Since most investors willing to accept the high risks of investment in a startup and wish to obtain the rewards derived from equity ownership, a common method of initial financing is through the sale of an equity security: common shares, preferred shares or convertible preferred shares. Since the common shares usually carry the full right to participate in earnings and thus increases proportionately in value as the startup grows in earnings and net worth, common shares are the usual method of investment for the founders and sometimes the initial outside investors.
On the other hand, investors may wish to own a security senior to the common shares insofar as liquidation and dividend preferences are concerned. Thus, if the company is liquidated or re-capitalized in a manner that requires a payment to the preferred equal to its liquidation preference, the aggregate amount of the dividends would be included in such par value and/or liquidation preference.
Convertible Preferred Shares
Often preferred shares are sold to the investors with the right to convert such preferred shares into common shares. In addition to being commonly used for venture capital investors, convertible preferred shares might be used where there is a substantial difference in the price per share of equity securities issued to the founders as compared to that sold to the investors. Instead of issuing common shares, for example, at $10.00 a share to the founders, and $50.00 a share to the outside investors (which bargain element of $40.00 a share might be viewed as taxable compensation to the founders for services rendered), the startup could issue convertible preferred shares to the outside investors, convertible at $50.00 per share or, even up to $100.00 per share, without creating adverse tax consequences to the founders for having received common shares at $10.00 per share. Also, if the preferred is convertible, the conversion price, when divided into the par value or liquidation preference, including the dividends, will provide the convertible preferred shareholder with additional common shares equal to the dollar amount of the dividends divided by the conversion price.
Hybrid Preferred Shares
These are preferred shares with provisions more common to debt securities, as for example, a provision allowing the holder to exchange the preferred into debentures, which are in turn convertible into common shares.
Since most risk investors wish to have an equity interest, convertible debentures offer investors a senior security with preferences on liquidation, payment of interest and other rights senior to common and preferred shares, while offering the investor the right to convert such debentures into common shares at his or her election at a time when the conversion equity security is more valuable than the principal amount of the convertible debentures. Convertible debentures are the ideal structure for angel investments with the following provisions: The convertible notes would compulsory convert into a qualifying venture capital round, with a discount, and a default provision allowing the debentures to be converted into common or series A preferred at a multiple of earnings or revenues, with a floor and/or a cap for the valuation amount, at maturity or upon a liquidity event. Such a structure would tend to protect the angel investors from being crammed down as they would be if they held a simple series A preferred invested at a higher valuation.
Debentures With Warrants
Debentures with detachable warrants offer the same election to the holder, except that the warrants may have a longer term than the debentures so that investor could obtain repayment of the debentures but continue to hold warrants to purchase common shares after the maturity of the debentures. If the warrants are coterminous with the debentures, there is no real difference in such a security as compared with convertible debentures unless the debentures with warrants are prepaid before the warrants expire.