One of the cardinal aspects to consider when building up a company is the management of its ownership. Over numerous investment rounds, founders’ equity is diluted and new owners are introduced into the company. Therefore, equity mismanagement might cause the founders to lose control of their own company.
Good equity management is also essential to attract potential investors. Ideas, business model, financial plans, expansions and other elements won’t be taken into consideration by investors if the cap table is not polished and well-strategized. Equity management has always been a daunting task because it is a game of balance among ownership distribution, profitability, growth and cooperation with shareholders.
Definition of Cap table
A capitalization table is a document that lists all the startup’s securities, their owners and the prices paid by those parties to acquire those securities. Moreover, it is also used to calculate the percentage of ownership of a project or business. Besides being a document that helps to keep track of ownership in the entity, it is also used to calculate dilution scenarios in the occurrence of capital raise activities.
Overview of equity and financing methods
Before addressing the numerous clauses and concepts in this field, let’s briefly define what is meant by equity. Equity, from a financial perspective, can be defined as the residual claim on the company value after that all the debtholders have been satisfied. This term is also used as a proxy for ownership and referred to as financial interest.
Generally speaking, there are two main categories of equity: common equity and preferred equity. The main difference between them concerns the type and quantity of rights which includes, but not limits to, voting rights, dividend rights, conversion rates, dilution clauses.
The first step that startups can take to protect or manage their equity in an efficient manner concerns recurring to the right type of financing solution. We can classify all the types of financing into 3 categories: Pure equity, Hybrid and Pure debt. Startups won’t be using pure debt securities given their loss-making nature. Given the lack of market presence and high R&D costs, startups’ life is usually characterized by negative returns over the first years of operations. Moreover, since startups nowadays don’t possess physical assets, they are not able to provide collaterals for debt financing. This leaves us with 2 methods to raise capital: pure equity and Hybrid securities.
Pure equity, which we can refer to as common or preferred stocks, will only be owned by founders up to the point the company goes public or decides to reach out to private investors. It is highly unlikely that startups can raise money through common stocks since VCs, family offices and other institutional investors would only provide financing over preferred stocks. The main reason as to why this is so essential is about the preferential treatments that this type of security bears.
The followings rights consist of the main features investors are interested in when asking for preferred ownership:
Each equity holder has the right to receive dividends once the board authorizes their distribution. Preferred stockholders will receive the dividend first and the remaining part will be divided among common shareholders which are employees and founders.
Upon the winding up of the startup, the first money out of the selling process will go to preferred stockholders. Might happen that if the company is asset-heavy or has high-value IP, the early-stage investors might get back their investments or even multiply it. Indeed, if the assets under liquidation exceed the preference amount, preferred stockholders are allowed to participate together with common equity holders, a process called participating preferred equity. However, investors do not ask for this clause as a means to make money in case of winding up but as a protection for their investment against startup failure.
Usually, investors ask for the possibility to elect one or more seats of the BOD together with the possibility to have special protective provisions. This mechanism is built up to provide investors with some degree of control over the startup management to prevent the company from implementing certain decisions without the approval of the preferred stockholders.
This clause gives investors the possibility to sell their shares back to the company in case there is no exit within a set timeline. This clause is protective by nature and increases the liquidity of the investment. It allows investors to realize their return or claw back the investment. Investors would never allocate capital in the first place if liquidity is not guaranteed.
These clauses are more uncommon since dilution is a normal process over the life of a startup. However, anti-dilution clauses are put in place to avoid extreme and/or opportunistic behaviors by startups. For example, issuing to the founders a great number of shares to dilute current investors or raise capital at a valuation lower than the previous round to reduce the equity value of current shareholders. Besides extreme cases, no general anti-dilution provisions are usually applied.
Drag-along and tag-along rights
Drag-along clauses protect the interest of the major shareholders by giving them the opportunity to drag the other shareholders into selling their shares to a new buyer. Whereas tag-along rights give the minority shareholders the possibility to join the majority shareholders in case a potential buyer wants to acquire shares.
This clause gives the opportunity to current shareholders to buy the shares of an exiting equity holder. The main reason for this clause is to avoid the entry of an unwanted shareholder. The acquisition can happen in proportion to their existing shareholdings and at a price that is equal to or higher than the price offered to the potential buyer.
The last category concerns hybrid instruments. The go-to security to collect capital in a hybrid format for startups is convertible bonds. A convertible bond is a hybrid security that is composed of debt and equity features. These securities contain a normal bond with an option to buy the company’s underlying equity. Moreover, they are useful in case the company doesn’t want to incur into dilutive scenarios and avoid any type of valuation process which would consume time and resources. These financing tools are also usually issued as a bond with a principal amount and a semi-annual interest rate for its bond side.
Concerning its equity side, this security has a conversion rate that allows bondholders to convert the bond into a specific number of shares. Discount rates and valuation cap are usually also attached to the bond. In this fashion, investors have minimum ownership granted if the company valuation increases above a pre-set valuation.
Besides convertible bonds, startups can also utilize bonds with warranties even though they are less common. This is a hybrid instrument that is leaning more towards the debt family. Generally speaking, since startups can’t provide actual warranties to the bondholders, they obtain the possibility to acquire ownership in the company over the next financial round by buying more shares at a discounted price.
Other forms of financing are available for startups such as friends, family and fools (FFF financing), crowdfunding, government funding or prizes from startup competitions just to name a few. The methodology through which raising capital is up to the startup and its plan for the future
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