Private Equity Financing Structures

There are several Private Equity Financing Structures that Private Equity Funds and Hedge Funds use when they give the green light to fund a company. The basic structures for private companies are common stock and convertible preferred stock. These structures usually contain an anti-dilution provision, so the lead investor doesn’t start out purchasing say 40% of your company for $4,000,000 and then end up with only 5% because you dilute his stock position with subsequent financing rounds.

On the other hand, Hedge Funds , as a source of capital, will typically use convertible debenture financing structures and require that the company be publicly listed or file for a public listing in the immediate future. Hedge Fund structures, however, are very similar to private equity financing structures. There are several advantages of seeking hedge fund financing though a Hedge Fund rather than a private equity or venture capital firm. Hedge Funds can usually make investment decisions and close in a shorter time frame than private equity and venture capital firms. While Private Equity Financing Structures are similar to Hedge Fund Financing Structures, typical Private Equity Financing Structures have longer much more complex term sheets and closing documents. Private equity firms also require much more control and management can lose majority control if the company doesn't perform exactly they way they thought in terms of gross sales or other milestones.

An often used funding structure is a private placement that is done by a PIPE Fund. Two of the most common funding structures used by PIPE Funds are the Convertible Debenture and the Standby Equity Purchase Agreement also known as an Equity Line Funding.

Convertible Debentures are basically debt instruments like a promissory note, but are convertible at the investor's option into shares of the company's common stock. They allow a company to raise capital but should be carefully structured so that they do not turn into a death spiral or toxic convertible with no floor. Some hedge funds, especially offshore funds, were shorting in violation of the terms of the convertible debenture and United States securities laws. My best advice is to know your investor and carefully structure the deal.

A Standby Equity Purchase Agreement or an Equity Line Funding is sometimes preferred over a convertible debenture funding if the company is not in urgent need of capital. This funding vehicles require a company to register the common stock in advance and then the company can "put" shares to the investor in the form of a "draw down notice". Based on an agreed formula of stock price and volume the investor funds the company and receives the common stock. Benefits to the company are that it is a funding vehicle in place, usually for a two year period, and the company controls the frequency and timing of the draw downs.

Hedge Funds may require a company to go public through a Reverse Merger or private companies may consider a Reverse Merger Funding in which they can get financed and become publicly listed at the same time. Once they become publicly listed, it makes it much easier for companies to raise capital in the future for their growth and expansion needs.

While private equity firms will not require a reverse merger they typically take several months just to make a funding decision. On the other hand, my experience with Hedge Fund clients I have represented has been they conduct due diligence faster than private equity firms, they make decisions faster and are quite capable of closing on the funding and reverse merger transaction in less time than it takes most private equity firms to make a funding decision. Venture Capital firms tend to be even slower, this is because of the increased risk they face when dealing with start-up companies.

1. Common Stock. Common Stock is another hedge fund and private equity funding structure; sometimes this structure includes a reset feature and Warrants. The company and investor agree on a dollar amount to be funded and the percentage of stock, also called the equity position, the investor will receive. Most private companies, however, will find they have very little bargaining power with private equity funds. Usually, it is the money that dictates the terms of the financing structure. Part of the reason is that if you don’t like the deal terms you don’t have to take the money. Another reason is that Private Equity firms know which structures work for them and which ones don’t.

2. Preferred Stock. Private Equity firms use Preferred Stock structures the most. The Preferred Stock is convertible into Common Stock, usually anytime at the option of the holder. The convertible Preferred Stock can be convertible into either a fixed number of shares of Common Stock or a certain percentage of the Common Stock outstanding on a future date. Most Preferred structures also have a built in dividend. The dividend could range from 6% to 12%. This allows the Private Equity firm to receive some return on its investment before the Exit Strategy is used.

3. Debt Financing with an Equity Kicker. Another commonly used private equity financing structure, if your company is already operating, is debt financing with an equity kicker. Although this structure will be difficult to get from a Private Equity firm, it is worth exploring.

Sometimes Private Equity Firms have excess cash and may consider such a structure.The key here is to convince them that it is a low risk transaction because you are profitable or close to it and can service the debt. Maybe you are doing an acquisition to increase cash flow. They may ask for security of some sort however.

You are more likely to get this kind of financing from Angel investors. Maybe even family and friends would consider providing this type of financing if the amount is not too large and you have good cashflow. Say you feel $200,000 can get you over the hurdle and profitable. Structure the $200,000 as a 3 to 5 year loan and give the investor 10% of your company in common stock. The number of shares and percentage you give the investor/lender is based on the size of the loan and the value of your company.I only used 10% as an example.

4. Convertible Debt.Some investors will use this private equity financing structure in the form of a convertible note or convertible debenture. This security is convertible at their option into Common Stock of the company. Usually they will not convert until the Common Stock is trading and they can get out of their position.

Smart investors will also use what is called a "4.9% Clause". I have used this many times for my private investor and hedge fund clients. Certain securities laws require investors that own 5% of more to make certain filings with the U.S. Securities & Exchange Commission (SEC). This allows investors to get around that requirement since the 4.9% Clause does not allow the investor to own more than 4.9% of the company at one point in time.

Also, if an investor owns more than 10% of a company they are deemed an "Affiliate" and a number of other rules kick in. An investor can remain more nimble with his investment without having to comply with these regulations. The 4.9% Clause also benefits the Management Team. If the investor can't own more than 4.9% of the company it is very difficult for the investor to take over the company or make management changes. This 4.9% clause and even the 9.9% clause are used fairly often in private equity financing structures.

5. Reverse Mergers. A Reverse Merger is when an existing private company merges into an existing public company with a stock symbol, which is usually a “shell company”. A shell company is a public company that although still in existence and having a stock symbol, is no longer operating a business. The business plan obviously failed and that company went out of business, but the public entity or shell still exists. A viable private company then does a Reverse Merger into the shell.

If you want some more funding tips you can visit Equity Line Financing.

Now that you know about the various Financing Structures used by investors, here are some more Tips on Private Equity Financing Structures. These tips will help you negotiate with investors and level the playing field especially when it comes to negotiating private equity financing structures.

Overview of Venture Capital and Private Equity Firms
Learn why they are the leading source for raising significant amounts of capital from $1,000,000 to $25,000,000 or more. This information will add to your knowledge about Private Equity Financing Structures.

Tips On Venture Capital Deal Terms - Part One
This section starts out with a discussion about when you should ask potential investors about "deal terms". We then go on to discuss using a separate Executive Summary to save time screening potential investors and to protect confidential information.

Tips On Venture Capital Deal Terms - Part Two
This is a discussion of Venture Capital Deal Terms from two different perspectives, Business Venture Capital and Angel Funding. Learn some of the nuances of dealing with each type of investor.

Tips On Venture Capital Deal Terms - Part Three Examination of Venture Capital Deal Terms as they affect Management’s equity position and cash compensation, which is directly influenced by the private equity financing structures covered on this page. Part Three then concludes with a discussion about Exit Strategies.

Joseph LaRocco has advised investment managers on numerous trading, regulatory, compliance and anti-money laundering issues. He has structured and formed domestic and offshore hedge funds, advised them on private equity financing structures and has represented hedge funds in many private placement transactions. Visit this section if you are looking for information on Hedge Fund Formation.