Understand Your Options Regarding Equity And Debt Instruments

An equity instrument can carry the title of common stock, preferred stock, LLC membership interest, LLC membership unit, warrant or option, each with a particular meaning and typically not interchangeable. Here, we discuss the various types of equity instruments.

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 nonfinancial, 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 usually carries voting rights, especially in publicly traded equity markets, issuers can designate it as either voting or nonvoting. Common stock carries no fixed dividend or other fixed or special rights or preferences.

Preferred Stock

Preferred stock is the most commonly used investment vehicle due to its flexibility. Issuers can structure preferred stock to offer all the characteristics of equity and debt in financial and nonfinancial terms. Issuers can also structure preferred stock in any way that suits a particular deal. The following outline lists some of the many features that a preferred stock designation may include:

Dividends

A dividend is a fixed amount that issuers agree to pay per share based on either the face value of the preferred stock or the price the investor paid for the preferred stock (which is often the same). A dividend can take 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 issuers can structure a dividend substantially similar to a debt instrument, legal impediments may block a dividend payment. 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) before 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. Review these additional considerations when it comes to dividends.

As an issuer may or may not pay a dividend when promised, a dividend either accrues and cumulates (the issuer owes each missed dividend to the preferred shareholder) or does not (we did not get the dividend this quarter, but hopefully next).

Although issuers can structure a dividend payment for any interval, they usually structure payments no more frequently than quarterly and often annually.

Preferred stock dividends generally take priority, meaning that issuers must pay all accrued dividends on preferred stock in full before paying any dividends on common stock or other junior securities.

Voting Rights

Issuers can set up preferred stock to create any level of voting rights. These can range from no voting rights at all to limited rights on certain matters, such as a sole vote on one board seat or control over the sale of a particular asset. Preferred stock can also grant 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 to 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. Here are a few additional things to know about them:

• Conversion rights include a conversion price that can be set as any mathematical formula such as a discount to market (75% of the average 7-day trading price immediately before conversion), a fixed price per share (preferred stock with a face value of $5.00 converts into five 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. Still, the issuer can have such rights as well, typically based on the happening of an event such as a firm commitment underwriting (the 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 financing over $10,000,000).
• Conversion rights usually specify whether they are in whole or in part, and for public companies, limits are often set (conversion limits such that they cannot own more than 4.99% of outstanding common stock at the 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 (five 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 their investment due to future issuances at a lower valuation. Generally, the issuer agrees to issue additional securities to the holder without further consideration if a future issuance is made at a lower valuation. This maintains the investor’s overall value of the investment. An anti-dilution provision can also be tied to a specific percentage ownership (the holder will never own below 10% of the total issued capital of the issuer).

Registration Rights

Registration rights refer to SEC registration rights. They can include demand registration rights, where the holder can require the issuer to register their equity securities. They can also include piggyback registration rights, where the issuer registers other securities and adds the holder’s securities to the filing.

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 the issuer or other security holders.

Co-Sale Or Tag-Along Rights

Co-sale or tag-along rights are rights of holders to participate in certain stock sales 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 stock sale by the holder.

Other Nonfinancial 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 include the right to appoint one or more persons to the board of directors and to assert control over management and operations. Other such rights include prohibitions against related party transactions, information delivery requirements, noncompete 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 vital assets or intellectual property rights. In essence, nonfinancial covenants can be any rights the preferred stockholder negotiates for.

Options And Warrants

An option or warrant is the right to purchase equity, generally common stock, at a specific price during a certain period.

Debt Instruments

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. A conversion is simply a form of payment: instead of cash, the holder accepts an equity instrument as either a 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 (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 of real or personal property? It 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 be paid before other debts incurred before or after the debt date. A right to receive payment in advance of other obligations is a payment preference, often called “senior debt.” In contrast, debt below the senior debt is often called “subordinated debt.”
• Convertibility – A debt can be convertible into an equity instrument 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 nonmonetary. Generally, a debt accelerates and becomes due and payable in full upon default.
• Nonfinancial covenants – Any nonfinancial covenants discussed under preferred stock can be attached to a debt instrument.

If you have additional questions, one of our attorneys can help. Call 877-541-3263 to get started.

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Matters involving equity and debt instruments can be highly technical, detail-oriented and highly regulated. We can help you navigate everything and help you make complicated decisions that can affect your future goals at ANTHONY, LINDER & CACOMANOLIS, PLLC. Call 877-541-3263 or visit our contact page to schedule a free consultation with someone from our staff today.