Private Equity and Venture Capital Financing Structures
By Joseph B. LaRocco
There are several structures that Private Equity funds (also known as venture
capital funds) use when they give the green light to fund a company. The
basic structures for private companies are common stock and convertible preferred
stock. These structures usually contain an anti-dilution provision, so the lead
investor doesn’t start out purchasing say 40% of your company for $4,000,000 and
then end up with only 5% because you dilute his stock position with subsequent financing
1. A Common Stock. Common Stock funding structures are pretty simple.
The company and investor agree on a dollar amount to be funded and the percentage
of stock, also called the equity position, the investor will receive. Most private
companies, however, will find they have very little bargaining power with private
equity funds. Usually, it is the money that dictates the terms of the financing
structure. Part of the reason is that if you don’t like the deal terms you don’t
have to take the money. Another reason is that Private Equity firms know which structures
work for them and which ones don’t.
2. Preferred Stock. Private Equity firms use Preferred Stock structures
the most. The Preferred Stock is convertible into Common Stock, usually anytime
at the option of the holder. The convertible Preferred Stock can be convertible
into either a fixed number of shares of Common Stock or a certain percentage of
the Common Stock outstanding on a future date. Most Preferred structures also have
a built in dividend. The dividend could range from 6% to 12%. This allows the Private
Equity firm to receive some return on its investment before the Exit Strategy is
3. Debt Financing with an Equity Kicker. Another possible structure,
if your company is already operating and profitable, or close to it, is debt financing
with an equity kicker. Although this structure will be difficult to get
from a Private Equity firm, it is worth exploring.
You are more likely to get this kind of financing from Angel investors. Maybe even
family and friends would even provide this type of financing if the amount is not
too large and you have good cashflow. Say you feel $200,000 can get you over the
hurdle and profitable. Structure the $200,000 as a 3 to 5 year loan and give the
investor 10% of your company in common stock. The number of shares and percentage
you give the investor/lender is based on the size of the loan and the value of your
company. I only used 10% as an example.
4. Convertible Debt.Some investors will structure their funding as
a convertible note or convertible debenture. This security is convertible at their
option into Common Stock of the company. Usually they will not convert until the
Common Stock is trading and they can get out of their position.
Smart investors will also use what is called a "4.9% Clause". I have used
this many times for my private investor and hedge fund clients. Certain securities
laws require investors that own 5% of more to make certain filings with the U.S.
Securities & Exchange Commission (SEC). This allows investors to get around
that requirement since the 4.9% Clause does not allow the investor to own more than
4.9% of the company at one point in time.
Also, if an investor owns more than 10% of a company they are deemed an "Affiliate"
and a number of other rules kick in. An investor can remain more nimble with his
investment without having to comply with these regulations. The 4.9% Clause also
benefits the Management Team. If the investor can't own more than 4.9% of the company
it is very difficult for the investor to take over the company or make management
5. Reverse Mergers. A Reverse Merger is when an existing private company
merges into an existing public company with a stock symbol, which is usually a “shell
company”. A shell company is a public company that although still in existence
and having a stock symbol, is no longer operating a business. The business plan
obviously failed and that company went out of business, but the public entity or
shell still exists. This is the key ingredient in the Reverse Merger.
Joseph B. LaRocco has represented and advised private and public companies concerning
the internet, securities and investments. He also has extensive experience advising
hedge funds on numerous trading and investment strategies. Mr. LaRocco is an attorney
who practices law in New Canaan, CT, and is currently General Counsel and a Director
of NetSky Holdings, Inc. (Symbol: NKYH).