Key Terms in Equity Financings (Institutional)
An equity financing is a transaction in which the startup issues stock in the company to investors. Institutional investors, venture capital funds or other investment funds will invariably ask for preferred stock. The main difference between preferred stock and common stock is the liquidation preference given to preferred stock, which gives owners of preferred stock their money back (plus any accrued dividends, if any) before any amounts are paid to common stockholders. However, in terms of priority of payment upon a sale or liquidation of the company, preferred stock sits behind debt.
Additional rights that may be given to preferred stockholders include:
- Protective provisions. Preferred stockholders almost always have a right to a separate vote to approve certain corporate actions, including liquidation or dissolution, amending the company’s organizational documents, creating or authorizing new securities (including debt securities), redeeming or buying back outstanding equity, creating subsidiaries, or increasing or decreasing the size of the board of directors.
- Anti-dilution adjustments (down-round protection). In a down round (i.e., a financing in which the valuation of the company is lower than the valuation at the previous round of financing), preferred stockholders who have down-round protection will be able to adjust their conversion ratio (the ratio at which they convert into common stock, which is initially 1:1) to a lower ratio such that they are entitled to receive more shares of common stock upon conversion. Full-ratchet anti-dilution protection lowers the ratio as if the preferred stockholder had invested at the lower valuation. Weighted-average anti-dilution protection is standard and is in between full-ratchet anti-dilution protection and no anti-dilution protection.
- Board seats. Preferred stockholders may be entitled to designate one or more board members to look after their interests. Sometimes these board members will have veto rights over certain matters.
- Preemptive/participation rights. Companies must offer any new securities proposed to be issued and sold to existing preferred stockholders with preemptive or participation rights. This protects the preferred stockholders from dilution by allowing them to maintain their pro rata percentage in the company.
- Information rights. Preferred stockholders with information rights are entitled to receive annual, quarterly and sometimes monthly financial statements from the company. In addition, preferred stockholders may also be entitled to receive the company’s annual budget and a statement of equity.
- Right of first refusal. Rights of first refusal entitle the preferred stockholders to purchase shares proposed to be sold by common stockholders (and sometimes other preferred stockholders) to third parties.
- Co-sale rights. Co-sale rights entitle preferred stockholders to sell alongside common stockholders (and sometimes preferred stockholders) who propose to sell their stock to a third party.
- Drag-along provision. This provision requires common and preferred stockholders to approve a sale of the company if a certain percentage of the stockholders desire to sell.
- Registration rights. Registration rights entitle the stockholder to include their shares in a registration statement at an IPO or a follow-on public offering.
- Operational covenants. Investors will typically ask that the company comply with certain operational covenants, including a requirement to have every employee and contractor sign an inventions assignment, noncompete, nonsolicit and nondisclosure agreement; standard vesting schedules for option awards; employment agreements for founders and executives in the form approved by the investors; and directors’ and officers’ insurance and key-man life insurance policies.
The above is a high-level summary of the rights institutional investors typically receive in preferred equity financing transactions. But each transaction is unique and molded based on a multitude of factors, including leverage the parties may have, economic circumstances, the company’s financial outlook, and management and/or corporate governance dynamics.
For more information, please contact a member of our Early Stage & Emerging Companies practice group.