LegalVision’s Startup Manual is essential reading material for any startup founder looking to launch and grow a successful startup.<\/p>\n <\/div>\n \n\nDownload Now<\/a> <\/section>\n <\/div>\n\n\n\n\n Pure equity financing refers to investors receiving ordinary shares<\/a> in the company in exchange for the company issuing them ordinary shares. These \u201cordinary shares\u201d may have the same rights as the founders\u2019 shares. Alternatively, there may be slight variations in the weight of voting rights or the right to a return of capital upon winding up. <\/p>\n\n\n\n While you may agree to pure equity financing with outside investors, most startup investors structure their investments through alternative means.<\/p>\n<\/div>\n\n\n\n Ordinary shares provide outside investors with the most significant upside potential. This is because shareholders in a profitable business have rights to all the business\u2019s profits after it has paid its lenders and other creditors. <\/p>\n\n\n\n However, ordinary shareholders also face the most risk. If a business does not grow or runs into trouble, it must pay its lenders and preference shareholders back before shareholders receive a return. In the worst-case scenario, shareholders may lose everything if the business fails. <\/p>\n\n\n\n As a result, investors looking to participate in the business’s profits seek downside protection. This might mean that in exchange for financing, investors may require it to be structured using a combination of:<\/p>\n\n\n\n Investors also negotiate favourable shareholders’ agreements to secure their positions better. We will look at each of these structures in further detail below.\u00a0<\/p>\n\n\n\n Preference shares combine elements of debt and equity through the use of fixed dividends. In effect, most preference shares stipulate that the company must pay preference shareholders a fixed percentage of dividends before it can return any money to ordinary shareholders. <\/p>\n\n\n\n Suppose your startup issues 1 million preference shares at \u00a31 per share. Suppose the preference shares state that preference shareholders receive a preferential dividend of 7% of the value of each share held.<\/p>\n \n This means preference shareholders receive \u00a30.07 for every share they hold if a dividend is declared. Therefore, all preference shareholders are guaranteed the first \u00a370,000 in declared dividends. This is an addition to any other dividends preference shareholders receive because they hold ordinary shares.<\/p>\n <\/p>\n<\/div>\n\n\n\n In the context of equity financing, preference shares are less common than convertible loan notes. This is because a company has to pay corporation tax on the declared dividends. Therefore, \u00a31 in declared dividends costs your startup more than \u00a31 it pays in interest. <\/p>\n\n\n\n More startups are using convertible loan notes as a common method to raise capital. Convertible loan notes are a form of hybrid financing. When the company issues the loan notes, its investors are the startup\u2019s creditors. This gives them priority rights of repayment before ordinary and preference shareholders.\u00a0<\/p>\n\n\n\n However, the terms of the convertible loan note usually give the noteholders the right to convert the outstanding debt to ordinary shares in the future. Investors, therefore, have tremendous upside potential while preserving the downside protection from being a financial creditor. <\/p>\n\n\n\n This is because while the loan notes remain unconverted, it is like any other debt. The company must make regular interest payments and repay the loan upon maturity. These interest payments function like dividends. Nevertheless, interest payments are better than dividends because a company\u2019s management chooses when to declare dividends. This means preference or ordinary shareholders never have an automatic right to a dividend. <\/p>\n\n\n\n However, a company must always pay loan interest. If it does not, the startup will have defaulted on its debt. If a company runs into trouble, loan noteholders will have a better right to demand repayment than shareholders. <\/p>\n\n\n\n Even if your startup secures traditional equity financing, the investors will almost certainly negotiate favourable rights. The effect will be to ensure that they have better downside protection than the startup\u2019s founders. Alternatively, loan noteholders or preference shareholders may also seek additional protection. <\/p>\n\n\n\n These protections are usually found in shareholders\u2019 agreements, which are private agreements between the startup\u2019s founders and other investors. Alternatively, or in addition to a shareholders\u2019 agreement, the founders may require the startup to rewrite its articles of association<\/a>.<\/p>\n\n\n\n These sorts of arrangements may have the following effects:<\/p>\n\n\n\nWhat is Equity Financing? <\/h2>\n\n\n\n
Why Do Startup Equity Investors Prefer Non-Traditional Equity?<\/h2>\n\n\n\n
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1. Preference Shares <\/h3>\n\n\n\n
2. Convertible Loan Notes<\/h3>\n\n\n\n
3. Other Specially Negotiated Rights <\/h3>\n\n\n\n
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\n UK Startup Manual<\/div>\n
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