INTRODUCTION TO EQUITY FINANCING

What is an equity financing?

Equity financing refers to the financing of the company via issuance and distribution of shares to the third parties. This method of financing is an exemplary method of raising funds for the businesses that are at the initial stage of their growth and lack the essential financial resources for the expansion of business.

Such kind of financing is motivational and beneficial both to the seller (hereinafter referred to as “the Company”) of the shares and to the buyer of the shares (hereinafter also referred to as “the Investor”). From the perspective of the Company, the Company is being provided with the necessary resources for the development of the planned projects that would otherwise not be initiated because of the lack of the essential
monetary resources.  From the perspective of the Investor, it is a potential business venture that could possibly generate a satisfactory amount of profit.

What are the common methods of equity financing?

The main methods of equity financing are the following:

Private investments;

Private investments are usually made from persons with a close familial relationship with the company owners, and/or from so called “angel investors” by the way of selling shares to them. However, a simple selling of shares is only one of the methods of equity financing. It is widely acceptable practice to provide financing via convertible loan notes, which is much safer for the investor; hence, by referring to this method, in many cases, it would be easier to persuade them to invest. So, it is important to understand what type of shares to offer to such investors, which will be both attractive for the investors and legally prudent from
the perspective of the Company.

Investments made via Venture Capital funds (VC);

Venture capital funds are specialized in financing start-ups with the potential of growth. There аre two important nuances with this type of financing, that are worth mentioning:
– Active role in the management of the Company; The way that the active role of the VCs is illustrated, often is having seats at the board and guiding the Company in the daily business operations.
– A solid way of mitigation of the risks from the side of the VCs, which often results a massive amount of returns for the investors and decreases the returns for the Company; The mitigation of the risks is often illustrated by putting in the contracts clauses like “liquidation event” and “antidilution” clauses.

Initial public offering (IPO);

The companies generally go public at the point when they have proven to be a successful business venture and have reached at a certain level of valuation.
There is an immense amount of legal implications that shall be processed and be discussed before a company goes public. It is important to take into consideration the following factors: the necessity of restructuring, intellectual property protection, data privacy and most importantly the right underwriters.

2 What are the most important fundamentals to lay at the initial stage of equity financing from the side of the company?

Regardless of the preferred method of equity financing there are several principal implications that a company shall take into consideration in terms of negotiations regarding the contractual terms of the investments as well as in terms of understanding the best legal structure for project.
It is a widely known fact that in the prevailing part of cases the bargaining power in the negotiations between the investor and the investment subject is on the side of the investor.
It is expected that investors will put much effort to turn into their favor clauses in the investment contract like “liquidation event”, “antidilution”, “management and control” clauses.

So, it is important to balance these clauses between the company and the investor in a way that will let the company to remain attractive for the other investors as well.
Because if an investor will have a right of a full liquidation preference, a protection of share ownership percentage and a substantial amount in the company, it will make the company unattractive for the potential investors, since they’ll have to make a risky and potentially unprotected investment. Besides, it is important to consider the risk of a potential takeover, since in case if an investor turns into its favor the aforementioned clauses of the investment contract, it will potentially have the necessary mechanisms for the initiation of the process of takeover.

Disclaimer:

This material is produced by Legelata LLC. The material contained in this newsletter is provided for general information purposes only and does not contain a comprehensive analysis of each item described. Before taking (or not taking) any action, readers should seek professional advice specific to their situation. No liability is accepted for acts or omissions taken in reliance upon the contents of this material.