As a company gets into initial fund-raising efforts, it may find that it either needs to or prefers to raise money from “angel” investors rather than through traditional venture capital firms.
Type of Security Sold
Angels will typically be expecting one of two types of securities in exchange for their money - preferred shares or debt convertible into preferred shares. Preferred shares give the holder certain preferences and privileges relative to the holders of common shares.
Conversion and Anti-Dilution Protection
Preferred shares typically are convertible into common shares. Usually the conversion ratio at the time the preferred shares are issued is one-to-one - that is the preferred shareholder may convert each share of preferred stock into one share of common stock at any time. The preferred shareholder typically has protection that results in an increase in the conversion ratio in the event that the company sells any of its shares at below the price paid for it by the preferred shareholder - so-called anti-dilution protection.
The “conversion price” is a key concept for understanding the mechanics of anti-dilution protection. Upon issuance, preferred shares typically convert into a number of shares equal to the original purchase price per share of the preferred stock divided by the conversion price. Before any adjustment, the conversion price usually equals the purchase price, and therefore the original conversion rate is one share for one share. The conversion price, and as a result the number of shares into which each preferred shares may be converted, changes when the shares are sold at a price below the price per share paid by the preferred shareholder and an anti-dilution adjustment results. The calculation of the “new conversion price” depends on the nature of the anti-dilution protection.
The most favourable kind of anti-dilution protection for a preferred shareholder is called “full ratchet” protection. In full ratchet protection, the “conversion price” equals the most recent price per share of common shares sold by the company. To take a simple example, assume there were 300 shares of common shares held by the founders on January 1, 2014. Assume also that the company sold 100 preferred shares to investors at $1 per share on that date, convertible one-to-one into 100 common shares, or 25 percent of all common shares. Then assume that 100 common shares were subsequently sold at 50 cents per share. The new conversion ratio would be $1 divided by fifty cents, or two, and the preferred shares would then be convertible into 200 common shares, which on an as converted basis would equal 33 percent of all common shares.
Typically full ratchet anti-dilution protection is applied without regard to how many shares are subsequently sold at the lower price. In the above example, if just one common share was sold at 50 cents, the result would have been much more favourable to the preferred stockholder, who would still have the benefit of the two-to-one conversion ratio. With that ratio, the preferred shareholder would then own shares convertible into 200 out of a total of 501 shares of common shares, or nearly 40 percent of the common shares!
A type of anti-dilution protection more favourable to the company is called “weighted average” protection. Weighted average protection gives effect to the dilutive effect that the subsequent issuance has, and typically results in a much less dramatic change in the conversion ratio.
Issues Associated with Preferred Shares
Although preferred shares are a widely accepted security for early stage financing, relative to convertible notes, they have certain shortcomings.
Fixing Fair Market Value
Issuing preferred stock to angel investors requires the company and the prospective investors to establish a pre-money valuation of the company without the benefit of someone in the business of determining such valuations (such as a VC). The company and the angel investors might not be entirely comfortable placing a valuation on the company at this stage. They might fear that the valuation will turn out to be substantially different (even after taking into account the development of the company between the two rounds of financing) than that established in the next, VC round of financing.
Once a series of preferred shares have been issued, the company would typically need the consent of the holders of the preferred to approve future issuance of preferred shares, including the issuance of shares to VCs. This can occasionally result in problems with the angels, who might, for example, disagree with the valuation being offered to the VCs.
Instead of issuing preferred stock to angels, early stage companies may issue notes that convert into whatever the company issues in the future, presumably to VCs, but at a discount. The single most attractive benefit of this is that the valuation of the company can be deferred until the VCs, who are generally professional investors, make their investment. The tax consequences of an issuance of convertible debt may be more complicated than those associated with preferred stock financing, and should be considered carefully by the company and the investors. The basic terms of a convertible note offering are discussed below.
The security sold in a convertible debt offering is a promissory note that automatically converts into preferred shares at some future time. The intent of the company and investors is that the preferred shares into which the note will convert will be whatever is negotiated between the company and the VCs in the first venture financing - typically Series A Preferred Shares. The debt typically converts at some discount - usually in the 15 percent to 30 percent range from the price paid by the VC investors. Companies occasionally try to come up with complicated discount matrixes in which the discount may vary as a function of:
• The VC valuation. (The higher the valuation, the steeper the discount in order to align the interests of the note holder and the company); and
• The duration that elapses between the time of the sale of the convertible note and the closing of the VC round. (The longer the duration, the steeper the discount, on the theory that the venture must have been riskier at such an early stage).
These complicated structures are something to avoid. They are very difficult to explain and they confuse investors. Convertible debt financing seem to work best when they are kept clean and simple.
In the event that there is no subsequent VC financing within a certain period of time, the notes convert (usually automatically, but sometimes at the option of either the company or the investors) into a pre-defined class of preferred stock, at a pre-determined pre-money valuation. This type of default conversion allows the company to remove the debt from its books.