Taking Full Advantage of the Direct Corporate Private Offering
Thomas E. Vass, President, The Private Capital Market, Inc.©2012
Introduction: The Direct Corporate Private Offering As A Better Model For Obtaining Financing
Since 1933, private companies have had an avenue of raising funds called a self-underwriting, or a direct corporate private offering, but it has not been widely used as a method for raising capital. In a self-underwriting, the company issues securities directly to investors, without the benefit of a securities broker or financial intermediary between buyers and sellers of capital.
Most young companies and startup firms have primarily relied on a broker or venture firm to assist it in conducting another business model to raise capital that features presentations to venture capital firms or angel groups. Each capital firm or group listens to the company presentation, and then may, or may not, make the company an offer to invest, generally under terms and conditions that are more favorable to the sources of capital than to the company.
In this older model, the broker or intermediary represents the financial interests of the investors, and not the company. The broker or intermediary will often form partnerships or syndicates with other brokers to sell the securities.
Industry statistics show that about 2 in 10 firms are successful in obtaining funds using this older model, and that after about 3 years, of all the firms that raised capital this way, about 60% are terminated by the sources of capital because the company did not meet the performance metrics of the capital firms.
In contrast to the startups, most established firms, with real top line sales revenues, are generally not viable candidates for the older model because the established firms do not have a clear path to an exit that results in a rapid capital gain for the venture capitalists or angels.
In addition, for many established companies, the amount of capital needed to fund growth is too small to interest the sources of capital, and the type of capital needed by the company does not fit the type of securities that the venture capitalists most prefer as an investment vehicle.
Obtaining Favorable Terms and Conditions for the Company In Raising Capital
One of the advantages of a direct corporate private offering over the conventional methods of raising capital is the company’s ability to control the terms and conditions of the offering. By creating the documents related to the offering in advance of the offering period, the company avoids the costs and time lost in frustrating negotiations with multiple sources of capital, all of who may want to impose their own terms and conditions.
The benefits of the company controlling the terms and conditions must be tempered by two key considerations. First, the terms and conditions must be attractive to a wide range of investors based upon the merits of the investment itself. In other words, the terms must be fair to the investors so that they may enjoy the benefits associated with making the investment.
The investors are not going to have an opportunity to negotiate over the terms and conditions of their private securities, so the terms must be fair for them from the start.
Second, the terms and conditions for an early round of capital must be compatible with future rounds. This means that a logical sequence of terms and conditions must flow through all of the eventual rounds of capital raising.
The priority for the company CEO in the creation of the documents must be that they are created right and fairly from the beginning and then continue to be fair for future investors, throughout the life of the company.
The company will need to work with legal counsel to get the exact form and text of the terms and conditions to fit the type of securities for the specific offering today and in the future.
Preferred stock – The Workhorse Security of Private Placements
The first consideration for the CEO in contemplating a private placement is the type of security for the business to issue to investors. Most companies that have some capital gain potential, as opposed to an investor’s interest in the dividend income potential from stable revenues, issue preferred stock.
Preferred stock has various “preferences” over common stock. These preferences can include liquidation preferences, dividend rights, redemption rights, conversion rights and voting rights, as described in more detail below. The “preferences” in preferred stock are also called terms and conditions.
The text for the conditions attach to both the security itself, and to other elements associated with the investment. The same terms, such as “participating,” may be used for different parts of the investment. For example, “participating” can apply to both participating in the flow dividends and to participating in the profits at liquidation.
When used in different elements of the investment, the preferences tend to compound the original, single use of the term “preference.” The preferences associated with preferred stock allows the investor to benefit from a capital gain event because the stock represents equity in the company, and as the value of the equity goes up, the investors can obtain the larger gain when the stock is sold.
Venture capitalists and other investors in the older model typically receive preferred stock for their investment. Most of the negotiations in raising capital in the conventional method, where the company goes searching for capital at individual venture capital sources, concern the priorities and rights for the “preferences” between the investors and the company.
All of the good features and rights associated with the self-underwriting of preferred stock can be used to provide investors with greater security and reduced risk of loss of capital, while the more onerous features regarding venture capital control over decision making authority, can be eliminated.
An additional benefit for investors and the company in a direct corporate private offering (DCPO), is that standardization across many different companies, all of whom issued stock with common terms and conditions, would eventually lead to easier transactions in the future via private securities exchanges.
Common terms and conditions would lead to greater liquidity in the private capital marketplace because less time and expense would be involved in determining how one security’s rights and features differed from another security.
One of the important features and rights associated with preferred stock is its ability to be issued with conversion rights into common stock at some point in the future. In the older method, the convertible preferred stock contained onerous anti-dilution protection for investors in the event that a second round of securities is issued to new investors at lower prices than the earlier rounds.
In the conventional model, the earlier investors had a built-in conflict of financial interest with the company associated with their capital costs of owning the stock. If the value of the company dropped, or the company did not meet the metrics of performance imposed by the capitalists, the conversion rights allowed the earlier investors to obtain a bigger profit when the stock was eventually sold, or the company itself was sold, for a gain.
As the name suggests, convertible preferred stock can also convert into common stock at either the holder’s option or at the option of the company. Usually, there is some form of coerced or mandatory conversion feature for all investors if the company becomes involved in an Initial Public Offering (IPO), or company buy-out, where all the private stock is converted to publicly-traded stock.
Some of the onerous features in the older method of this form of equity, from the company’s and founder’s perspective, is that the earlier rights provide for a guaranteed return of capital through redemption provisions if the company’s performance is mediocre. This explains one of the reasons why such a high percentage of companies in the earlier method were terminated by the capitalists if the company did not meet performance metrics.
In the earlier method, the investors were going to obtain a profit no matter what happened to the company.
These more onerous features of conversion upon redemption do not have to be inserted in company self-underwriting.
Convertible preferred stock often pays or agrees to pay some form of dividends, which can be paid in cash, or in the form of deferred additional shares. Usually the dividend rate is set by a vote of the Board of Directors. In the older model, one of the terms set by the investors was control over the Board of Directors, who could vote for dividends and also had the power to fire or terminate the original founders and entrepreneurs.
The payment of dividends is very beneficial to investors, as it gives them two ways to benefit from owning company stock. First, they may obtain a capital gain profit when they sell their stock, and second, they may also be paid income during the period of time they are waiting for the value of their stock to go up in price.
This type of outside investor control by the Board of Directors so prevalent in the earlier model can be avoided in the self-underwriting.
Conclusion: Making the Terms and Conditions of the Self Underwriting Fair Form the Start
The burden of making the self underwritten private offering attractive to investors from the beginning means that the company and its legal counsel will need to carefully balance provisions that shareholders would find attractive with provisions that are fair to the company.
Since the direct corporate private self underwriting process does not involve negotiations like the older model, the initial set of provisions needs to be attractive to both the investors and the company right from the start.
Among the important considerations of additional protective provisions are:
- A majority vote of the outstanding preferred stock holders to make any amendment or changes to the rights, preferences, privileges, or powers of, or the restrictions provided for the benefit of, the preferred stock;
- A majority vote of the outstanding preferred stock holders to authorize any increases or decreases in the authorized number of shares of Common or Preferred stock;
- A majority vote of the outstanding preferred stock holders any action that authorizes, creates, or issues shares of any class of stock having senior rights or preferences over existing shareholders;
- The broadest possible information rights and inspection rights possible with greater rights attached to owners of at least 15% of the total outstanding preferred stock.
In conformity with the provisions of Sarbanes-Oxley on public companies, private companies should aim at transparency and truthful dealings with their shareholders. Documents such as audited annual and unaudited quarterly financial statements, annual budgets and monthly financial statements, minutes of the meetings of the Board should be made available to preferred shareholders in pass word protected areas of the company’s investor relations web page.
The major desired outcome of raising growth capital, from the perspective of the company, is to obtain capital that helps the company grow. With direct corporate private offering, companies gain more control over their destiny when the seek growth capital.
Part of the solution for small companies gaining control over their destiny is to offer the securities directly to investors in a private placement self underwriting, always mindful of the fact that the prosperity that results from the company’s successful growth must be distributed fairly to all those who took the risk to invest.
Upcoming Article: The Solution to Dilution
About Thomas E. Vass: Vass is a registered investment advisor and regional economist with an interest in the relationship between technological innovation and capital markets. He offers investment management advice to private investors, based on a 2007 investment management method patent issued to him. As a part of his capital market advisory services, he offers advanced web-based tools to help companies conduct a self-underwriting. He is based in Raleigh, N. C. 919 975 4856.