Debt and Equity Raises
Our Gold Coast corporate lawyers regularly provide advice on the benefits and detriments of equity raises and debt raises. Where necessary, we provide our corporate clients with the necessary corporate advisory services to achieve an appropriate balance between debt and equity financing to progress their company model.
Structuring an equity round
Debt and equity capital raises each have separate structures. A debt capital raise involves taking on a loan that is repaid with interest and though it does not sacrifice your equity in the company it restricts cash flow in order to make repayments.
An equity capital raise can fall into one of two (2) categories: 1. Equity rounds; and 2. Convertible notes.
An equity round involves the owners of a company accepting funds and in exchange providing private investors with shares in the company. In order to conduct an equity round, the parties must negotiate and decide upon a fair valuation of the company – the higher the valuation, the less shares an investor can expect to receive in exchange for his or her contribution.
It is at the initial stages where decisions have to be made about what sort of protections will be offered to investors through the shares they are given. For example, shares are often divided into classes with different rights and obligations attaching to each class.
There are a number of rights that are generally offered to investors in exchange for their capital contribution including voting rights, appointment rights and preference shares amongst a multitude of extraordinary rights that may be on offer depending on the particular circumstances and context of a given capital raise.
To ensure you receive a fair deal it is important to balance the need to promote investor confidence (by awarding them some degree of protection over their investment) while still retaining the essential elements and unique methods of operation that attracted those parties to invest in the first place. If too much control is relinquished a company can potentially deprive itself of its unique approach and competitive advantage in the marketplace.
Convertible Notes Levels
Convertible notes combine the otherwise separate concepts of debt and equity.
Convertible notes operate on two (2) levels:
(a) firstly, the convertible note is given to the investor in exchange for capital; and
(b) secondly, at a predetermined date or at the happening of a certain event, the note converts to equity in the form of shares in the company.
An essential consideration with convertible notes is what will happen to the notes if the loan (the capital given) does not automatically convert into equity before the term of the agreement expires.
Convertible Notes Options
In the event that a conversion does not occur before the term of the agreement expires, there are two (2) options to consider:
(a) the company can repay the loan; or
(b) the loan can automatically convert to equity.
Convertible notes will often be accompanied by a “valuation cap” on the maximum amount that can convert into equity. The valuation cap acts as a quasi-company valuation in a circumstance where the company does not technically undergo valuations until the conversion occurs.
It is also important to decide on what happens if the notes do not automatically convert prior to the expiration of the term and what rate will be applied to the conversion. Typically the rate used is calculated based on the share price offered in the round, or the share price for a stock exchange listing.
Interest can be applied to the loan amount, which is then reflected in the conversion to equity. In conjunction with or in place of interest the loan can convert to equity at a discounted rate. In either case, the rationale is that people or entities that invest in your company at the early seed stages (which is when investors also take on the most risk as there is less evidence of your company’s potential to succeed) should be rewarded for their faith.
Convertible notes are most common at the seed stage or as a method of bridging finance though they can also be used when the valuation of a company is in doubt.
Convertible notes, while easy to execute with Australian Securities Investments Commission (‘ASIC’) are not always the most appropriate for the circumstances.
Convertible Notes Disadvantages
Some disadvantages to consider with convertible notes are that:
(a) the risk in a seed round is much higher than future rounds and this is not always accurately reflected in the returns to investors;
(b) seed-round investors want any subsequent rounds to be as low as feasible so that more of the notes convert to equity while company founders would prefer to raise as much capital as possible as not to have to relinquish any more equity than necessary; and
(c) convertible notes are favoured for smaller capital raises but may not be preferable for larger raises where a valuation at the outset may be demanded by investors.
Simple Agreement for Future Equity
A recent development designed to replace convertible notes has been the Simple Agreement for Future Equity (‘SAFE’). In a SAFE the investor instead receives a contractual right to receive equity when a trigger event occurs, the main advantages being an infinite term, a lack of interest on the loan and no regulation (because there is technically no debt, only a contractual right).
Debt capital is capital that a company raises when it engages a bank to provide it with a loan. Debt capital is different from the capital advanced as part of an equity round as the provider that advances funds to the company does not become a part owner of the company by receiving shares. The bank (or other lending institution) simply becomes a creditor and in exchange for providing the funds receives an annual percentage return on the loan as set out in the agreement you enter into with your provider.
Balancing debt and equity capital
While debt capital should be used frugally, it is oftentimes a necessary component as part of a large corporate project. By raising debt capital, a profitable company model can raise necessary funds faster than through equity capital as there is no need to discuss the types of shares and attaching rights and obligations of shareholders as would be the case with equity capital.
As your company grows part of the art of expanding correctly is balancing your debt-to-equity ratio, that is, as a company owner you need to ensure that you do not rely on loans too heavily as to accumulate more debt than is reasonably serviceable. At the same time, relying too heavily on equity raises can be equally disastrous as it dilutes your ownership (and subsequently your influence) in the company.
Balancing debt and equity capital
If you decide that a loan is necessary for the growth or sustainability of your company, it is important to ensure that you can point to defined and quantifiable reasons as to why a lender should provide you with funds. Buying equipment is a common reason, as is renting space to operate or scaling the company. The smaller your company is, the more documentation and justifications you will need to provide to a lender that evidences your company plan, available collateral to secure the loan, and any growth success the company has had to date.
Some common reasons for seeking finance include purchasing inventory, building an online presence, hiring workers, conducting renovations or premises alterations. At other times a loan may simply be needed to help the company over a temporary financial hurdle.
Balancing debt and equity capital
While too much uncontrolled debt can lead to a credit downgrade (at best), not engaging with debt at all may also have negative consequences. If a company can generate a higher rate of return than the interest being charged by a lender, a loan would increase the company’s success. By implication, if a company refuses to engage with debt it may be taken as a sign by potential investors that the profit margins are too thin to justify a loan. Of course, that does not mean a company operating on tight margins should simply enter into a loan for the sake of it. A company operator should have a clear reason for believing that a loan can assist the company before we engage a lender on your behalf. If a loan is not right for your company, consider allowing us to produce a hire purchase agreement or a short term lease to acquire the equipment you need to make your company profitable.
Our Gold Coast corporate lawyers regularly advise our corporate clients on debt and equity financing. If you have any queries or concerns regarding initiating a debt or equity raise, our corporate lawyers would be pleased to advise you on the benefits and detriments of each approach.