Part 1 of this Primer series talked about the history and limited liability of corporations. Part 2 dove into the corporate hierarchy. This post will dive into investment structures.
- Corporate Structures
- Grants, debt, and equity(this post)
- Daily, monthly, … annual management
All the young companies I meet want to raise money. I do a lot of work in Africa and thus do meet quite a few companies that receive grants, but those are generally small amounts of money and while they look to be “free” money, they generally come with a large amounts of “strings” attached.
The more common forms of capital for young companies are debt and equity.
Debt and loans are synonymous. When an investor provides debt, they are lending you their money. You in turn are promising to pay back that “principal” plus “interest” for the use of their money. For a specified amount a time. With a specified schedule for repayments.
Of all those details, the most important to understand before you sign the loan is the repayment schedule. If the lender did not provide a spreadsheet showing the date and size of every repayment, ask for it.
Before you sign the loan, compare that schedule with your own expected cashflows. If they don’t line up, e.g. if you have a seasonal business and one repayment is due a month or two before you’ll have the cash to make the payment, then ask to change the schedule.
What you’ll find if you don’t do that is a bad relationship with a lender. Their expectation is that you’ll make every payment listed in the payment reschedule, on time and in full. They’ll get upset anytime after you sign the loan when you ask for a change, as they based their terms on you following the agreed (and signed) contract.
Equity looks simpler than debt. Investors give you money in exchange for shares, and don’t expect to get repaid from you. That does seem simpler on the surface, but underneath the reality is at least as complex as debt, if not more complex.
First and foremost, the investors do expect to be repaid. They expect a lot more money to back than they provided. But yes, typically they don’t expect this from you, but instead from some future acquirer of your company.
In exchange for this unknown timeline and for the opportunity of losing all their money, investors expect (if not demand) some protection of their investment. This typically takes the form of “preferred” shares. These are shares issued by the corporation, by the consent of the existing shareholders, at the request of the Board, and usually documented in an amended Articles of Incorporation (a.k.a. Constitution) that is filed with the government where the company is incorporated.
Sometimes the “preferences” attached to those shares are also documented in the Articles of Incorporation or the Bylaws or a separate Shareholder Agreement, and often they are also documented in a Preferred Shareholder Purchase Agreement.
Investopedia and Wikipedia have multiple articles describing the wide variety of preferences that early-stage investors often include in their preferred shares. There is no single set of terms used by every investor. But rarely are any of these terms onerous. They all exist to add some protection to the investors, especially around the value of the investors’ shares during an acquisition.
The most common preference is the “liquidation preference” and it only applies if the company is acquired. It exists to prevent the case where the investor would get back less money than they provided, even if the company is acquired for more money than the investor provided.
The second most common preference is the right by the investor to assign one or two seats on the Board of Directors. This ensures that the investors’ get a vote in Board-level decisions.
Third are a set of protective covenants. This looks like a list of decisions that the investor must agree to that can’t be made by the CEO or the Board or even the rest of the shareholders without also having this investor agree. The list usually includes any big expenditures, any new debt, any new shares, and the acquisition of the company. This may feel onerous to a founder/CEO, but put yourself in the shoes of the investor, who otherwise typically just has a minority of votes on the Board and a minority of votes by the shareholders, but who often provided the majority of cash, or at least the most recent and thus most critical tranche of capital.