Note: This article is the first in an ongoing series on Early-Stage Deal Terms. To learn more about navigating term sheets and investment documents, download this free eBook today Understanding Early-Stage Deal Terms or purchase our books at Amazon.com.
The first time you try to something new or unfamiliar - square dance at a fair or pick up a new sport - you feel a little clumsy until you begin to see the patterns, understand the basic moves and develop the rhythm to get your limbs reliably moving in the right directions. Newcomers to early stage investing know this feeling. To the uninitiated, early stage investment deals seem to come in a bewildering number of different shapes and sizes.
While it is true that at a detailed level every deal is unique, under the surface it is just minor variations on a very manageable number of basic structures. With some knowledge of the rules and a little practice, people can learn the “sport” pretty quickly.
What is needed to get up the curve is a framework of the basic structures with their key variations. Christopher is just the person to provide such an overview since he combines a corporate law background with tons of experience leading and negotiating virtually every kind of early stage deal structure. Let’s see if he can take us through this and make what sounds complex, seem simple.
Q: Christopher, let’s start at the beginning. In fact, now that I think about it, where is the beginning?
The best place to start is to recognize that, at the highest level of abstraction, there are only two ways to participate in the financing of a company. That’s right, TWO basic deal structures. You can either:
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Become a shareholder by purchasing stock (e.g. preferred or common stock or some kind of derivative security meant to become stock).
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Become a lender by lending money to the company in a traditional lender/debtor bank loan type of transaction with interest and a repayment right.
So at the 30,000 foot level, you become either a long-term owner signed up for the full ride with the company, or a short-term lender who expects to be paid back, with interest, in a closed-end transaction.
There are important differences between these two broad categories of deal and the differences have implications for your relationship to the founders. Stock ownership means you are fundamentally aligned with the founders. You are an owner right alongside them. You share all the upside potential (proportionately based on your ownership percentage) and you absorb all the downside risk proportionately. If the company goes out of business (assuming no fraud or malfeasance), you lose all your investment and have no recourse.
Being a lender, on the other hand, means you are fundamentally opposed rather than aligned with the founders. They are legal debtors to you and are obligated by law to repay your principal plus whatever interest is agreed upon. If they don’t repay you, you have legal remedies.
I mention the traditional debtor/creditor lending deals mostly just to be complete. In actual point of fact, they are pretty much unheard of with early startups, and for good reason. Because young startups have minimal assets and no free cash flow, they are totally uncreditworthy from a traditional lender’s perspective. Regular debt deal structures like this are very uncommon in the early years of a company’s history. Debt intended to convert into stock is much more common - more about that in a moment.
Q: OK, so if there is just debt vs equity, what are the key variations on each of these options?
Well, the main variations on debt seen in the early stage world are as follows:
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Straight debt - this is what I discussed above where you lend money and are repaid cash plus interest. This is the bread and butter of what banks do and, for the reasons noted above, is not common with startups.
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Convertible debt - this is debt, with an interest rate and a maturity date, but rather than being paid back in cash, it is intended to be converted into stock.
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Venture debt - this is riskier higher yield debt that includes some features providing more upside to compensate for greater risk (typically warrants).
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Revenue Participation debt (aka Royalty Based Financing) - these are loans which specify that the lender is entitled to a percentage of revenue until such time as an agreed-upon multiple of return is achieved.
The main variations on early stage equity deals are as follows:
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Straight priced equity - here investors are directly purchasing stock in the company (either preferred or common stock) for cash at an agreed upon price (expressed either as a company valuation or a per share price or both.)
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Purchase of a Derivative Security - derivatives come in all shapes and sizes, but they are basically a contract intended to convert into equity at some point in the future. At their most basic level they are a contract which specifies that the buyer will have a right to receive an agreed upon amount of stock, at an agreed upon price (usually arrived at by formula) on an agreed upon date or dates. Common examples include: option grants, warrants, restricted stock grants, SAFE notes, KISS notes, and convertible debt deals.
Q: Which of these is the most common?
The vast majority of deals in the early stage space are equity or derivatives intended to turn into equity. Equity suits early stage investing very well because, by its nature, it compensates for the high risk by giving the investor high potential for returns. As a part owner of the company, you bear a proportionate risk of loss, and absent fraud or misdeed, you have no recourse in a meltdown. But in return for taking that risk, as a part owner you stand to participate directly and proportionately in the huge upside if the company goes on to be very valuable.
In terms of rough frequency or market share of the various deal types, here is the order of most common to least common:
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Priced equity rounds account for the biggest percentage of deals (and almost certainly the majority of dollars invested). These are the classic structure of most of the billions of venture capital and angel capital invested into startups.
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Derivative security deals are the next most common. These are the classic convertible note deals where the money lent is intended to convert into stock. (KISS or Keep It Simple Securities are a less common derivative that are conceptually very similar to convertible debt.)
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Basic futures instruments like Warrants and SAFE notes (Simple Agreement for Future Equity) are probably the next most common type of deal. Warrants and SAFEs are very similar. The main difference is the pricing mechanism. Warrants tend to be priced outright and SAFEs will often derive their price from a yet-to-be consummated financing down the road.
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Revenue Participation or Royalty Financing deals account for most of the small remaining fraction of deals. These deals have some drawbacks in terms of tax efficiency and the impact they can have on growth because they drain cash. But, there is growing interest in them for companies deemed to have slightly lower growth potential than the extreme growth levels required for angel and VC investors.
Side note on Initial Coin Offerings (ICOs). Recently it has also been possible to purchase digital coins or tokens, often built on blockchain based distributed ledger systems, by companies raising money via an ICO. These coins vary wildly in their structures as well as their risk/return profile. They quickly came to prominence in the absence of any regulation, but regulators (and regulation) is quickly catching up with them. The underlying value is sometimes based on the notion of utility and is other times based on or pegged to yet another … (wait for it) ... digital currency. Detail on this subject is beyond the scope of this discussion, but suffice to say investors should exercise caution in the extreme when transacting in these instruments, or in the stock of companies transacting in these digital instruments. The underlying technology is interesting computer science that has lots of potential, but there are a tremendous number of unanswered questions about how it has been applied so far. As of yet, there is no real clarity on what it means to be an investor in a digital coin as well as what it means to be an investor in a company interacting with digital coins.
Q: What are the key variations on the most common deal types?
I will provide a high level summary, but for greater detail on priced rounds, see this overview of equity deal terms and for more nuance on the advantages and disadvantages of convertible notes see this discussion of convertible notes.
The main variations on equity deals are just a question of how the key risks are allocated between founders and investors. This is done by means of customization of the preferred stock terms and supplemental contractual rights. The biggest of the variables include:
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Pre-Money Valuation/purchase price
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Size of round
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Liquidation preference
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Board seats & approval rights
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Information rights
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Anti-dilution
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Participation rights
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Redemption rights
With convertible notes, there are fewer variables and paperwork (which is their main appeal), but also fewer protections. The key variables are:
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Size of note
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Maturity date
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Interest rate
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Whether the conversion price is capped
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Whether there is a discount on the conversion price
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Whether there is a liquidated early exit premium
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Whether there is a noteholder’s agreement with some governance and information rights
While not actually debt like convertible notes, SAFEs and KISSes present many of the same questions as convertible notes. SAFEs often feature caps and discounts, KISSes often feature interest rates and maturity dates.
Q: Why is owning stock the most common approach?
As I noted above, equity suits early stage investing very well because by its nature, it compensates for the high risk by giving the investor high potential for returns. Stock deals offer near perfect alignment between investors and founders. Investors don’t win unless founders win, and vise versa. Stock ownership is a marriage: for better or worse, in sickness and in health.
This has some important implications. One is that there is a natural alignment. It means no crossed purposes as you find with convertible notes. Founders and investors share the same economic situation. Nobody profits unless the stock price goes up. Nobody takes cash out of the business unless everybody takes cash out of the business (dividends or a sale of the business.)
Co-ownership in high growth companies also means the concept of “profit” in these shared-ownership situations can be misleading. Traditionally “profit” means that stockholders are entitled to proportional share of excess earnings (profits) that are returned to shareholders (dividends). But in practice, with high-growth/high-potential startups, it is rare to see a distribution of profits in early years because cash is plowed back into the company as an investment in further growth. The operative economic assumption is that superior risk-adjusted returns can be achieved by investing the money back into the company, rather than pulling it out and investing it somewhere else. Without a realistic expectation of any near-term distribution of profits, why would a stock investor invest? They are betting on the gain from a proportional slice of the proceeds when the entire company is sold.
Q: What's the catch? If the benefits of this alignment are so great, why doesn't everyone use them all the time?
It’s because of the slightly greater complexity (and resulting slightly greater cost) of the transactions. These stock transactions permanently alter the capitalization of the company by adding new stockholders, who are typically purchasing an entirely new class of stock created for them. This is typically a series designated class of preferred stock with special rights and privileges that have been negotiated. Once negotiated, the terms are filed in an updated charter with the jurisdiction of incorporation. Given this permanence, and the associated complexity of creating the permanence, there are a great number of different types of deal documents normally used in stock transactions. (But I’d hasten to point out that it is not that hard - it is a well worn path with good norms and forms to make it easier.)
Q: Anything else a new investor needs to appreciate about deal structures?
In closing it is probably worth touching on the corporate entity question - what types of entities the investors are investing in. The two most common categories of entity are:
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Traditional C Corporation
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Limited Liability Company (LLC)
C Corporations are the norm and the more commonly used form, though there is some interest in using LLCs by some investors. S Corps are pass-through entities and are capped in the number of investors and are not eligible for special IRS tax treatment (e.g. 1202, 1045 or 1244) so are not a good fit. Sole proprietorships are just a lightweight corporate liability cloak around an individual conducting business and are not feasible or appropriate for investment. Partnerships (including LLPs) are not appropriate for the kind of divided third party ownership rights required by the investment model.
Q: If C Corps and LLC are the most common, what are the main differences and relative advantages between them?
C Corps are taxable at the corporate entity level. LLCs are a pass-through tax vehicle allowing losses and profits to flow down to the members of the LLC before taxation. Because LLCs themselves don’t pay that additional layer of taxes at the entity level, they might appear to be more attractive at first blush. But on closer examination it turns out that LLCs have some key drawbacks in the early stage investing context:
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LLCs are based on the concept of “membership” rather than stockholders. It is complicated to create an LLC Operating Agreement which mimics and acts exactly like traditional preferred stock;
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The law around C Corps is very well-settled, well-known and predictable, so deal lawyers are more efficient in negotiating, drafting and advising C Corps;
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The pass-through of losses for LLCs can be attractive, but C Corps can build up NOLs (net operating losses) that can be valuable to acquirers at exit. Plus, startups generally lose money in early years so being taxable at the entity level doesn’t matter;
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LLCs cannot take advantage of IRS Sec. 1202, 1045 or 1244 tax incentives;
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It is more complicated to try and mimic employee stock options with LLCs and if you do, they are not tax incentive eligible like ordinary C-Corp stock options are;
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Annual capital accounting and tax reporting is much more work for all involved; and
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From an angel perspective, later VCs can balk at investing because of ECI (“effectively connected income” under Section 871(b)) and UBTI (“unrelated business taxable income”) issues.
It is very easy and tax efficient to convert from an LLC to a C Corp (but not the other way around). Investors are typically most familiar/comfortable with a C Corp, and its always a safe choice. My advice is typically to keep it simple: start as a C Corp, or if you want to start as an LLC, plan to convert to a C Corp when you are ready to raise money.
So that concludes our overview of early stage deal structures. There is a fair bit of detail when you unpack it, but you can keep it all straight by recognizing that it all boils down to either equity or debt, and most of the deals boil down to one of two main categories of equity. With a little practice on those common forms, you will be ready to get out there and square dance with the best of them.
Next up in this series: Understanding Equity Deal Terms.
To learn more about navigating term sheets and investment documents, download this free eBook today Understanding Early-Stage Deal Terms or purchase our books at Amazon.com.
