Generally, capital raised for new businesses takes one of two structures: debt or equity. Debt capital is raised in the form of a loan or promissory note to be paid back at some point in the future usually with interest. Conversely, equity is issued as stock in a company, representing a form of ownership with no defined maturity date. While hybrid financial products exist, they are outside the scope of this writing.
Investing in Debt
In a debt financing, there are two parties to the transaction, the debtor and the creditor. In exchange for capital, the company (debtor) will issue a loan or promissory note to the investor (creditor). The documents governing and representing the loan will outline the complete provisions of the transaction, however, there are a handful of key terms investors should understand before investing in a debt product.
Principal: amount of capital originally invested in a debt product
Interest rate: the percentage rate, usually quoted annually, at which interest is paid by the debtor to the creditor while the loan is outstanding
Interest: the cash paid to the creditor by the debtor until loan maturity calculated as (interest rate ÷ payment frequency) * outstanding principal balance
Amortization: the act of paying the principal balance over time between the issuance of the loan and loan maturity
Maturity: the date at which the outstanding principal balance must be paid and returned to a creditor in full
Default: failure to make timely payments of principal or interest
An attractive aspect of debt financing is current income generated through interest payments over the life of the loan. Typically, interest is paid to creditors on a quarterly or monthly basis providing cash flow to investors while the principal is outstanding. Principal can be amortized, meaning paid in installments over the life of the loan, or paid in full at maturity, known as a bullet maturity.
Figure 1 is a depiction of a typical amortizing cash flow stream for a three-year $500,000 loan with an interest rate of 5% and a quarterly payment frequency. Each total payment (interest plus principal) is equal while the principal balance is paid over time. This cash flow structure is similar to a mortgage or auto loan.
Figure 2 illustrates a bullet maturity structure, showing interest only payments throughout the loan until maturity. This structure is commonly used by corporations as interest, a tax-deductible expense, is maximized. The transaction terms in Figure 1 are assumed for Figure 2.
Another advantage to debt from an investor’s vantage point is security. In most cases, debt sits at the very top of the capital structure and in scenarios of liquidation or bankruptcy is first to be repaid with the assets of the debtor. Debt transactions can also include security features tied to certain assets of a debtor providing an even greater level of security to creditors in the event of default or bankruptcy. Given the seniority of debt within the capital structure, the rate of return for debt investments is typically lower than its equity investment counterpart.
Debt can be (and often is) a very complex financing structure. The discussion above barely scratches the surface of the mechanics of a debt investment. Other important facets of debt investments include any covenants required of the debtor, events of default, recourse, prepayment provisions, fraudulent conveyance, underlying security, and many others. Additionally, debt can take on multiple structures including but not limited to senior secured, mortgage, unsecured, convertible, zero-coupon, payment-in-kind, revolvers, floating-rate, and structured products among countless others. The most common debt product in a venture capital context is a convertible note, the properties of which we discuss extensively in our Convertible Note Whitepaper.
In summary, debt investments can provide investors with current income and security not afforded to equity investors. Given the relative position in the capital structure and security surrounding debt investments, the rate of return for creditors of a given company is typically lower than the company’s equity holders. Moreover, debt investments have a finite life and an investor’s relationship with the company ends upon maturity and repayment of the debt capping the potential upside afforded to equity investments.
Risks of Investing in Debt
There are a number of risks involved in investing in debt instruments. The four primary risks are liquidity, inflation, interest rate, and default.
Liquidity risk: is a financial risk that can occur when a given financial asset, security, or commodity cannot be traded quickly enough in the market to prevent or minimize a loss.
Inflation risk: is the chance that cash flow from an investment won’t be worth as much in the future because of changes in purchasing power due to inflation.
Interest rate risk: is the risk that an investment’s value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve, or in any other interest rate relationship.
Default risk: is the risk that a company may be unable to make the required payments of principal or interest and may result in the loss of some or all of the principal invested.
Investing in Equity
When an investor makes an equity investment, he or she is issued shares in exchange for capital and becomes a shareholder, or owner, of the company. There are two types of equity securities routinely used in financing new businesses: preferred and common. As owners of a company, both common and preferred shareholders have voting rights related to the board of directors, ultimately influencing control over the company’s activities and direction.
While the equity portion of a publicly traded company’s capital structure will more heavily lean towards common, venture capital investors typically utilize a preferred equity structure due to certain rights and privileges afforded preferred shareholders, most notably a liquidation preference. Prior to making an investment in preferred equity it’s important to understand the additional features attached to preferred shares.
Preferred shareholders are typically entitled to a dividend, if and when declared by the board of directors, before any dividends are paid to common shareholders. Dividends for preferred shareholders are established at a percent of the principal, similar to an interest paying debt product, usually between 4% and 10% annually.
In the event of a liquidation or acquisition, preferred shareholders may receive back at least the original investment value and, often, a multiple thereof before any distributions are made to common shareholders. A liquidation preference of 1x is typical, although a preference of 3x is not uncommon. In addition to a multiple preference, some preferred equity structures include participating provisions whereby preferred shareholders will receive a multiple of the original purchase price and then participate ratably on an as-converted basis in the remaining proceeds of the liquidity event. As-converted simply refers to the preferred shareholders participation if each preferred share was converted into a common share.
Most always, preferred shares are convertible into common shares at the option of the preferred shareholder at a 1:1 conversion ratio. There are several instances where conversion into common could be advantageous to a preferred shareholder including an acquisition of the company at a value well exceeding the liquidation preferences, where common shareholders receive a greater amount of the acquisition proceeds. Some preferred structures include automatic conversion provisions where if the company is executing a Qualified Initial Public Offering above a certain valuation threshold, preferred shares are converted into common to enable selling in the secondary market following a public offering.
Pay-to-play provisions are used to incentivize early investors to participate in future financing rounds. Essentially, if an investor subject to a pay-to-play provision does not participate in a future financing round of the company, the investor could lose certain rights and privileges associated with preferred stock. In a stricter construct, if an investor does not participate in his or her pro rata participation in a future financing round, the preferred stock could be converted to common. Pay-to-play provisions can be helpful to both entrepreneurs and investors.
Board of Directors
In a preferred equity investment, investors will negotiate for the ability to join the board of directors in order to influence company direction and serve as a proxy for preferred shareholders. By taking a board seat, investors can actively monitor activities of the company, ensuring the company’s actions are in the best interest of investors and employees.
While additional terms are found in a typical preferred equity financing, the few listed above serve as the primary reasoning behind venture capital investors pursuing a preferred stock structure when making an equity investment. As implied earlier, another advantage to preferred stock is its seniority to common stock.
Common stock ranks as the lowest priority in a company’s capital structure, and consequently, is often the class of stock held by company founders and employees. While common stockholders are afforded certain voting rights, economic participation in the event of a liquidity event or declaration of dividends is subordinate to creditor and preferred shareholder cash distributions. Given its relative rank in the capital structure, common stockholders often assume the most risk of any investor class in a given company, while potentially reaping the greatest rewards.
Risks of Investing in Equity
The primary risk involved with investing in equity investments is the loss of part or all of investments and principal. There is no guarantee of dividends or return on investment. Furthermore, share prices are subject to fluctuation.
While debt investments can provide a stable cash flow stream and security for investors, participation in value expansion, and return on investment, is capped at the interest and principal payments outlined in the financing documents. By taking on more risk as an equity investor, one can economically participate in a company’s value creation activities providing an enhanced return profile relative to a company’s debt offerings. Given this dynamic, several early stage venture capital investors utilize a convertible note structure, a financial product that begins as a debt instrument and converts into equity at a future date. To learn more about the convertible debt financing structure, download our Convertible Note White Paper.
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