Introduction

Founders of emerging companies often ask us how they should raise their first round of third-party financing. Should they offer agreements for future equity (SAFEs), convertible debt, or should they sell shares?

While of late market practice seems to favour the issuance of convertible instruments (particularly SAFEs in the US and Canada markets), there is no one size fits all answer. Some of the key considerations for founders and investors include:

Size of the fund raising: How much money should be raised up front, and how much should be deferred until a later date (and, if so, what conditions or milestones need to be satisfied in order for such funds to be advanced)?
Valuation: Is it possible to agree on a valuation of the start-up at the point of investment, or should valuation be agreed at a later date?
Control and Dilution: How much control are the founders willing to cede and the investors requesting to have? In addition, what is an acceptable level of dilution for the founders?
Number of investors: How many investors will there be and what impact will this have on the capitalization (cap) table and decision-making? The type of investors that make up the cap table is also an important consideration for the company.

In the four articles of this venture capital series, we discuss some of the most commonly used equity and equity-like instruments used by emerging companies in the UK, the US and Canada. Over the coming weeks, we will discuss:

Up this week: priced equity.


Priced Equity


Like any financial decision, priced equity rounds are both straightforward and challenging at the same time.

Straightforward: A priced equity round can be straightforward, if, on a first round of financing, the company issues already authorized ordinary shares (UK) or shares of common stock (US and Canada) or preferred shares to investors at an agreed price per share.
Challenging: Founders and investors have to agree on:

Size of the fund raising: Since the negotiation of both share terms and investor documents can be expensive and time-consuming, the size of the raise will need to justify the added time and expense.
Valuation: The valuation of the company is mutually agreed at the time of signing to determine the size of stake that the investment will purchase.

Advantages: value of the company and price per share is set, generally no convertible securities on the cap table
Considerations: valuation is difficult to assess at an early stage of growth, which may result in overpaying or underpaying for equity at a point in time when it is not clear how the start-up will fare

Control (shareholder rights): founders and investors should bear in mind that, once a shareholder, always a shareholder. Investor or shareholder rights agreements clarify rights as between the company, the founders and the investors in their capacity as shareholders

Advantages: investor documents are entered into at the time of the investment, which clarify rights going forward, including, to some extent, with respect to future funding rounds
Considerations: negotiating investor documents is expensive and time-consuming at a time when the emerging company needs the funds to develop its technology or product
Dilution: The acquisition of equity by investors will result in dilution of the founders’ stake. The amount of such dilution will depend on the agreed pre-money valuation and the size of the investment. Whilst founders will generally accept dilution, they will still want to retain control and the ability to manage the company going forward with little obstruction from the investors

Share Class: Investors may purchase common shares or ordinary shares from treasury (which are likely the type of shares held by founders) but are more likely to require preferred shares which, on exit, take out their investment first before common or ordinary shares see a return

Advantages:  on a common or ordinary share issuance, investors sit alongside founder shares, with no enhanced preference rights or downside protection
Considerations: the negotiation of preferred share terms can be expensive and time-consuming and will give investors enhanced preference rights and downside protection

Ranking: On a liquidation of the company, an equity investment would rank behind debt structures (and any more senior securities). 



Quick Summary

Funding structure

Time consuming / long form documents

Valuation of company or price per share decided at a later date?

Repayable?

Maturity date?

Priced Equity Round

Yes

No

No

No