This is the first of a three part series on structuring private equity and venture capital transactions. VC Experts enables practitioners all over the world to implement best practices through our premium content sections, see specifically the legal forms sections... contributed by experts from the best professional firms in the world.
The capital structure that ultimately will be created upon consummation of a financing directly reflects the core terms stipulated and agreed to in a term sheet between a venture firm or syndicate of investors and a company. One of the core issues upon which entrepreneurs are wise to focus is the relationship between preferred and common stock as stipulated in the term sheet. This relationship can vary significantly and can, depending on the terms negotiated, produce significantly different capital structures and economic outcomes.
I have worked closely with a number of firms with the goal to assemble syndicates of investors capable of committing the amount of capital a growing company desires to reach cash flow break-even. While each firm often has its own hot buttons and preferred method of structuring a term sheet, syndicates always agree to the terms in a term sheet, fully cognizant of the capital structure that will be created or effected as a result of a pending financing and the specific relationship stipulated between preferred and common stockholders.
There are two traditional approaches to structuring venture capital investments and to creating a class of security with which outside investors, venture or angel, will be comfortable. The first uses straight common stock. The second uses convertible preferred stock to accommodate institutional or later-stage investors while maintaining common stock for founders and early-stage angel investors. Both approaches have merits.
Relationship Between Common and Preferred Stock
Often misunderstood by the entrepreneur are the nuances in the ways convertible preferred stock and common stock function as part of the capital structure. Use of convertible preferred stock to accommodate venture or outside investors clearly distinguishes the preferred from the common; the interests of both types of security are most clearly and technically aligned when conversion of the preferred into common actually comes about. But this usually happens only at an IPO or sale of the company; in the meantime, preferred stockholders have many rights and preferences that the common stockholders do not have.
The relationship between the two classes of stock is largely a function of the relationship between a company's pace of growth and the Liquidation Preference and Redemption features the convertible preferred requires. When an investor purchases only convertible preferred, the relationship between the preferred and the common is pretty straightforward; preferred investors are entirely ahead of common in the company's capital structure.
A number of firms use a third approach that results in the sale of both straight common and non-convertible redeemable preferred stock to investors during a single round of financing. This third approach has been used with considerable success by venture firms large and small as an alternative to the traditional straight common or convertible preferred approach. Depending on a company's rate of growth and future capital needs, the combination common and non-convertible preferred has advantages over either the more traditional straight common or convertible preferred approaches.
The balance of this chapter discusses the interplay between common and preferred securities, examines the pros and cons of straight common and convertible preferred structures, and considers as an alternative approach the use of a common/non-convertible stock structure. Finally, the chapter considers how the common/non-convertible preferred structure affects the form a term sheet follows.
Straight Common or Convertible Preferred Structures
For discussion purposes, consider as a model a start-up company seeking its first venture round of $2 million. The management/shareholders, who own 100 percent of the company, value their holdings in the company at $3 million before the financing. Assuming this pre-financing valuation, after the financing the investors' $2 million interest will equal 40 percent of the equity; management will retain 60 percent of the equity; and the company will have a post-financing valuation of $5 million.
Typically, early-stage investments that involve friends and family of an entrepreneur or an early-stage management team will involve only common stock. The structure is simple, and the interests of the investors and management are clearly aligned. Both groups own common stock, and both are motivated to maximize its value. It has become customary for the first major round of professional venture investors to structure rounds of financing with convertible preferred stock. When an investment goes well, there is every motivation for convertible preferred stockholders to convert to common. If the model company cited above is sold or goes public at a $20 million value, the preferred holders would convert the 40 percent of the company they might hold in convertible preferred stock to common stock worth $8 million. The management team would have common stock worth $12 million.
On the downside, however, the use of preferred stock could give the investor certain protections and leave open the potential for less than optimal alignment between investors and management. The Liquidation Preference and Redemption sections of a term sheet specifically highlight the extent to which certain protective provisions can be afforded the convertible preferred investor. Assume the model company cited above does poorly and is sold for $4 million, $1 million less than the post-money valuation in the round. In a structure with straight common stock, management, owning 60 percent, would receive $2.4 million, while the investors would receive only $1.6 million, absorbing a loss of $400,000 on their investment. In such a scenario, the investors are likely to feel shortchanged, since management, responsible for the outcome, produced a meaningful gain for themselves and a loss for the investors. For this reason, a liquidation preference is typically attached to convertible preferred stock to provide first for complete return of capital to the preferred investors and then return of capital to common stockholders.
In the model cited above, the first $2 million of $4 million distributed in a sale would be distributed to the convertible stockholders. The next $2 million would be returned to common stockholders who would in this instance receive just $2 million of the original $3 million in value attributable to their common stock. The interests of preferred and common shareholders appear less aligned when the preferred require greater protection or, indeed, a guaranteed or minimum return of, say, one-and-one-half to two or more times. In such investor-favorable instances, the preferred investor could potentially receive all of the proceeds of a sale or liquidation. In our model, were the convertible preferred to require a return of two times and the company to be sold for $4 million, common shareholders would receive no value.
Reprint permission from and originally published in Deal Terms, Aspatore Books, All Rights Reserved.