Private Placement Offering Terms for Early Stage Companies
Author: Peter Weinberg
Author: Peter Weinberg
Although there are no hard rules with respect to financing your start-up, in our experience we generally see clients successfully raise their first round of capital through either convertible debt or preferred equity. Private Placement for Convertible Debt This is typically the easier of the two structures to negotiate and execute. The investment is in the form of a promissory note that converts into equity on the terms of a qualified financing in the future. The qualified financing is defined by having a minimum amount for example $1.5 million of total investment over a specified period of time. The note will either convert at a discount to the price of the qualified financing (usually in the 20% to 40% range), will have warrant coverage (usually in the 20% to 40% range), or both. The discount and/or warrant coverage gives the investors some additional ownership in exchange for taking on early risk. Advantages: The exercise of establishing a valuation is delayed until the next equity round. Many early- stage investors and entrepreneurs agree that setting a valuation at a time when the business model remains largely unproven is a tenuous exercise at best. The convertible debt instrument provides priority over stockholders in the event of a liquidation of the company. The conversion feature provides an opportunity for the note holder to convert into equity and share in the upside. The ability to convert principal and interest (at a discount) may provide the note holder with an opportunity to purchase a greater share of the company than if the investor had simply entered into a straight equity purchase. Unless converted, the investment remains a note payable at maturity in the event that the right circumstances for conversion do not materialize. Disadvantages: In the event the triggers for conversion do not occur, the debt will become due and payable upon maturity. This timing can be a significant hardship for the company. Misalignment of interest the company wants the price of the next round (qualifying event) to be as high as possible, while the note holder wants the price to be as low as possible (since the conversion price of their note will be based on the price of the next round). Private Placement for Preferred Equity Also known as a light Series A or a Series AA round. This is typically preferred stock that is similar to what later stage venture capital demands, but usually with lighter terms due to the relatively lower valuation. The terms that are generally agreed to be fair to both sides of the transaction include liquidation preference, right to convert to common stock, automatic conversion, protective provisions and right to maintain proportionate ownership (anti-dilution). Advantages: Unlike debt, there is no obligation to repay the investment amount at some future date. The companys ability to take on debt in the future, as it becomes creditworthy, will not be impeded since no preexisting debt exists. By purchasing equity, the investor shares in the upside success of the company. Disadvantages: As discussed, it can be challenging for the company and the investor to conduct an accurate valuation of the company at the time of the financing. There is a significant risk that the company will misprice its valuation, which can have a negative effect in the future. Equity ownership is subject to downside risk, and its possible for the investor to lose his entire investment. The investor will likely be diluted over time (or at least be required to contribute additional capital to protect his ownership percentage). About the Author:
Elevate provides capital formation and consulting services to entrepreneurial stage and emerging growth companies. Learn more about our custom
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