You’re considering an equity investment in a private company with exciting prospects… Great, but do you really know what your “equity” investment in the company will get you?
Investment characteristics of one type of private equity investment can be very, very different from another. This guide can help you understand better what’s being offered to you.
There are 5 basic questions you must quickly address from the onset…
Is this equity publicly registered or private? Just to make sure … the following is about a private investment that is not registered with the Securities Exchange Commission and, therefore, does not enjoy some of the investor protections inherent in public registration.
Is preferred equity or common equity being offered? Preferred equity can have all sorts of investor benefits relative to common equity, in particular, liquidation preference if the company’s business fails and ends up having to sell its assets.
Voting rights … majority or minority? Most equity carries voting rights for important decisions the Issuer must make (like selling the business), but not all. If you get voting rights and are in the minority (as most venture investment is), you should be looking for special terms which protect you as a minority investor (see below).
Is Company management motivated to run the business for the benefit of equity investors? All sorts of decisions will be made in running the business after you invest, and you likely won’t be able to influence very many of them. Do key managers win big when you win as an equity investor?
Is this a Limited Liability Company (an “LLC”), a C Corporation or an S Corporation, and in what state is it registered? We’re getting into the legal weeds, but it has an impact on a number of factors: the special protections you should be looking for (S corporations have virtually none); whether you are getting shares, membership interests, units, etc. as the security for your investment; how the investment affects your taxes (LLCs and S Corps are “pass-throughs”); and which state’s laws govern the internal affairs of the business (Delaware is the most commonly used state for organization).
A Summary of Terms (often called a Term Sheet) like the one described below, should be created and agreed to before you make an equity investment in a private business. This document is the simplest way for the investor and issuer to understand the deal they are making, and the Term Sheet will be the basis upon which the other closing documents are drafted. We strongly encourage you to retain legal counsel specializing in private finance when negotiating a Term Sheet and reviewing Closing Documents.
Since a common equity investment usually has no special rights relative to other, previously issued, common equity, the following will emphasize terms associated with preferred equity, indicated by a (P), which is usually only available to preferred equity investors.
SUMMARY OF TERMS
Amount ($) offered to Investors
|Issuer||This states the legal name and location of the Issuer, which all closing documents should reference exactly. It may also describe the Company’s primary activity and summarizes the demand for the product / service.|
|Securities Offered:||A description of the type of securities being offered, e.g., Common or Preferred Membership Interests (if an LLC), type of Preferred (e.g., Convertible, redeemable or participating) and, for older companies, which Series is now being offered (typically lettered as A, B, C, etc.). Different Series of preferred can have different terms relative to each other which must be considered before making an investment in a new Series.
If a Preferred Offering, it will describe what the Investors should expect in the way of a Preferred Return through a Distribution Waterfall or liquidation preference that describes the manner that Issuer distributions to equity investors are treated (e.g., first to Preferred then to Common). Furthermore, it will identify the controlling documentation, such as an Operating Agreement for an LLC or the Articles of Incorporation for a C Corp. You should read and reconcile the Summary of Terms to the language contained within these documents.
|Offering Amount:||How much is being offered for investment within this Series or Class of equity.|
|Use of Proceeds||This outlines how the proceeds from this financing will be used by the Issuer. Fees, such as a Placement Agent Fee, and other expenses, such as legal, which are associated with the Offering, should also be identified.|
|Pre-Money Valuation||The equity value of the business that is requested by the Issuer before additional capital is raised through the Offering. This value is the basis for determining the share price assigned to the new equity, which is calculated by dividing the Pre-Money Valuation by the sum of all outstanding equity, options to purchase equity and equity resulting from outstanding convertible securities (also known as the fully diluted capitalization). The sum of the Pre-money Valuation and the amount of capital raised through the Offering is the Post-money Valuation.|
|Share Price & Number of Shares Offered||The price assigned to the share purchased (or Unit for an LLC). Investment profit (capital gains for tax purposes) are calculated by subtracting the sale price from the original purchase price, adjusted for subsequent splits in the stock price.|
|Investor Qualification||Defines which Investors are eligible to participate in the Offering, such as a requirement that they meet the “Accredited Investor” definition within SEC Regulation D, Rule 501. (CFG’s investments are sold only to Accredited Investors).|
|Minimum “Subscription Amount”||Defines the minimum investment amount each Investor must commit to participate in the Offering.|
|Offering Period||A timeframe for the Offering to be completed, often with a 60-day extension option by the Issuer.|
|Escrow||If there is a minimum total issuance amount specified by the Issuer for the Offering (a Min/Max Offering), an Escrow account must be established at a bank providing escrow services for investors as fiduciary. This bank will be the Escrow Agent for the Offering. Until the minimum amount has been raised, Investors’ funds are held in safekeeping by the Escrow Agent before being released to the Issuer. If the minimum has not been raised by the termination of the Offering, funds are returned to Investors.|
Terms of the Security:
|Preferred Return on Investment (P)||Specifies a minimum return on the preferred equity, e.g., a [X]% Cumulative Annual Return on invested capital. This would also define when the Distributions are to be made (typically quarterly) and how they are authorized by the Board of Directors.|
|Preferred Return of Capital (P)||Specifies the manner in which the funds originally invested by the preferred equity investor are treated in distributions (Dividends) relative to other preferred investors and to common equity investors.|
|Common Stock Vesting||Ownership transfer of common equity awarded to Issuer employees is regularly assigned a vesting schedule wherein the transfer of ownership occurs over 3 to 4 years as an incentive for employee retention. Upon a qualifying liquidity event, such as the sale of the Issuer or its initial public offering, all the equity that has not yet been transferred to the employee is then accelerated.|
|Anti-Dilution Protection (P)||This clause partially or sometimes fully protects Investors from dilution in their equity position if a subsequent issuance of equity is at a lower price than what is being paid in the current Offering. All such protection effectively awards more equity to protected investors. “Weighted Average Dilution Protection” only provides a proportionate level of protection while “Full Ratchet Dilution Protection” lowers the Investor’s share price to that established for the subsequent, lower-priced round of equity financing.|
|General Voting Rights (P)||Specifies the voting rights of the equity being offered. Voting is typically pro-rata to share ownership with Preferred Investors voting with common on an As If Converted basis as well as within the preferred equity class when its approval is designated for certain major strategic events affecting the preferred investors, such as a sale of the business to a third party or initial public Offering.|
|Protective Provisions (P)||So long as there remains certain amount outstanding of preferred stock, consent of the holders of at least 50% of the preferred stock is usually required to:
Alter any provision of the certificate of incorporation or the bylaws if it would adversely alter the rights, preferences, privileges or powers of or restrictions on the preferred stock;
Increase or decrease the authorized number of shares of preferred stock or any series of preferred;
Authorize or create (by reclassification or otherwise) any new class or series of shares having rights, preferences or privileges with respect to dividends or liquidation senior to or on a parity with the preferred or having voting rights other than those granted to the preferred stock generally; for purposes of this event, the majority of the preferred stock as a class shall be required for approval;
Approve the voluntary liquidation or dissolution of the Company (often only required if the implied return on investment is below a specified cash-on-cash return, such as 2X); or
Declare or pay any dividend or distribution or approve any repurchase with respect to the preferred stock (except as otherwise provided in the certificate of incorporation) or the common stock (subject to customary exceptions).
|Board of Directors (P)||This clause defines the size of the Board of Directors (or Managers) and how they are to be selected. It is common for preferred investors to have a designated number of seats on the Board who only they elect as their representatives. Board Committees are also defined (e.g., an Audit Committee or a Compensation Committee) and whether the Investors will be represented on each committee, generally with special voting rights on the Committees.|
|Information Rights||A private equity Investor should have ongoing access to financial and other information about the Company’s performance, usually on a quarterly and annual basis.|
|Registration Rights & Lock-up Restrictions (P)||Provides that the equity held by preferred equity investors will receive registration with newly issued public shares at the time of an initial public Offering. Though the shares are thereafter registered, there will usually be a 6 month or longer lock-up assigned to the shares that restricts public trading of these shares during this period to avoid downward pricing pressure on the freely trading public shares.|
|Preemptive Rights (P)||Provides new investors with a “first right of refusal” to invest in a subsequent equity financing in an amount relative to their ownership in the Issuer.|
|Co-Sale/Tag-Along Rights (P)||Protects minority shareholders. This right enables Preferred Investors to sell their shares alongside certain other selling Shareholders (usually 5% or greater holders of the Issuer’s outstanding shares) in a potential private transaction to a third party, on the same terms, and in proportion to their relative ownership in the Issuer to the seller.|
|Drag-Along Rights||Protects the Shareholders holding a majority of the Issuer’s equity. This enables the Issuer to pursue certain strategic transactions, such as a sale of the Company, if approved by a majority (or possibly super-majority) of all shareholders. Minority shareholders are forced to join the transaction on the same price and terms as other selling shareholders. The percent necessary to “trigger” Drag-Along Rights often is as high as 75% approval for the transaction in question.|
|Vesting of employee shares||Subject to the discretion of the board, shares and options issued to employees, directors and consultants are often subject to multi-year-year vesting, with initial vesting on the first anniversary of the commencement of services and the remainder vesting monthly or quarterly thereafter.|
|Proprietary information agreements||The Company will have all employees and consultants enter into proprietary information and inventions agreements.
|“Key person” life insurance||The Company will obtain a “key person” life insurance policy on key managers, with proceeds payable to the Company and in amounts sufficient to replace the Manager.|
|Purchase Agreement||The investment will be made pursuant to a stock purchase agreement which will contain, among other things, appropriate representations and warranties of the Company and the investors and appropriate conditions of closing.|
|Conditions Precedent||The closing of the investment (when investor funds are transferred to the Issuer) is subject to customary pre-conditions, including but not limited to:
Completion of due diligence to the satisfaction of the investors;
Negotiation and execution of definitive agreements customary in transactions of this nature;
Negotiation and execution of a formal distribution agreement;
Receipt of all required authorizations, approvals and consents;
Delivery of customary closing certificates; and
The absence of material adverse changes with respect to the Company.
|Fees and Expenses||Placement fee: Ordinarily, this is calculated as a percentage of the funds being raised and is paid to a Placement Agent, if used, by the borrowers from the funds being advanced to the Issuer.
Borrowers will also reimburse the Placement Agent and other professional service providers for any Offering expenses, which will include out-of-pocket due diligence expenses, legal, travel, and other expenses related to the Offering.
The Summary of Terms specifies the rights and other terms of an equity security being offered for investment, identifying, in detail, what a potential Investor should expect from the investment. Once an Investor has indicated interest in the Offering, and Closing Documents have been crafted, these are forwarded to the investor for subscription in the Offering.
For information about terms that usually apply to debt investments, please see “Private Lending Term Sheet: Typical Investment Terms and Conditions.”
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