A company that is poised for growth often will look to outside equity investors to provide funding for the growth initiative.  Several clients recently completed capital raise transactions, which provides a good opportunity to examine several common issues that arise in such transactions.  This entry will constitute one entry of a two-part series on common issues in capital raise transactions.

A baseline issue that arises is how to structure the basic form of the equity instrument that the investor or investors will receive in exchange for their investment.  Three alternatives include common stock (or units), convertible preferred stock (or units) and participating preferred stock (or units).

Common Stock or Units.  Common stock or units is the simplest form of equity to describe.  The concept behind common stock or units is that the investor(s) joins the existing shareholders or members in receiving equity that has the same rights and privileges as the currently outstanding common shares or units on a per share basis.  The key for the parties is to agree upon a pre-money valuation of the company.  For example, if a company with a pre-money valuation of $3 million issues common stock to an investor for $1 million, the investor would be entitled to receive 25% of the common shares of the company on a fully-diluted basis.

Investors are often hesitant to accept common stock for their contribution of cash to a company.  If the company fails to increase in value after spending the investment proceeds and is eventually sold for its pre-money value, the pre-investment owners would share in the proceeds on a pro rata basis and the investors would experience a loss of a portion of their investment.  In the example above, a future sale of the company for $3 million would result in a liquidating payment to the investor of $750,000, resulting in a loss on the investment of $250,000.  Meanwhile, the pre-investment shareholders would receive $2,250,000 in cash on the distribution.

Convertible Preferred Stock or Units.  Convertible preferred stock or units provide that the investor(s) will receive the protection of a return of its cash plus a preferred dividend prior to any cash being distributed to the existing shareholders.  The investor(s) also receives the option to convert the preferred shares into common shares if the payout would be greater.

Consider the example above, but assume that the investor receives pure convertible preferred stock in exchange for its $1 million investment.  In the event of a future sale for $3 million, the investor will receive the first $1 million of cash, plus an annual preferred dividend calculated as a percentage of the outstanding investment.  The balance of the cash would be distributed to the pre-investment shareholders.  In this case, the investor's contributed capital is protected through the preference and is compensated for the investment with the preferred dividend.  If the company were to be sold for $10 million, the investor would convert the shares into common shares and receive 25%, or $2.5 million, instead of $1 million plus the preferred dividend (unless the dividend would produce more than $1.5 million).

Participating Preferred Stock or Units.  Participating preferred stock or units provide that the investor(s) will receive: (1) the protection of a preferred return; (2) the compensation of a preferred dividend; and (3) up-side participation in future appreciation and earnings of the company.  In the example above with a $10 million sale of the company, the investor would receive its $1 million investment, the preferred dividend and would share in 25% of the balance of the proceeds to be distributed.

The optimal form of equity investment will depend of the parties' negotiations and the facts relating to the company, including the company's pre-money valuation and plans for post-investment growth.  The existing shareholders must be comfortable with the ownership dilution that they will experience as a result of the investment and the investors must be comfortable with the risk and reward opportunity available to them.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.