Corporate Blog: Revisiting Capital Structure and Its Importance – Private Capital Raising Options – Securities

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In the current economic environment, cash flow and the availability of cash have become kings. These economic circumstances are causing many companies to reassess their capital structure, even those with strong balance sheets. Private companies exploring options for raising capital have two main decisions to make: (1) what type of security to offer and (2) what method to use to comply with securities laws.

1. Capital structure options: what security to offer

Rising interest rates make raising equity or other similar solutions more attractive to founders and business owners looking to fund their growth. The table below illustrates capital structure options ranging from senior debt (much like a typical secured bank loan) to common stock.














CAPITAL STRUCTURE



senior debt

  • Revolving Loans and Term Loans


  • Fully secured by tangible assets


  • Short-term in nature with strict amortization




  • Requires personal guarantees from the founders

Mezzanine debt

  • Usually 2n/a Senior Term Loans


  • Requires positive cash flow


  • Long-term capital with limited or no amortization


  • Flexible and personalized agreements


  • Typically includes warrants, but is less dilutive than equity

Hybrid financing (e.g. convertible debt, convertible equity)

  • Date of conversion into preferred shares


  • Interest rate that can be repaid upon conversion


  • Investors convert to common stock once the company goes public



Simple Agreement for Future Fairness (SAFE Rating)

  • Considered more founder-friendly than convertible debt and closer to equity than convertible debt


  • Outstanding indefinitely until next equity financing (“NEF”)


  • No maturity date/conversion date


  • Investors only receive the right to convert shares at a lower price than the NEF

Favorite stock

  • Typically includes liquidation, conversion, call and voting provisions


  • Usually carries a dividend, but no amortization





Common equity

  • Highly dilutive emissions generally affect control








2.
Methods to raise private capital

After deciding which security to offer, issuers typically evaluate four main factors to determine the type of securities offering to pursue: (1) the dollar value of the offer, (2) whether the offer will require general solicitation to be successful, (3) whether funds can only be raised from accredited investors, either through the friends and family of the issuer or through the contacts of a broker or crowdfunding platform, and (4) what type of SEC filing is required.

After the changes made by the JOBS law and the adoption of the CF regulations, the main difference between the methods of exempt offer is
whether the offer permits general solicitation. It is also the most influential factor in terms of the risk that the offer represents for the issuer. General solicitation offers require additional compliance efforts. Below is a summary of bid waivers based on the above factors. Although there are other things to consider, such as whether securities will be restricted after the offering, or what requirements apply (for example“bad actor” disqualifications apply or audited financial statements must be provided), the bulk of evaluating the appropriate offer often comes down to these factors for medium and small businesses.



Capital Raising Methods and Exemptions Available






















Nature of exemption


Offer a limit of $ in a 12 month period

Prohibits general solicitation

Allows general solicitation

Accredited investors only

SEC Filing Required

None

Reg. D Rule 506(b)

Unlimited accredited investors, limited to 35 sophisticated investors in a 90 day period

Yes. Form D

None

§4(a)(2) Transactions must not involve any public offering. Typically involve institutional buyers performing due diligence who do not need the protection of the 1933 Act. SEC vs. Ralston Purina Co.

Nope

No, but state registration requirements are not preempted by federal law.

None

Reg D, Rule 506(c)

Only Accredited Investors and Reasonable Due Diligence Steps Required

Yes. Form D

$5 million

FC regulations

Non-accredited investors subject to investment limits based on income and net worth.


Requires the use of a regulated crowdfunding platform, such as Dealmaker, Republic.com

Yes. Form C (including 2-year financial statements, certified, revised or audited, as required)

Individual state limits typically $1-5 million

Intrastate Rules: §3(a)(11), Rule 147, Rule 147A

Current requirements for the issuer and the investor

No SEC filings, but states vary in notice/registration filing requirements

$10 million

Rule 504

Applicable requirements for issuer and investors

Yes

$20 million

Reg A, Level 1

None

Yes

$75 million

Reg A, Level 2

Non-accredited investors subject to investment limits, unless the issuer is listed

Yes

Securities Filings Required: State or Federal

The vast majority of waivers require the filing of a securities filing with state and/or federal regulatory authorities (e.g., Form D, Form C, Form 1-A, or state filings) and the preparation of subscription agreements and disclosure documents. Many offerings also require audited financial statements and the issuance of an offering circular to each investor. These documents should be prepared by a securities lawyer.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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