Different ways of raising equity funds

Introduction

For SME’s that are thinking about raising equity funds, one of the first things to consider is the type of equity instrument to be offered to new investors. (For fund raising through debt, please see this note written by Stephanie).

Ordinary shares

The most obvious way to raise equity is through the issue of new shares.

Often, an early-stage SME will have only one single class of ordinary shares meaning all shares carry equal rights on voting, dividends and capital distribution upon a company sale or winding-up.

In this case, issuing new ordinary shares to investors will be the most straightforward way of raising equity, once the value of the company and new shares has been determined and agreed.

There will be some procedural steps that need to be undertaken first including either disapplying the pre-emption rights of existing shareholders to take up new shares or first offering the new shares to existing shareholders at the same price and terms being offered to the new incoming investors.

Preferred shares

Where an SME already has a roster of one or more external investors, new investors may wish to invest on the basis of being issued a new preferred class of shares (i.e. Series A, Series B, etc).

Preferred shares will grant the holders a preferential claim over the proceeds of a company sale (or wind-up). The amount per share that preferred shareholders will be entitled to ahead of ordinary shareholders will usually be the share price paid by the preferred shareholders for their preferred shares. This share price amount would need to be paid out first to holders of the preferred shares before any remaining proceeds are distributed to shareholders.

Where the share price from a company sale (or wind-up) is higher than what the preferred shareholders paid, then the preferred and ordinary shareholders will instead typically share the proceeds of a company sale (or wind-up) on an equal basis, as if the preferred shares were ordinary shares. This way the preferred shareholder investors get the best of both worlds. In a downside scenario, the preferred shareholders will be paid out their original investment ahead of the ordinary shareholders. In an upside scenario, the preferred shareholder investors will share in such upside.

Aside from the sale and liquidation preference as described, preferred shares may additionally have preferred dividend rights which will often accrue at a fixed percentage per annum. The voting rights of preferred shares will typically be on an equal footing to ordinary shares.

Raising equity via the issue of preferred shares usually involves more complexity than issuing ordinary shares. The issue of preferred shares will typically involve amending the company articles to document the additional rights for the new investors.

Convertible notes

Where an SME wishes to delay having to place a valuation on itself, fund raising via the issue of convertible notes can be a useful alternative.

Convertible notes are a hybrid of debt and equity. The notes will initially work like a debt instrument which accrues interest at a fixed annual rate. The notes will typically have a fixed maturity date upon which either (a) the principal and accrued interest must be repaid, or (b) the notes convert into shares at a share price that is either predetermined or calculated through an agreed formula. The number of shares to be issued to the noteholders would be the sum of the principal and accrued interest outstanding under the notes divided by the conversion share price.

Prior to the maturity date, convertible notes may also convert into shares upon certain events such as the completion of a significant equity raise or a company sale. On a significant equity raise event, typically the pre-agreed price per share at which the notes can convert will be at a discount to the share price being paid by the investors on such equity raise.

Prior to conversion, convertible noteholders are not treated as shareholders and have no voting rights. Full shareholder rights will only kick in for the noteholders after the notes convert to equity.

One benefit of convertible notes is that they are usually much simpler and quicker to document compared to the issue of preferred shares although complexity may arise over how to define the pre-agreed formula to determine the conversion price of the notes. Pre-emption rights of existing shareholders would also apply to the issue of convertible notes unless these were disapplied.

Advanced Subscription Agreements (“ASA”)

ASAs are very similar to convertible notes. ASA instruments grant investors the right to receive shares at a future point in time but unlike convertible notes, ASAs do not typically accrue interest and there is no obligation or option on the SME to repay the amounts funded under the ASAs.

ASAs will convert into shares upon certain trigger points. Typically, these include a subsequent equity funding round meeting a pre-agreed monetary threshold and a company sale. Usually, the conversion price of an ASA instrument will be capped at the lower of (a) a pre-agreed level and (b) the equity round or company sale share price as reduced by an agreed discount.

If no conversion trigger event occurs, then an ASA instrument will convert to shares automatically on a long stop date at a share price that is either predetermined or calculated by a negotiated formula. The long stop date for an ASA conversion is typically up to two years but this may need to be significantly shortened if the ASA investment is to be eligible for EIS relief.

Similar negotiation and execution issues that apply to convertible notes will also apply to ASA instruments, although ASA instruments are generally shorter and more simple documents than convertible notes.

For SMEs that are interested in attracting US investors, Simple Agreements for Future Equity (“SAFE”) are a common US investment instrument with similar characteristics to ASA instruments.

Conclusion

The above provides a very brief snapshot of different types of equity raising instruments. Whichever route is taken will largely depend on the relative bargaining power between an SME and its potential investors, as well as the current growth stage of the SME.

Feel free to get in touch if you’d like some help with your fund raise.