANCINGS
Startups need capital to grow and scale their business. In this three-part series, we will walk you through the most prevalent methods of raising capital at an early stage for emerging growth companies. This series will provide founders with a high level understanding of three common investment structures: SAFE financings, convertible debt financings and equity financings.
In this post, we will discuss equity financings.
Where the company and a lead investor are able to come to an agreement on valuation, the company may choose to forego a SAFE or convertible debt financing and issue equity in exchange for capital. Companies can issue equity in the form of common shares or preferred shares.
The term “preferred” shares refers to the liquidation preference inherent to this class of shares. In the context of a liquidity event (whether a sale, IPO or dissolution), preferred shares are repaid in priority to common shares based on an agreed liquidation preference. The current market liquidation preference for a while now has been a 1x non-participating preference, however financings in uncertain times may see companies and VC investors encountering down-rounds for the first time in a decade or longer and it might not be so uncommon to see liquidation preferences of 1.5x, 2x and even greater (albeit, mainly for later rounds), as well as “participating preferred”. With a 1x non-participating preference, this effectively means that on a liquidity event, an investor will receive the greater of (i) an amount equal to 1x their investment, or (ii) the amount the investor would otherwise receive if their preferred shares converted into common shares immediately prior to the liquidity event, but not both. If a liquidation preference is 1.5x or 2x, an investor would receive the greater of 1.5x their investment, or 2x their investment, as applicable. If a preferred share is “participating” rather than “non-participating”, then the investor receives both their liquidation preference and participate with common shareholders in the distribution of remaining proceeds.
It is also important to consider how multiple classes or series of preferred shares will rank with each other in terms of priority. In recent years, sequential rounds of preferred shares often rank pari passu on liquidation (i.e., all investors holding preferred shares, regardless of which series they participated in, rank equally when it comes to liquidation proceeds). This is often negotiated, however, and especially in lean times, a “last in, first out” ethos usually prevails, such that the last money takes priority in the waterfall before earlier series of preferred holders receive their proceeds.
Other preferred share attributes may include: dividends, redemption rights, price protection (anti-dilution), etc. It is very important to speak with your advisors and legal team on each of these when structuring your preferred equity financing.
Where a company raises capital by issuing shares, the investors will become shareholders of the company following the completion of the financing, and as a result, will immediately inherit various shareholder rights in accordance with applicable law and often enhanced contractual rights pursuant to a company’s shareholders agreement. In some cases, these rights can affect a founder’s ability to control the day-to-day management and operation of their business and erode a founder’s overall voting power. However, regardless of how much equity is sold in a Company, a founder’s control can always be preserved through the use of shareholder agreements.
A standard shareholder agreement (or agreements) would address the board composition (it is important for founders to maintain control of their boards in the context of earlier stage financings), pro rata ownership rights in the context of future share issuances, share transfer restrictions, and voting drag along rights (to ensure passive minority shareholders can’t block or delay significant corporate decisions or a potential exit). From an investor perspective, investors will want to ensure their investment is protected through the use of protective provisions (or veto rights) over major corporate decisions, information rights (such as delivery of monthly, quarterly or annual financial statements) and pro rata, right of first refusal or co-sale rights.
Equity financings are an effective way to raise large amounts of capital. However, before you sign a term sheet agreeing to issue shares, it is important that you understand the legal significance of issuing shares and the economic effect on your existing ownership before you settle on a company valuation and financing amount. For these reasons, it is essential that you engage an experienced startup or venture capital lawyer when embarking on term sheet negotiations in the context of an equity financing.
If you are considering an equity financing in the near future, please feel free to reach out to Chase Irwin (firstname.lastname@example.org) or Sean Del Giallo (email@example.com) at Dentons Canada LLP and we’d be happy to discuss.