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What are some structures for angel and seed financing rounds?
Angels and seed investors typically choose between two options for structuring their financing—non-priced or priced rounds. A non-priced round does not place a value on the company at the time of the investment. Often that means using either convertible notes or convertible equity instruments called equity certificates or SAFEs (Simple Agreement for Future Equity). The convertible notes are typically unsecured and have a nominal interest rate. In exchange, the angel will receive a discounted conversion rate at which his or her principal and accrued interest converts into equity. To guarantee the angel will get a certain amount of equity in the event the price-per-share at the preferred financing round is higher than anticipated, the angel and the company will sometimes negotiate a valuation cap above which the convertible note cannot convert. The valuation cap allows the angel to convert his or her principal at either the discounted price-per-share or the negotiated capped price-per-share, whichever is lower. It seems, inevitably, to take longer than parties realize to raise an initial venture financing so companies and angels negotiating convertible notes should agree to a maturity date for the notes that is realistically distant. Equity certificates generally operate the same way as convertible notes, but they are equity instruments instead of debt instruments, which means that they are typically structured to have neither an interest rate nor maturity date.
A priced round refers to early-stage financing in which preferred stock is sold to investors based on an agreed upon valuation of the company. The valuation translates into a fixed price per share of the equity security that is purchased by the investor. Whereas a convertible note or SAFE does not set a value on the company, the sale of equity for cash does. The valuation of the company is important: any future issuance of equity will be valued for tax and other purposes by reference to the price in the priced round. The first step in an equity round is for the company and investors to negotiate a valuation, which will determine the price of the preferred stock. The company will need to balance a desire to raise a sufficient amount of capital with the amount of dilution it is willing to take. Presumably, the seed financing round will be the lowest priced of the company’s financing rounds. Also, investors and the company may seek to establish an option plan reserve for future employee options. If so, they will need to negotiate how big a reserve, and how much dilution the founders are willing to take for the initial employee pool.
What are some ways that private companies can provide liquidity to employees and option holders?
Startup employees may want to liquidate some of their stock or options to buy a house, diversify their holdings, or just pay for ordinary living expenses. There are basically two potential sources for the cash: the company can use available cash to buy stock, or investors can buy the stock. While the sources of cash are limited, the possible structures are more varied. A somewhat common structure will have the company buy the employees’ stock, but do so via a financing round raising cash with that specific purpose in mind. Other times an investor will want more stock than the company wants to issue, and the investor will buy part (or all) of its shares directly from the employees.
The overarching consideration is how the company and existing investors want its stock ownership to look after the buyback. For example, a company buying back employee stock and options will, in effect, raise all remaining investors’ ownership on a relative basis. An investor buying the stock will, of course, increase its ownership in the company. The buyback from employees also has the potential to consolidate many small shareholders into a single voting bloc. Companies usually limit the offer to a certain number of shares or percentage of an employee’s holdings to, among other things, keep employees incentivized to increase the value of the stock they continue to hold.
How should our company prepare for a potential M&A exit?
Before entering into a deal with your company, a buyer or investor will want to know exactly in what it’s buying or investing. It will want to know more about your assets, your liabilities, your rights, and especially your obligations. The process for collecting and analyzing that information is referred to as “due diligence.” More often than not, a potential investor or acquiror of your company begins the process by sending you a due diligence request. The due diligence request can take several forms—it can be a list of specific questions and document requests or it can be an exhaustive set of blanket requests set forth on a form the potential investor or acquiror could use in just about any transaction. In the event no request is submitted, you can work with your legal counsel to determine what information should be provided.
Where does all this information come from? The bulk of due diligence review involves lawyers poring over your business’ documents. These documents are typically kept in an online “data room” like Google Drive, Dropbox, or Firmex. These data rooms are usually password protected and access is limited. Your legal counsel and you should work together as early as your incorporation to collect over time the important legal documents of your business so that when a financing or acquisition opportunity arises, the needed diligence documents can quickly be provided in an organized form to a potential investor or acquiror.
What are the advantages and disadvantages of pursuing an IPO?
For companies that meet the requirements for an IPO, going public offers a number of potential advantages, including:
- Potentially higher valuations in a public market than a private exit;
- Help facilitating capital raising from a broad universe of investors to expand the business, fund R&D, or pay off existing debt;
- Availability of liquidity for employees, founders, and early investors who hold company shares;
- Raising the company’s profile, enhanced legitimacy as a counterparty for strategic transactions, and increased brand awareness;
- Attracting talent by offering equity incentives such as employee stock options;
- Creating an acquisition currency by offering company stock to targets;
- Opportunity to borrow money at more attractive rates as a public company;
- Potential dilution of large private shareholders to facilitate management control; and
- Encouraging potential acquirors to accelerate pursuit of an acquisition and increased valuation.
While going public has many advantages, there are certain considerations to take into account such as:
- High costs and a significant time commitment by management and employees associated with the IPO process;
- Post-IPO pressure to increase current earnings and a shift in focus from strategic/long-term investments to short-term earnings to please stockholders;
- High costs associated with compliance requirements such as audit fees and the expense of generating financial reports and establishing accounting oversight committees;
- Public company reporting requirements may result in mandatory disclosure of sensitive information; and
- An inability to control the investor base and exposure to the risk of loss of control through shareholder activism or unsolicited takeovers.
How can our company expand its operations outside the US?
There are a variety of legal structures that you can use to enter a new market, offering flexibility to meet the needs of your organization and the market segment you are pursuing. The various alternatives involve a number of considerations and trade-offs.
Greenfield Investment: A “greenfield” investment is the building of a subsidiary or branch in a foreign jurisdiction from the ground up. Such cross-border expansion offers the highest degree of control, but in exchange for a slower start up.
Mergers & Acquisitions: If a suitable target can be identified, M&A can be the most impactful way of jumpstarting market entry, but can be expensive, complex and depends on successful integration.
Joint Ventures: JVs are a popular means of initial expansion into a new market. A local partner can be instrumental in navigating cultural, regulatory, and business challenges and allows sharing of resources; but shared control can lead to decision-making challenges and potential disputes.
Licensing: A licensing agreement is often an expedient way to get a service or product to a new market in jurisdictions with strong property rights laws and where the product or service is adequately documented and protected in that jurisdiction.
Franchising: A franchise agreement resembles a license agreement in the risk/control profile, but franchises center around a brand and a trademark as opposed to a set of IP rights bound up in a service or product.
Piggyback Marketing: A low-cost strategy where firms with complementary, but non-competing, products share a marketing channel. The arrangement can be mutual—each firm representing the other in their respective domestic markets, or unilateral—with a smaller firm joining with a larger firm already present in the foreign market.
Distributor/Re-Seller Arrangements: Identifying an appropriate distributor or reseller in the foreign market who will buy your products or services and resell them in their territory is a fast and inexpensive option for entering a foreign market.