United States: Financing Your Start-Up

In a typical financing scenario which involves several rounds of financing, BIZ.com may capitalize itself as follows: the corporation first issues common stock to its founders and key employees at cheap prices in the founders or seed round. This common stock participates directly in the growth and profits of BIZ.com. However, common stock (a junior security) is subordinate in priority of distribution of the assets of BIZ.com to any debt or preferred stock, as discussed below.

On its next round of financing, BIZ.com may issue Series A preferred stock to an angel investor. This Series A preferred stock will likely convert into common stock of BIZ.com automatically upon the occurrence of certain events, including the sale or liquidation of the company or the closing of an initial public offering of BIZ.com’s common stock. It may also convert into common stock at the election of the angel investor, for example, any time after closing of the transaction or any time after the first or second anniversary of the closing.

Among its other benefits, the Series A preferred stock is a senior security in that it gives its holders a liquidation preference, or the right to receive a return of their investment before the common shareholders receive any proceeds upon the sale or liquidation of the company.

The Series A preferred stock will typically have the right to elect one or more directors to BIZ.com’s board of directors and special voting rights or veto rights with respect to certain corporate transactions, such as incurring debt above a certain amount, issuing shares of stock with rights or preferences equal to or senior to the Series A preferred stock, selling or merging the company or amending its charter or bylaws. Typically, these actions may not be taken without the approval of the holders of the Series A preferred stock voting as a separate class. The Series A preferred may also have anti-dilution protection, or the right to receive additional shares of BIZ.com if the company issues any of its equity securities at a price less than the price at which the Series A preferred stock is convertible into common stock. In some instances, the Series A preferred stock may accrue a dividend which is payable currently or upon the sale or liquidation of the company. However, the payment of dividends may be burdensome to a start-up company. Usually, the nature of the investor drives the decision whether the Series A preferred stock carries a dividend. That is, if the investor requires current income to cover its operating expenses, for example, it may require a dividend. If, as is the case with many angel investors, the investor does not require current income, the investor may forego a dividend so the company can reinvest those proceeds in the business.

If BIZ.com effectively uses the proceeds from the seed capital and the angel rounds of financing, the value of BIZ.com should increase. Although its future looks bright, the company will need more capital. BIZ.com may now turn to venture capital funds for its next round of financing. Because the value of BIZ.com has increased, the venture capitalist will be paying a higher price per share for the security it purchases than the angel investor paid. As a result, the venture capitalist will demand greater rights and preferences in its security than those granted to the holders of the common stock and the Series A preferred stock. In the typical scenario, BIZ.com will issue a Series B preferred stock to the venture capitalist. The terms of the Series B preferred stock are more restrictive to BIZ.com, reflecting the fact that the venture capitalist is paying a higher price for its ownership interest in the company. Like the Series A preferred stock, the Series B preferred stock will be convertible into common stock and will have a liquidation preference. However, the Series B liquidation preference will be even more senior than the liquidation preference granted to the holders of the Series A preferred stock. The Series B investors will have the same or greater voting (or veto) rights as the Series A investors and the right to appoint directors to BIZ.com’s board. The Series B preferred stock will typically carry a dividend, which may or may not be cumulative (that is, accumulate from year to year, whether or not paid at the end of each year). Because the venture capital firm typically has operating expenses and limited partners to whom it owes a fiduciary duty to gain a current return on its investments, the Series B preferred stock will likely contain a cumulative dividend. Like the Series A preferred stock, the Series B preferred stock will also contain anti-dilution protection for issuances of equity securities below the price at which the Series B preferred stock converts to common stock.

The investors in both the Series A round and the Series B round will likely require registration rights for their securities. These registration rights give the investors the right to register shares of their stock when BIZ.com files a registration statement for a public offering of its stock. Even though the Series A preferred holders had registration rights before the Series B round was initiated, the holders of the Series B stock will demand the right to register their stock before the holders of the Series A and common stock holders register their stock. In some instances, the holders of the Series B stock will agree to share equally their registration rights with the Series A investors.

After BIZ.com uses all of the proceeds from the Series A and Series B rounds, the company may need to raise additional capital. It may do so by issuing another equity security (Series C preferred stock) or debt securities to bridge the company to its next round of financing or to its initial public offering. A bridge loan typically will bear interest in the 12% to 15% range and will likely convert into common stock upon the company reaching its next financing and will be issued with warrants. A warrant is a security which gives the holder the right to purchase a specified number of shares of Biz.com’s equity securities (typically common stock) at a specified price before a stated expiration date. Warrants provide the incentive, or "equity kicker," for investors to purchase a debt security which, by itself, would not allow the investor to participate in the economic upside of a successful venture. Along with the warrant, the convertible feature of the bridge note (if it is convertible) provides the economic incentive for an investor to purchase a company’s debt instrument. If the debt instrument is not convertible into the company’s equity securities, but is "straight debt" payable over some fixed term, the attached warrant is a practical necessity to make the straight debt security attractive enough for purchase.