NFIB

Capital-Formation Strategies
10/ 01/ 2002

Provided by Kiplinger

There are many choices available to a small but growing company that's looking to raise capital, but basically your choices are limited to two flavors: debt and equity. Defining your "optimal capital structure" -- the proper balance between the two -- is a challenge, as is finding those sources of capital at affordable rates. What's considered affordable varies, depending on whether you're pursuing debt or equity. Affordability in the "debt" context refers to the term, the interest rate, the amortization and the penalties for non-payment. In the context of "equity," affordability refers to worth (known as valuation), dilution of the shares or control held by the current owners, and any special terms or preferences such as mandatory dividends or redemption rights.

Your first available option is to issue securities. There are essentially three types: debt securities, equity securities and hybrid (or convertible) securities. Each has certain characteristics, variable features and attendant costs.

Debt Securities

When you authorize the issuance of a debt security, it is usually in the form of a bond, a note or a debenture. Typically, a bond is an obligation secured by a mortgage on some property of the company. A debenture or note is unsecured and therefore is issued on the strength of the company's reputation, projected earnings and growth potential. (It usually carries a higher rate of interest.) The terms of the debt security and the earnings, or yield, to the holder will be determined by an evaluation of the level of risk and the likelihood of default. Growing companies that lack a high bond or credit rating will often be faced with restrictive clauses, or covenants, in the debenture purchase agreement or in the actual terms of the bond, which govern your activities during the term of the instrument. For example, the covenants might restrict management's ability to get raises or bonuses, or might require that you maintain a certain debt-to-equity ratio at all times. You and your attorney should assess the direct and indirect costs of these terms and covenants before you choose this option.

Equity Securities

Equity securities include common stock, preferred stock, and warrants and options. Each type carries a different set of rights, preferences and potential rates of return in exchange for the capital contributed to the company. The typical growing company (whose value to an investor usually depends on intangible assets, such as patents, trade secrets or goodwill, and projected earnings) will issue equity securities before incurring additional debt. This is because it lacks the assets necessary to secure the debt, and additional debt is likely to increase the company's failure risk to unacceptable levels.

The three types of equity securities are:

Common stock
An offering of common stock and the related dilution of interest in the company is often traumatic for owners of growing companies that operate as closely held corporations. The need for additional capital for growth, combined with the lack of readily available personal savings or corporate retained earnings, causes a realignment of the capital structure and a redistribution of ownership and control. Although the offering of common stock is generally costly and entails a surrender of some ownership and control, it does offer you an increased equity base and a more secure foundation on which to grow, and increases your chances of getting loans in the future.

Preferred stock
Broadly speaking, preferred stock is an equity security that shares some characteristics with debt securities. Preferred-stock holders are entitled to receive dividends at a fixed or adjustable rate of return (similar to a debt instrument) before dividends are distributed to holders of the common stock. Owners of preferred shares also participate ahead of common-stock holders in the distribution of assets in the event of liquidation. The preferred stock may carry certain rights regarding voting and convertibility to common stock. The shares may also have antidilution or preemptive rights, or redemption privileges that may be exercised by either the company or the shareholder. Although your fixed dividend payments are not tax-deductible (as interest payments would be) and company ownership is still diluted, the balance between risk and reward is achieved because you need not return the principal invested (unless there are provisions for redemption). In addition, the preferred-stock holders' return on investment is limited to a fixed rate of return (unless there are provisions for convertibility into common stock), and preferred-stock holders' claims are subordinated to the claims of creditors and bondholders in the event of the liquidation of the company. The use of convertible preferred stock is especially popular with venture capitalists.

Warrants and options
These give the holder the right to buy a stated number of shares of common or preferred stock at a specified price and within a specified period of time. If that right isn't exercised, it lapses. If the stock's price rises above the option price, the holder can essentially purchase the stock at a discount, thereby participating in the company's growth.

Convertible Securities

Convertible securities (in their most typical form) are similar to warrants and options in that they provide the holder with an option to convert the security-such as a convertible note or convertible preferred stock -- into common stock. The incentive is usually the same as for the exercise of a warrant: the conversion price (the price the company will receive for the common stock upon conversion) is more favorable than the current rate of return provided by the convertible security. Convertible securities offer your company several distinct advantages, including the opportunity to sell debt securities at lower interest rates and with fewer restrictive covenants (in exchange for the investor having a chance to participate in the company's success if it meets its projections and objectives).

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Andrew J. Sherman, a nationally recognized corporate and transactional attorney, has spent over two decades as a legal and strategic adviser to hundreds of entrepreneurs and growing companies. He is a senior partner of the Katten Muchin Zavis law firm in Washington, D.C. and chairs its local corporate and technology department. Sherman is also an adjunct professor at the University of Maryland and Georgetown University, where he teaches entrepreneurship and business planning.

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