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If you intend to raise equity financing for your startup, you are probably curious about how these financings are structured. Most professional startup investors do not inject capital in exchange for ordinary shares. Instead, investors will likely expect a mixture of debt and preference shares. This article will explain how startup equity financings are structured.
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What is Equity Financing?
Pure equity financing refers to investors receiving ordinary shares in the company in exchange for the company issuing them ordinary shares. These “ordinary shares” may have the same rights as the founders’ shares. Alternatively, there may be slight variations in the weight of voting rights or the right to a return of capital upon winding up.
Why Do Startup Equity Investors Prefer Non-Traditional Equity?
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’s profits after it has paid its lenders and other creditors.
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.
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:
- preference shares, which pay investors fixed dividends ahead of ordinary shareholders;
- convertible loan notes, which gives the investors a later right to convert some or all of the notes to ordinary shares in the future; and
- ordinary shares subject to special conditions.
Investors also negotiate favourable shareholders agreements to secure their positions better. We will look at each of these structures in further detail below.
1. Preference Shares
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.
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, £1 in declared dividends costs your startup more than £1 it pays in interest.
2. Convertible Loan Notes
More startups are using convertible loan notes as a common method to finance their capital raising. Convertible loan notes are a form of hybrid financing. When the company issues the loan notes, its investors are the startup’s creditors. This gives them priority rights of repayment before ordinary and preference shareholders.
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.
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’s management chooses when to declare dividends. This means preference or ordinary shareholders never have an automatic right to a dividend.
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.
3. Other Specially Negotiated Rights
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’s founders. Alternatively, loan noteholders or preference shareholders may also seek additional protection.
These protections are usually found in shareholders’ agreements, which are private agreements between the startup’s founders and other investors. Alternatively, or in addition to a shareholders’ agreement, the founders may require the startup to rewrite its articles of association.
These sorts of arrangements may have the following effects:
- investors can appoint or remove board members;
- investors obtain the benefit of discounted valuations for future financing rounds;
- existing shareholders must participate in future financing rounds; and
- the company must offer new investors the right to purchase future shares ahead of outside investors.
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Key Takeaways
Startup equity financing is structured in various ways to provide investors with upside potential while mitigating risk. While pure equity financing involves issuing ordinary shares to investors, most investors prefer alternative structures. This might mean that in exchange for financing, investors may require it to be structured using a combination of:
- preference shares, which pay investors fixed dividends ahead of ordinary shareholders;
- convertible loan notes, which gives the investors a later right to convert some or all of the notes to ordinary shares in the future; and
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Frequently Asked Questions
Startup investors tend to avoid becoming ordinary shareholders because ordinary shareholders bear the most risk while offering the most upside potential. Investors structure the financing through preference shares, convertible loan notes, and other downside protection to mitigate the risk.
Investors often negotiate additional rights to protect their investments in startups. These rights are typically contained in shareholders’ agreements or amended articles of association. Some examples of these negotiated rights include the ability to appoint or remove board members, access to discounted valuations for future financing rounds, mandatory participation of existing shareholders in future rounds, and offering new investors the right to purchase shares before outside investors. These measures ensure better downside protection and control for investors.
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