Equity Instruments

Agreeing a valuation figure is always problematic in a start up situation and much time and energy can be wasted on that. One interesting instrument I came across recently was a convertible loan note with a future valuation formula agreed.

Commonly, convertible loan notes work like this;

An investor makes a loan to a company and earns an agreed % of interest each year. The loan will then either be redeemable after an agreed time frame or be converted into equity at that time at an agreed price. The instrument is very flexible and you can have many different variables (what is done with the interest, the number of years etc).

This still leaves the problem of valuation to be agreed though. One of the loan notes I came across in Canada deals with this problem fairly neatly. The valuation is at an agreed discount (30%) on the next fund raising round. The benefit of this solution is that it allows valuation to be left till a future date when there should be some metric based valuation dependent on performance.

Another instrument I came across was a redeemable preference share. This acts like a convertible note but allows for massive upside in the case of a sale of the business. The example I came across was that an investment of $1m was made and this would equate to 20% of the business, but would be treated as a loan. If (when) the business was sold, the $1m would be repaid and 20% of the net sale proceeds would go to the equity holders as well. (So if the business sold for $10m, the Note holders ($1m) would get $2.8m ($1m + $1.8m (20% of $9m))). So although the business has doubled in value, the noteholders would get 2.8x the money invested.

I think these instruments will increasingly be used in the next two or three years as angel investors look to protect themselves against high valuations and to ensure that they get a good upside for the higher level of risk they are being asked to undertake (in terms of other competing financial assets).

Be interested in hearing from start ups about their thoughts on these instruments.

16
Jan 2011
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POSTED IN Fundraising General Commentary Investments
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  • RichC

    This is a Superb blog and very informative for companies seeking investment for equity

  • RichC

    Just wanted to add that i can see the redeemable preference share options being very popular in the future.

    As an established business looking at growth capital we have a slight variation on that redeemable option. In our case we are saying to the investor if you buy ordinary share capital for X (EIS qualified) we would match with same level of investment in non voting preference shares issue that are redeemable at point of sale. So at point of sale the investor is guaranteed 100% of money back from the preferance share sale out of proceeds  PLUS whatever the company investment returns from the ordinary share stock sale. Its a great way to make the upside potential more attractive for investors.
    You can see our pitch on Crowdcube – http://www.crowdcube.com/investment/red-advertising-ltd-10471
    Although, this method is only really of value where the business is existing and already has some worth and is likely to be sold for something way above the loan values. If a business is a pure start up then in the majority of cases the investor may be sitting on the investment for some time before that business has some decent sale value – in which case the business has to do as much as possible to make that investment attractive and consider all possible variations.