What will VC's want for a security?

Common stock? Preferred stock? Debt? Warrants?

As one programs any financing, as in corporate finance generally, the objective is to make 2 + 2 = 5; that is to obtain added value for the issuer.

In the course of a financing, the insiders are attempting to raise the maximum amount of money for the minimum amount of equity ("equity" meaning claims on the residual values of the firm after its creditors have been satisfied). A corporation will issue at least one class of common stock because it must; many firms stop there; they pursue the simplest capital structure possible in accordance with the KISS principle ("Keep it Simple, Stupid"). However, in so doing, the corporation may close down its chances to pursue the added-value equation (2 + 2 = 5) because that equation involves matching a custom-tailored security to the taste of a given investor. The top line of the term sheet will ordinarily specify the security the VCs opt to own; the following discussion takes up the most common possibilities.

Different investors have differing appetites for various combinations of risk and reward. If a given investor has a special liking for upside potential leavened with some downside protection, the investor may "pay up" for a convertible debt instrument. An investor indifferent to current returns prefers common stock. The tax law drives some preferences, since corporate investors must pay tax at full rates on interest but almost no tax on dividends.

On the other hand, the issuer of the security can deduct interest payments for tax purposes - interest is paid in pre-tax dollars - but not dividends. The sum of varying preferences, according to the plan, should be such that the issuer will get more for less - more money for less equity - by playing to the varying tastes of the investing population, and, in the process, putting together specially crafted instruments, custom made as it were. A potential investor interested in " locking in" a return will want a fixed rate on debt securities instead of a variable rate; the ultimate "lock-in" occurs in a zero coupon bond, which pays, albeit not until maturity, not only interest at a fixed rate but interest on interest at a fixed rate.

As the practice of tailoring or "hybridizing" securities has become more familiar and frequent, the traditional categories can become homogenized. Preferred stock may come to look very much like common stock and debt resembles equity. In fact, the draftsmen of the Revised Model Business Corporation Act no longer distinguish between common and preferred stock. Moreover, it may be advantageous (again with a view to making 2 + 2 = 5) to work with units or bundles of securities, meaning that an investor will be offered a group of securities, one share of preferred, one debenture, one share of common, and a warrant, all in one package.

Indeed, creativity by sponsors has spawned a variety of novel "securities," equity, and debt, which have played a role in venture capital, the underlying notion being to maximize values by crafting instruments to fit the tastes of each buyer and to capture current fashions in the market. The use of "junk" or "fluffy debt has been the focus of popular attention of late; however, junk bonds?debt securities which are less than investment grade and, therefore, unrated?are only one species of the complex phyla of hybrid securities invented by imaginative planners. Thus, a given issuer's financial structure can perhaps be best envisioned by thinking in terms of layers of securities. The top layer is the most senior: usually secured debt, "true" debt in the sense that the holder is opting for security of investment and "buying" that security by accepting a conservative rate of return, a fixed interest rate, or a variable rate tied to an objective index. The bottom layer is the most junior: common stock (and if the common stock is divided into different series, the most junior series); on occasion, this level is referred to as the "high-speed equity." The risk of a total wipeout is the greatest, but, because of the effects of leverage, so is the reward. In between are hybrids, layers of securities with differing positions, meaning differing claims on Newco's current cash flows and the proceeds of a sale or liquidation of the entire enterprise. The variables open to the planners include the following: a security can be denominated either debt or equity with different tax consequences to both the issuer and the holders; a security may be senior, or subordinated, or both, as in senior to one level and subordinate to another (the term " subordinated" opens, in and of itself, a variety of possibilities); a security may be convertible into another at a fixed or variable rate of exchange (and convertible over again, as in debt convertible into preferred stock, in turn convertible into common); an equity security may contemplate some form of fixed recoupment of principal, perhaps expressed in terms of a redemption right, and redemption can be at the option of the issuer, the holder, or both; and the issuer's obligations to make periodic payments with respect to a debt security can range from the simple to the exotic - monthly interest payments at a fixed rate to so-called PIK payments (payment in kind, meaning in stock versus cash) tied to the performance of a particular business segment (as in "alphabet stock").

*This article is reprinted from VC Experts Encyclopedia of Private Equity & Venture Capital at www.vcexperts.com.

(Image source: boredofdictators)