At a certain point in a company’s life cycle, founders are likely to be faced with the financial pinch of requiring outside sources of funding to finance further growth and expansion of the business. Previously, I posted an article that focused on one of the two most common paths that companies turn to for growth capital financing: traditional bank debt. In this post, I will focus on the second of the most common sources of financing—private equity investment.
Private equity investments can be intimidating for many founders because they are a relatively foreign landscape. It is worth it, however, for founders to educate themselves on the basic principals involved in venture capital deals, as these can be valuable sources of financing to fund a company’s leap to the next level. Minority investment venture capital deals can be employed at various stages of company growth. Typically, angel round financing or seed round financings will come in without a fixed price. At this stage, an investor will likely take a convertible note or a SAFE (simple agreement for future equity). These instruments are similar in that they both involve the investment of funds with an agreement to roll that investment into the next round of equity financing of the company, often at some discount or capped purchase price for that future round. The primary difference between convertible notes and SAFEs is that convertible notes are true debt instruments that carry interest and will require repayment upon maturity if they do not convert according to their terms. SAFEs, on the other hand, are not debt instruments and reflect the simple agreement between the company and the investor to convert the investment into future equity if and when another financing round occurs. SAFEs are generally considered more company-friendly, and it may be difficult to persuade a sophisticated investor to invest at an early stage via a SAFE rather than a convertible note, which offers more investor protections.
Once a company is considering a financing round beyond the seed funding stage (typically taking the form of an issuance of “Series A” equity interests), there will be a pre-money valuation agreed upon between the investors and the company, which will set the price for the round and dictate the amount of dilution that the round will generate for the founders. Series A and later rounds typically feature various investor protections, which can include a liquidation preference and/or an accruing dividend on the initial investment amount, board seats and/or board observer rights, negative control protections, preemptive rights with respect to future rounds, rights of first refusal on transfers of equity, and anti-dilution protection. Private investors may also require the company to set an increased employee equity incentive pool pre-investment (to avoid dilutive grants post-investment) and/or impose restrictions or vesting requirements on existing founders’ equity. At the end of the day, however, the right private investors can provide meaningful contributions as strategic partners with valuable management and executive leadership experience. And because private investor returns are primarily tied to company success, they are attractive in that repayment depends largely upon performance.
A Word of Caution for Small Business Contractors
It is important to note that many of the features typical of standard venture capital investments may be prohibited for companies that rely on their status as small businesses because these investment deals, if not carefully structured, can result in undesired deemed affiliation with larger investment funds. Structuring concerns are of even greater importance for companies in the 8(a) program or other state-level set-aside programs, for which many standard venture capital investor control/voting rights are considered impermissible. Note that if your company fits into any of these categories, it is vitally important to consult with your legal advisors to determine what structuring options are available prior to seeking private financing.
About the Author: Kathryn Hickey is a partner with PilieroMazza and heads the Business & Transactions Law Group. She may be reached at khickey@pilieromazza.com.