Private Equity and Venture Capital Financing Structures
— By Joseph B. LaRocco
There are several structures that Private Equity funds (also known as venture capital funds) use when they give the green light to fund a company. The basic structures for private companies are common stock and convertible preferred stock. These structures usually contain an anti-dilution provision, so the lead investor doesn’t start out purchasing say 40% of your company for $4,000,000 and then end up with only 5% because you dilute his stock position with subsequent financing rounds.
1. A Common Stock
Common Stock funding structures are pretty simple. The company and investor agree on a dollar amount to be funded and the percentage of stock, also called the equity position, the investor will receive. Most private companies, however, will find they have very little bargaining power with private equity funds. Usually, it is the money that dictates the terms of the financing structure. Part of the reason is that if you don’t like the deal terms you don’t have to take the money. Another reason is that Private Equity firms know which structures work for them and which ones don’t.
2. Preferred Stock
Private Equity firms use Preferred Stock structures the most. The Preferred Stock is convertible into Common Stock, usually anytime at the option of the holder. The convertible Preferred Stock can be convertible into either a fixed number of shares of Common Stock or a certain percentage of the Common Stock outstanding on a future date. Most Preferred structures also have a built in dividend. The dividend could range from 6% to 12%. This allows the Private Equity firm to receive some return on its investment before the Exit Strategy is used.
3. Debt Financing with an Equity Kicker
Another possible structure, if your company is already operating and profitable, or close to it, is debt financing with an equity kicker. Although this structure will be difficult to get from a Private Equity firm, it is worth exploring.
You are more likely to get this kind of financing from Angel investors. Maybe even family and friends would even provide this type of financing if the amount is not too large and you have good cashflow. Say you feel $200,000 can get you over the hurdle and profitable. Structure the $200,000 as a 3 to 5 year loan and give the investor 10% of your company in common stock. The number of shares and percentage you give the investor/lender is based on the size of the loan and the value of your company. I only used 10% as an example.
4. Convertible Debt
Some investors will structure their funding as a convertible note or convertible debenture. This security is convertible at their option into Common Stock of the company. Usually, they will not convert until the Common Stock is trading and they can get out of their position.
Smart investors will also use what is called a “4.9% Clause”. I have used this many times for my private investor and hedge fund clients. Certain securities laws require investors that own 5% of more to make certain filings with the U.S. Securities & Exchange Commission (SEC). This allows investors to get around that requirement since the 4.9% Clause does not allow the investor to own more than 4.9% of the company at one point in time.
Also, if an investor owns more than 10% of a company they are deemed an “Affiliate” and a number of other rules kick in. An investor can remain more nimble with his investment without having to comply with these regulations. The 4.9% Clause also benefits the Management Team. If the investor can’t own more than 4.9% of the company it is very difficult for the investor to take over the company or make management changes.
5. Reverse Mergers
A Reverse Merger is when an existing private company merges into an existing public company with a stock symbol, which is usually a “shell company”. A shell company is a public company that although still in existence and having a stock symbol, is no longer operating a business. The business plan obviously failed and that company went out of business, but the public entity or shell still exists. This is the key ingredient in the Reverse Merger.
Joseph B. LaRocco has represented and advised private and public companies concerning the internet, securities and investments. He also has extensive experience advising hedge funds on numerous trading and investment strategies. Mr. LaRocco is an attorney who practices law in New Canaan, CT, and is currently General Counsel and a Director of NetSky Holdings, Inc. (Symbol: NKYH).
Watch out our full video “How does Private Equity Differ From Venture Capital?“
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