Basic Securities and Structural Elements in a Venture Backed Capital Structure

On May 30, 2007 I published a post called How to Value Your Angel Round on how to think through valuation for your first external financing. In that post, I promised that the next post would be a basic explanation of capital structure concepts for start-ups. Well, I lied. Although we've talked around some of the issues from time to time, we've never really covered these concepts as promised. But today is the day!

Last bit of wind-up, I'm only going to cover securities appropriate in a C-corp. The next post (I promise! I already wrote it...I just have to push publish!!) will cover why you should choose a C-corp.

Every C-corp starts with common stock. Common stock defines the basic "unit" of a share. Convertible securities given to some investors generally convert into common shares. Employee options are exercised for common shares. Common shareholders as a class have rights, such as being able to elect some or all of the directors of the corporation and to vote on certain other matters. Many shareholder votes occur as if all convertible securities had already been converted (but optionholders generally cannot vote until they have exercised their options).

When public companies raise "equity" capital, they are generally selling common stock. In fact, when a public company sells preferred stock or convertible stock, much of the valuation is based on the debt components of those securities (ie - the interest or dividend promise and the high likelihood of the preservation of the capital invested). It's very different for private companies.

As I've written elsewhere, I think all investors in start-ups should get preferred stock.  This is because the preferred security holders will not convert their shares to common unless they are "in the money" (ie - above the price they invested at). Otherwise, they have the right to request the return of their capital (or more, as we'll soon see) before other shareholders can take any proceeds from a transaction (as a side note, this has the effect of driving down the effective share price other shareholders receive).

Before we get to those "or more" situations, there's one more important point. Most start-ups raise more than one round of preferred capital. Typically, each round is senior to the prior rounds. So, in a sale of the company, the most recent round gets first 'dibs'. If the most recent capital raise was, for example, $5mil and the company is sold for $7mil, the most recent investors would get their $5mil back and all other shareholders would share in the remaining $2mil (most likely to go entirely to the round immediately prior unless it was smaller than $2mil).

OK, but how can preferred shareholders attempt to "guarantee" getting even more than their capital back? These are called sweeteners and they come in several varieties, but they all have the same basic purpose, which is to enhance returns. There are:
1. cumulating dividends: typically, preferred dividends in a start-up aren't paid out as cash, but rather they accumulate on the preference. If the ultimate proceeds from a transaction exceeds the preference plus the accumulated dividends, then the dividends are of no effect. However, they do increase the "preference stack" by the amount of the dividends each year, usually 6 - 10%
2. multiple preferences: just like it sounds, in these cases the preferred shareholders have a right to a multiple of their capital before common or other shareholders are eligible for proceeds. This is less common and when used, generally it will be a 2x but have heard of 3x.
3. participations: this one sounds nice and benign, but its a strong one...a participation means that the preferred holder gets their capital back and then still gets the benefit of their full converted ownership. Although in some cases it wouldn't give the preferred holder economics as attractive as a 2x preference, the challenge is that no matter how well the company does, the fact that this capital has to come out off the top reduces the return for all other shareholders. There are even cases of multiple participations which make me wonder if the managers of those companies knew what they were signing.

Although I've been on all sides of sweeteners (asking, getting and subject to someone else's), in a 'normal' situation I think they are fundamentally a bad idea and I think most people, even VCs, agree. Why? They create perverse incentives for managers who realize that their opportunity for upside is buried under a pile of preferred shareholder economics. Those managers are then incented to "throw for the long ball" in an attempt to catch up. Or, they may just give up entirely and start looking for the next opportunity. In either case, all of the shareholders are put at risk...including all of those sweetened preferences and the junior employees who are as interested in keeping their jobs as they are in the value of their options.

So why do all of these sweeteners exist? Well, lest it seem that I'm castigating evil investors, I think entrepreneurs have to take responsibility for the existence of sweeteners. They result from one of three circumstances:
1 - 3. Overfocus on valuation: Entrepreneurs measure their success in a capital raise primarily by the valuation they get. Investors respond to "valuation inflation" by adding sweeteners. Research shows that sweeteners occur more in boom times than in lean times. When tech is flying high, entrepreneurs convince themselves that they need a big "sticker price". VCs will give in but will insist on sweeteners that seem innocuous at the time but can end up destroying the company. In my view, the smart entrepreneur takes a lower valuation and keeps everyone's interests aligned.
4. Ignorance of implications: We'll assume that managers are all properly advised by their counsel as to the mechanics of these structures. But even that doesn't mean that managers are thinking through all of the implications. Remove rose colored glasses, replace with gimlet eye and do the math on various scenarios / outcomes and the implications will literally jump off the page.
5. Desperation: There is a 3rd alternative and while it sounds the worst, it's at least the most honorable. If, as a manager, you have a situation where there's only one capital source and they know it, you may not have much of a choice. Still, my advice would be to trade down on valuation as far as possible (I'll write later on anti-dilution issues which could come into play here) and minimize the sweeteners. It's painful, but a lower value tends to clean the slate, clarify everyone's situation and allow the company to develop organically as it should.