Legal Stuff, Explained

Equity Financing 101:

Last week Zeke Vermillion taught us the nuts and bolts of equity financing. Check out the first few slides (full presentation can be downloaded here) and 3 main takeaways from the presentation.

1. What is Equity?

Equity is ownership interest in a business. The owners shoulder the greatest risk of all stakeholders, and reap the greatest reward if the business is successful. A company’s capital structure is comprised of debt and equity. Common stock is the riskiest investment class. If the company performs poorly, lenders and preferred stockholders are paid first. Stockholders may be left high and dry, and common stockholders will be the highest and driest.

2. Hybrid Instruments Can Reduce Risk:

The features of different instruments can be combined to adjust the risk/reward payout. Most venture investors use convertible preferred or other hybrid investment vehicles to limit downside risk while ensuring ability to participate fully in any upside. Presented with a liquidity event, convertible preferred investors can choose either to recoup their preference amount (usually a low multiple of invested capital) or convert to common stock. Unless the investors hold “participating preferred”, in which case they get both their preference amount and then participate alongside common stockholders in the remaining upside.

3. Dilution:

Early investors are diluted by later investors. That is, the portion of the company’s equity held by early investors is reduced when additional investors join. Investors hope that the dilution is offset by increasing valuation. That is, investors accept holding a smaller piece of a much larger pie. However, in a “down round” – where later investors come in at a lower valuation – existing owners will get a smaller piece of a smaller pie. Investors will often ask for protection against dilution so that their proportional interest is adjusted (at least partially) to counteract the dilutive effect of later investments. This can be accomplished through different mechanics. For convertible preferred stock, usually the price at which the preferred converts into common is the metric that gets adjusted.