An Equity Instrument can be titled common stock, preferred stock, LLC membership interest or LLC Membership Unit (or Unit for short), warrant or option, each having a particular meaning and not being interchangeable.
LLC Membership interest or LLC Membership Unit – An LLC Membership Unit is the broad title of equity in a limited liability company. Through an operating agreement, LLC Members delineate classes of equity and the rights and preferences associated with each class. The LLC structure is entirely flexible, and classes of equity can have any of the rights or preferences, both financial and non-financial available for common or preferred stock.
Common Stock – Common stockholders are behind preferred stockholders in the rights to receive dividends and behind both preferred stockholders and creditors in the rights to receive payments upon liquidation. Common stock is the most “common” type of equity security. Although common stock is usually voting, especially in publicly traded equity markets, it can be designated as either voting or non-voting. There is no fixed dividend or other fixed or special rights or preferences associated with common stock.
Preferred Stock – Preferred stock is the most commonly used investment vehicle due to its flexibility. Preferred stock can be structured to offer all the characteristics of equity as well as of debt, both in financial and non-financial terms. Preferred stock can be structured in any way that suits a particular deal. The following is an outline of some of the many features that can be included in a preferred stock designation:
Dividends – A dividend is a fixed amount agreed to be paid per share based on either the face value of the preferred stock or the price paid for the preferred stock (which is often the same); a dividend can be in the form of a return on investment (such as 8% per annum), the return of investment (25% of all net profits until the principal investment is repaid) or a combination of both. Although a dividend can be structured substantially similarly to a debt instrument, there can be legal impediments to a dividend payment and a creditor generally takes priority over an equity holder. The ability of an Issuer to pay a dividend is based on state corporate laws, the majority of which require that the Issuer be solvent (have the ability to pay creditors when due) prior to paying a dividend. Accordingly, even though the Issuer may have the contractual obligation to pay a dividend, it might not have the ability (either legally or monetarily) to make such payments.
- As a dividend may or may not be paid when promised, a dividend either accrues and cumulates (each missed dividend is owed to the preferred shareholder) or not (we didn’t get the dividend this quarter, but hopefully next).
- Although a dividend payment can be structured to be paid at any interval, payments are commonly structured to be paid no more frequently than quarterly, and often annually.
- Dividends on preferred stock are generally preferential, meaning that any accrued dividends on preferred stock must be fully paid before any dividends can be paid on common stock or other junior securities.
Voting Rights – Preferred stock can be set up to establish any level of voting rights from no voting rights at all, voting rights on certain matters (sole vote on at least one board seat; voting rights as to the disposition of a certain asset but otherwise none), or super voting rights (such as 10,000 to 1 or 51% of all votes).
Liquidation Preferences – A liquidation preference is a right to receive a distribution of funds or assets in the event of a liquidation or sale of the company Issuer. Generally creditors take precedence over equity holders; however, preferred stock can be set up substantially similar to a debt instrument whereby a liquidation preference is secured by certain assets, giving the preferred stockholder priority over general unsecured creditors vis-à-vis that asset. In addition, a liquidation preference gives the preferred stockholder priority over common stockholders and holders of other junior equities. The liquidation preference is usually set as an amount per share and is tied into the investment amount plus accrued and unpaid dividends.
- In addition to a liquidation preference, preferred stockholders can partake in liquidation profits (for example, the preferred stockholder gets the entire investment back plus all accrued and unpaid dividends, plus 30% of all profits from the sale of the company Issuer; or the preferred stockholder gets the entire investment back plus all accrued and unpaid dividends and then participates pro rata with common stockholders on any remaining proceeds (known as a participating liquidation preference) ).
Conversion or exchange rights – A conversion or exchange right is the right to convert or exchange into a different security, usually common stock.
- Conversion rights include a conversion price which can be set as any mathematical formula, such as a discount to market (75% of the average 7 day trading price immediately prior to conversion); a set price per share (preferred stock with a face value of $5.00 converts into 5 shares of common stock thus $1.00 per share of common stock); or a valuation (converts at a company valuation of $30,000,000).
- Conversion rights are generally at the option of the stockholder, but the Issuer can have such rights as well, generally based on the happening of an event such as a firm commitment underwriting (Issuer has the right to convert all preferred stock at a conversion price of $10.00 per share upon receipt of a firm commitment for the underwriting of a $50,000,000 IPO).
- The timing of conversion rights must be established (at any time after issuance; only between months 12 and 24; within 90 days of receipt of a firm commitment for a financing in excess of $10,000,000).
- Conversion rights usually specify whether they are in whole or in part, and for public companies limits are often set (conversion limited such that they cannot own more than 4.99% of outstanding common stock at time of conversion).
Redemption/Put Rights – A redemption right in the form of a put right is the right of the Holder to require the Issuer to redeem the preferred stock investment (to “put” the preferred stock back to the Issuer); the redemption price is generally the face value of the preferred stock or investment plus any accrued and unpaid dividends; redemption rights generally kick in after a certain period of time (5 years) and provide an exit strategy for a preferred stock investor.
Redemption/Call Rights – A redemption right in favor of the Issuer is a call option (the Issuer can “call” back the preferred stock); generally when the redemption right is in the form of a call, a premium is placed on the redemption price (for example, 125% of face value plus any accrued and unpaid dividends or a pro rata share of 2.5 times EBITDA).
Anti-dilution protection – Anti-dilution protection protects the investor from a decline in the value of his or her investment as a result of future issuances at a lower valuation. Generally the Issuer agrees to issue additional securities to the Holder, without additional consideration, in the event that a future issuance is made at a lower valuation such as to maintain the investors overall value of investment; an anti-dilution provision can also be as to a specific percent ownership (Holder will never own below 10% of the total issued capital of the Issuer).
Registration rights – Registration rights refer to SEC registration rights and can include demand registration rights (the Holder can demand that the Issuer register his or her equity securities) or piggyback registration rights (if the Issuer is registering other securities, it will include the Holder’s securities, as well).
Transfer restrictions – Preferred stock can be subject to transfer restrictions, either in the preferred stock instrument itself or separately in a shareholder’s or other contractual agreement; transfer restrictions usually take the form of a right of first refusal in favor of either the Issuer or other security holders, or both.
Co-sale or tag along rights – Co-sale or tag along rights are rights of Holders to participate in certain sales of stock by management or other key stockholders.
Drag along rights – Drag along rights are the rights of the Holder to require certain management or other key stockholders to participate in a sale of stock by the Holder.
Other non-financial covenants – Preferred stock, either through the instrument itself or a separate shareholder or other contractual agreement, can contain a myriad of non-financial covenants, the most common being the right to appoint one or more persons to the Board of Directors and to otherwise assert control over management and operations; other such rights include prohibitions against related party transactions, information delivery requirements, non-compete agreements, confidentiality agreements, limitations on management compensation, limitations on future capital transactions such as reverse or forward splits, and prohibitions against the sale of certain key assets or intellectual property rights. In essence, non-financial covenants can be any rights that the preferred stockholder investor negotiates for.
Options/Warrants – An option or warrant is the right to purchase equity, generally common stock, at a certain price during a certain period of time.
As mentioned above, a Debt Instrument can be titled a promissory note, note, or debenture, each having the same meaning and each term being interchangeable. Moreover, a debt instrument can either be convertible into equity or not convertible. Conversion is simply a form of payment: Instead of cash, the Holder is accepting an equity instrument as either whole or partial payment for the debt obligation.
The basic elements of a debt instrument are as follows:
Amount – What is the amount of the debt in monetary terms?
Term – When does the debt obligation become due; a date can be specified; the debt can be payable on demand by the Holder, or payable upon the happening of certain events with a backup term (the receipt of a firm commitment financing for $XX but in no event later than May 1, 2014) or the reaching of certain milestones (Issuer signs ABC Company as a client, but in no event later than May 1, 2014).
Interest rate – What is the rate of interest being charged on the debt; is the interest compounded (i.e., do you pay interest on interest)?
Transferability or assignability – Can one or both parties assign their rights and interests in the debt instrument to a third party?
Secured or unsecured – Is the debt instrument secured by collateral generally consisting of real or personal property, but can also consist of other financial instruments (sometimes called a pledge agreement).
Guaranty – Is a third party, such as a principal of the Issuer, guaranteeing the obligations in the debt instrument?
Prepayment rights – Can the debt be prepaid in whole or in part?
Payment Preferences/Subordination/Senior debt – The debt instrument can contractually require that it will be paid prior to other debts incurred either before or after the debt date. A right to receive payment in advance of other obligations is a payment preference, which is often referred to as “senior debt,” whereas the debt that is below the senior debt is often referred to as “subordinated debt.”
Convertibility – A debt can be convertible into an equity instrument either in whole or in part. If convertible into an equity instrument, the conversion price must be decided (for example, $1.00 of debt for each share of common stock) and the type of equity (see discussion on types of equity instruments); the term “mezzanine debt” is often used to refer to convertible debt instruments, or the concurrent issuance of a combination of debt and equity (for example, mezzanine financing may involve a $1,000,000 convertible senior loan together with 250,000 warrants for the purchase of common stock).
Default provisions – Default may be monetary or non-monetary; generally a debt accelerates and becomes due and payable in full upon default.
Non-Financial covenants – any of the non-financial covenants discussed under preferred stock can be attached to a debt instrument.