From Seed to Success: Capital Raising Structures

The hard part is over.  You have taken your idea to market.  Your product is gaining traction.  Then here comes the harder part – the company needs more capital to fund its new product development, grow operations, and expand its market reach. This article outlines key capital raising structures, as well as the main features and considerations for selecting the right capital raising method for your company.

Overarchingly, a company can raise capital by way of the following methods:

1. Equity raising;
2. Debt financing; or
3. Hybrid financing (i.e. combination of both debt and equity financing).

In any of the above circumstances, the capital raise can be done within the company internally (as between the shareholders / founders) or externally (by onboarding new investors).  Whilst accepting external investment could present greater funding potential to a growing company, the significant consideration affecting founders with respect to this decision is the involvement of a third party into the conduct of the company’s affairs, particularly where the external capital brings about dilutionary effect to their shareholding and decision-making dynamics in the company.

Equity raising

A company can raise capital by issuing more equity. This involves the company issuing more shares and selling those shares in exchange for capital funding (which can be sold to shareholders exercising their pre-emptive rights or to external investors).

The primary benefit to an equity raise is that there are generally no repayment obligations on the company for capital received in exchange for shares, given that the treatment of the company’s receipt of that capital is characterised as consideration for share subscription. Relevantly, by becoming a shareholder, an investor is effectively buying into a proportion of the profits and assets of the company as represented by their shares.  Thus, whilst the investor risks not receiving any return of capital investment that it has contributed in the company, it is entitled to dividends declared in the company and the division of surplus company assets in a wind up of the company in accordance with their shareholding proportion.

In a founder’s perspective, an equity raise poses the disadvantage of diluting their shareholding.  Importantly, the increase of newly issued shares in the company results in the increase of the total number of issued shares in the company, which dilutes all shareholding in the company prior to the equity round.  Consequently, earnings-per-share is also reduced, given that dividends in the company is now divided across a larger shareholding base.  A further consideration affecting most founders is also the impact to the company’s governance and decision-making dynamics as a result of new shareholder(s) being onboarded into the company.

Debt financing

A company can also raise capital by way of debt, which can be taken out from a shareholder (via shareholder’s loan) or by third party loans, such as a financial institution.  The main disadvantage to debt financing is the difficulty for early-stage companies to obtain a third-party loan, and where such a loan is secured, fixed repayment obligations and interests would apply on the company.  Debt financing could thereby be constraining upon a company’s cashflow, particularly where the company does not yet have a stabilised performance.  In addition, third party lenders can also impose onerous lending terms upon the company which can restrict the conduct of the company’s affairs generally.

Notwithstanding the above, the key benefit to debt financing is that it enables founders to preserve their shareholding in the company and to retain control over their own company without onboarding new shareholders.

Hybrid financing

Hybrid financing involves raising capital by using a versatile instrument which combines both equity and debt financing elements.  The primary instrument of hybrid financing can be equity-based or debt-based, with the hybrid element to materialise in different forms under the terms of the relevant instrument.  Each of the two (2) common examples of equity-based and debt-based hybrid instruments are as follows.

Preference shares

 An equity-based hybrid financing instrument is preference shares.  This method is effectively an equity raise, whereby new preference class shares are issued in the company and sold to investors.  However, the company has obligations to repay capital to preference class shareholders pursuant to the rights attaching to their preference shares.  In addition to repayment of capital, preference class share rights can also confer other priority rights to preference class shareholders, e.g. priority over dividend distributions and division of surplus company assets on a wind up of the company in accordance with their shareholding proportions.  Given that this method provides investors with “best of both worlds” approach, this method is typically preferred by sophisticated investors (e.g. venture capital funds) to confer greater protection over their investment.

Convertible notes

Convertible note is effectively a debt financing instrument which contains equity conversion terms.  Initially, a convertible note is recorded as a loan between a company and an investor.  However, the loan can be converted to share subscription in the company on the occurrence of pre-determined trigger events (this could be such as when the company calls for a new capital round, or upon the company achieving a specific milestone, or simply on the occurrence of a maturity date).  A convertible note can be drafted to enable investors to lock in a conversion price or valuation cap under the convertible note’s terms, which provides a benefit to investors to lock in or cap the subscription price upon which the loan that they have provided would be applied as consideration for shares prior to further up-rounds in the company, thus enabling an investor to lock in a lower valuation to company’s shares.  Alternately, a convertible note can also provide flexibility for that investor to not elect for share conversion, in which case the company would be obliged to repay the investor on basis of the loan repayment terms under the convertible note.

Chamberlains has assisted many growth-stage businesses to undertake capital raisings under various structures.  Please speak to our Corporate and Commercial Team if you require any assistance or advice with respect to your capital raising options, processes and implementations.