As the impacts of COVID-19 deepen, both large and small TMT companies are reviewing their capital raising alternatives and structuring. We explore the difference between issuing ordinary shares, preference shares and convertible notes.
In some cases, a capital raise might be aimed at accelerating a growth opportunity and in other cases it will be to strengthen the balance sheet in light of new business pressures in the COVID-19 period.
In this short article, we review three alternative structures for private capital raisings: i) Ordinary Shares, ii) Preference Shares and iii) Convertible Notes. Choosing between these three alternatives will depend on your specific circumstances and you will need to carefully work through the pros and cons of each. Consider:
Issuing Ordinary Shares has the advantage of simplicity, and putting incoming and existing shareholders on the same footing, but it might result in large dilution for non-participating existing shareholders if the issue price is low, such as in a so called ‘down-round’.
Preference Shares will provide downside protection for incoming investors, and can avoid dilution to existing shareholders by setting a higher conversion ratio.
Finally, whilst a Convertible Notes might be considered expensive capital (depending on the coupon rate) it can be a mechanism whereby existing shareholders could avoid equity dilution altogether if the Convertible Notes are redeemed by the issuer.
Venture Advisory has worked with tech companies in relation to capital raising for over 10 years and would be happy to discuss your situation if you are contemplating a capital raise in the current environment.
Impact of COVID-19 can be both positive and negative, with both potentially requiring a raising of fresh capital
There is little doubt that COVID-19 is having, and will continue to have, a dramatic impact on many Australian tech businesses as the economy goes into a recession. The timing of a recovery to the economy is difficult to predict, making the decision of how much capital to raise and how to structure it more difficult.
Smaller private tech companies are likely to feel a larger share of both the opportunities and the threats of COVID-19. For some, this will mean chasing a ‘once in a lifetime’ expansion opportunity, and for others they will see a significant fall in revenue, increased supply chain risks, and tighter liquidity in capital markets.
How quickly and thoroughly a business is able to respond to the challenges of COVID-19 can make all the difference, and even determine survival. It is more important now than ever that firms focus on having a healthy balance sheet, and we believe companies should aim to have at least 12 months to 2 years of capital reserves if they are running a cash burn and scaling up.
There are no guarantees as to how we come out of COVID-19, but raising money and strengthening the balance sheet is a prudent position to take
There is much speculation around whether the economy will bounce back (in a so called V-shaped recovery), take time to recover (a U-shaped recovery), recover only to have another setback (W-shaped) or never return to historic growth rates (L-shaped or sometimes referred to as a ‘new normal’). If we knew the answer to this, capital raising decisions would certainly be much easier.
In the current environment, we would recommend that you take the “plan for the worst and hope for the best approach”. This might result in raising too much capital at a lower price i.e. dilution, but it is probably better than running the risk of corporate failure.
Broadly there are three alternatives structures that might be considered – Ordinary Shares, Preference Shares and Convertible Notes
We have summarised the pros and cons of each of these three alternatives in the table below.
Companies have the ability to issue equity in the form of Ordinary Shares or Preference Shares, with the key difference being that preference shares are more likely to receive payout, or a return on capital. This is because Preference Shares rank ahead of Ordinary Shares in the case of liquidation events (such as a sale, insolvency or bankruptcy). Preference Shares may also have additional rights such as anti-dilution provisions (protecting investors against dilution if the share price drops below the price the shares were purchased at) or voting rights, and even board seat allocations.
Convertible notes can be very flexible providing value to either the issuer or the noteholders, depending on how they are structured
Another option available to managers is the issuance of Convertible Notes, which are structured as a debt instrument with an equity upside on conversion. The Convertible Notes pay a coupon (either cash or accumulating) and converts into an equity investment at a later date or based on a trigger event.
The terms of conversion are crucial in determining the impact on the company’s existing shareholders and the incoming noteholder. In some cases, the Issuer (the company) can elect to convert or redeem the Convertible Notes, and in other cases it is the noteholder that has this right. Convertible Notes can also have mandatory conversion such as in the event of a takeover, or a subsequent equity capital raising.
Convertible Notes typically convert into equity at the next financing round, which can be beneficial as the company can defer valuation negotiations by having a reference conversion price (e.g. 15 to 20% discount to the next issue price or sale price if sold). In such a way, the valuation can be deferred to that later date in the company’s lifecycle.
Utilising a convertible note could prevent the firm from being valued until the negative headwinds of COVID-19 have passed. Another key benefit is that a convertible note requires less deal documentation and negotiation compared to issuing equity, resulting in lower costs and ensuring that the capital is raised as quickly as possible.
The choice of financial instrument must take into consideration your unique circumstances and capital raising objectives
From a firm’s management perspective, the following is a list of the pros and cons of issuing Ordinary Shares, Preference Shares or Convertible Notes when raising capital from external investors:
Incoming investors who are more risk averse would see convertible notes as being desirable. This is because they have less downside risk given the debt like structure, but they also retain the benefit of being able to share from the firm’s success through the ability of these instruments to convert into equity. In comparison, investors who are willing to take on slightly more risk for a higher return than what a convertible note provides, would likely prefer preference shares over ordinary shares due to the extra rights they receive, and the lower downside risk.
Reviewing alternatives early and acting quickly is essential and we can help
Venture Advisory has significant experience in determining what the best method is for clients to raise capital. In our view, it is of the utmost importance that shareholders, boards and management consider strengthening their balance sheet in the face of COVID-19. It is our view that there is an investment method that suits every client and target investor.
Over the past 10 yeas, we have consistently provided Boards of both ASX listed and private companies with capital raising advice, where our clients that are seeking to raise say between $10 to $50m for private companies or hundreds of millions or more in capital for larger private companies and those that are ASX listed or seeking to list.
Our advice is based on analysis that typically takes 2-3 weeks. We will provide an unbiased view on all the capital raising alternatives. We can then work with the company to raise the capital or help engage brokers and investment banks best suited to execute the capital raising.
We welcome any questions and would love to help your business work towards achieving its goals.