Issuing Securities for Capital Formation
Andrew J. Sherman, Partner, Dickstein Shapiro Morin and Oshinsky LLP
Defining the "optimal" capital structure is always a challenge for a business. An entrepreneurial company in search of capital can obtain it from various sources, but most come down to choosing between two basic flavors: debt or equity.
It's also a challenge for smaller companies to find sources of capital at affordable rates. Affordability with regard to debt refers to the term, interest rate, amortization and penalties for non-payment. In the context of equity, affordability refers to worth (known as "valuation"), dilution of ownership and any special terms or preferences, such as mandatory dividends or redemption rights.
Issuing securities is the first option available for obtaining capital. Essentially they come in three basic types: debt, equity and hybrid or convertible. Each type of security has certain fundamental characteristics, variable features and attendant costs.
Companies can incur debt by issuing securities, usually in the form of bonds, notes or debentures. Typically, a bond is an obligation secured by a mortgage on some property owned by the company, while a debenture or note is unsecured. Notes and debentures usually carry a higher rate of interest and, therefore, are issued on the strength of the company's reputation, projected earnings and growth potential.
The terms of the debt security and its earnings (referred to as "yield") for the holder will be determined by an evaluation of the level of risk to the holder and the likelihood of default. Growing companies that lack a high bond or credit rating are often faced with restrictive covenants in the debenture purchase agreement or in the bond's indenture (which governs the company's activities during the term of the instrument). For example, the covenants might restrict management's ability to get raises or bonuses, or require that a certain debt-to-equity ratio in the company's capitalization be maintained at all times. The direct and indirect costs of these terms and covenants should be carefully evaluated with the assistance of qualified legal counsel before this option is chosen.
The typical growing company--whose value to an investor may be greatly dependent on intangible assets such as patents, trade secrets or goodwill, as well as projected earnings--tends to issue equity securities before incurring additional debt, usually because its balance sheet lacks the assets necessary to secure the debt. Moreover, additional debt is likely to increase the risk of company failure to unacceptably dangerous levels.
Equity securities take the form of common stock, preferred stock, and warrants and options. Each type of equity security carries with it a different set of rights, preferences and potential rates of return in exchange for the capital contributed to the company.
Common stock offerings, and the related dilution of ownership interest, are often a traumatic experience for founders of growing companies that currently operate as closely-held corporations. The need for additional capital for growth, combined with the lack of readily available personal savings or corporate retained earnings, results in a realignment of the capital structure. Although a common stock offering is generally costly and entails a surrender of some ownership and control, it does give the business an increased equity base and a more secure foundation upon which to build, while the likelihood of obtaining future debt financing is greatly increased
Preferred stock is an equity security that has some of the characteristics of debt securities. Preferred stock carries with it the right to receive dividends at a fixed or even an adjustable rate of return (similar to a debt instrument), with priority over dividends distributed to the holders of the common stock, as well as a preference on the distribution of assets in the event of liquidation. The preferred stock may or may not have certain rights with respect to voting, convertibility to common stock, anti-dilution rights, or redemption privileges which may be exercised either by the company or the holder.
Although the fixed dividend payments from preferred stock are not tax-deductible (as interest payments would be) and ownership of the company is still diluted, the balance between risk and reward is still achieved because the principal invested need not be returned (unless there are provisions for redemption). In addition, preferred stockholders' return on investment is limited to a fixed rate of return (unless there are provisions for convertibility), and their claims are subordinated to the claims of creditors and bondholders in the event of a failure to pay dividends upon the liquidation of the company. The use of convertible preferred stock is especially popular with venture capitalists.
Warrants and options give the holder a right to buy a stated number of shares of common or preferred stock at a specified price and within a specific period of time. If that right is not exercised, it lapses. If the price of the stock rises above the option price, the holder can essentially purchase the stock at a discount, thereby participating in the company's growth.
In their most typical form, such as convertible notes or convertible preferred stock, these are similar to warrants and options in that the holder has an option to convert them, on specified terms and condition, into common stock. The incentive for conversion is usually the same as for the exercise of a warrant: that the conversion price (that is, the actual price the company will receive for the common stock when a conversion occurs) is more favorable than the current rate of return provided by the security.
Convertible securities offer several distinct advantages to a company, including:
- an opportunity to sell debt securities at lower interest rates and with less restrictive covenants, in exchange for a chance to participate in the company's success if it meets its projections and objectives.
- a means of generating proceeds 10% to 30% above the sale price of common stock at the time the convertible security is issued.
- a lower dilution in earnings per share (usually because the company can offer fewer shares when convertible securities are offered than in a "straight" debt or equity offering.
- a broader market of prospective purchasers, since certain investors may wish to avoid a direct purchase of common stock but would consider an investment in convertible securities.