Structuring a Private Placement Offering
A private placement offering’s basic structure involves either debt, equity, or some combination of debt and equity. Within the basic structure, an issuer has numerous options, from convertible securities (debts that convert to equity upon certain events), to priority distributions and resumptions. Not one structure fits every issuer. The offering structure is driven in large part by investor appetite for the particular investment.
A debt structure involves the investors simply purchasing promissory notes of the issuer and receiving interest and principal payments according to the terms that the issuer chooses. Interest payments can be payable in installments, monthly quarterly, or annually. Alternatively, they can be paid as a lump sum with the principal due on the maturity date. Investors become creditors of the issuer and typically have no voting or management rights.
This structure is typically limited to companies that have an identifiable revenue stream. Since debt offerings have limited upside potential, investors tend to be hesitant to invest in debt offerings that entail unpredictable or uncertain returns. An issuer that fails to make a payment will usually be deemed in immediate default and can put the entire company at risk. Start-up companies in which losses are expected for the first few years can find it difficult to have to pay investors every month or quarter when the cash would be better suited to keep operations progressing.
Equity structures involve more complex planning because they provide companies with greater flexibility on distributions to investors. An equity structure involves giving investors ownership interest in the issuer as stock in a corporation, membership interest in a limited liability company, limited partnership interest in a limited partnership, or other form of ownership interest in an entity. Many companies are hesitant to offer equity interests because of concerns about giving up voting control. However, there are various forms of equity interests that an issuer can pursue to limit or eliminate investors' voting or management control.
Valuation for an Equity Offering
Part of establishing an equity structure is determining the value of the equity offered. Valuation is simply the amount that investors are willing to invest in exchange for a given percentage of the equity of the company. However, to set a price per equity interest, companies must establish a pre-money and post-money valuation of a company, which is a very subjective measure and encompasses many factors. These factors include the company’s need for the capital, the quality of the potential product or service and its intellectual property, the quality of the management team, the size of the market for the product or service, and past and anticipated revenue.
One method of determining the value is based on a multiple of the issuer’s projected gross revenues, earnings before interest, taxes, depreciation, or amortization (EBITDA), or net income. After calculating that estimate, the issuer would calculate what percentage of the company an investor would need to receive in order for the investor to receive its money back plus a certain percentage of their investment (for example 200%).
Each type of entity has specified governing documents such as operating agreements for limited liability companies, bylaws for corporations and limited partnership agreements for limited partnerships. These documents direct how a company will operate. They include such items as how and when distributions are to be made, rights and responsibilities of the management and owners, and allocations of income to the owners.
Because the governing documents control the operations of the issuer, they must be tailored to conform to the terms of the offering. For example, if there are multiple classes of equity, then the governing documents must authorize each class and set forth, the preferences of distributions, the voting rights of the classes, and other rights of each class.
The governing documents should be revised or rewritten by the private placement attorney to correlate to the PPM to ensure that they correspond as to the terms of the offering. Failure to do so could result in investors receiving the wrong attributes to their interests, which could allow the investors (in some cases) to take control of the company and its management, or alternatively, the differences could be considered material misstatements, subjecting the issuer to penalties.
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