Understand Your Options Regarding Equity And Debt Instruments
An equity instrument can be titled common stock, preferred stock, LLC membership interest or LLC membership unit, warrant or option, each having 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 non-financial available for common or preferred 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. No fixed dividend or other fixed or special rights or preferences are associated with common 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 and debt 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:
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 similar to a debt instrument, there can be legal impediments to 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 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.
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 particular asset but otherwise none), or super-voting rights (such as 10,000 to 1 or 51% of all votes).
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. 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 limited such that they cannot own more than 4.99% of outstanding common stock at the time of conversion).
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.
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 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, such as to maintain the investor’s overall value of the investment; an anti-dilution provision can also be as to specific percent ownership (Holder will never own below 10% of the total issued capital of the Issuer).
Registration rights refer to SEC registration rights and can include demand registration rights (the Holder can demand that the Issuer register their equity securities) or piggyback registration rights (if the Issuer is registering other securities, it will include the Holder’s securities).
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 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 assert control over management and operations otherwise; 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, non-financial covenants can be any rights the preferred stockholder investor negotiates for.
Options/Warrants – An option or warrant is the right to purchase equity, generally common stock, at a specific price during a certain period.
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 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 – This is the debt instrument secured by collateral, generally of real or personal property. Still, 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, the debt below the senior debt is often called “subordinated debt.”
- Convertibility – A debt can be convertible into an equity instrument in whole or 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 non-financial 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 L.G., PLLC. Call 877-541-3263 or visit our contact page to schedule a free consultation with someone from our staff today.