What is an Equity Financing?
One of the key features of the CARE is its automatic conversion to shares on an ‘Equity Financing‘, i.e. when the company next raises capital by selling its shares. Simple, right? Well, not necessarily. How and when that conversion happens will depend on the specific terms of the CARE.
What price per share will be used for the conversion?
It depends on two things:
- the share price payable by the incoming investors in the Equity Financing; and
- the Discount Rate in the CARE.
You won’t need to value the company or fix a share price when signing the CARE. Instead, those valuation discussions can be handled later as part of a subsequent Equity Financing. The terms of that financing will include, among other things, the company’s valuation and the total amount the incoming investors will invest. From this you can calculate the number of shares to be issued and the price per share. The CARE will convert into shares at a discount to that price, i.e. the price per share in the Equity Financing multiplied by the Discount Rate.
Imagine a CARE was issued for a $500,000 investment with a 30% discount (70% Discount Rate). If, in an Equity Financing, the incoming investors pay $1.00 per share, the CARE will convert at a discounted rate of $0.70 per share ($1.00 × 70%). The $500,000 investment will convert to 714,285 shares, instead of the 500,000 shares if there were no discount.
Importantly, the CARE will convert into the same class of shares as will be issued to the incoming investors (often preference shares).
How will the conversion affect ownership in the company?
At the risk of over simplifying things, you can assume the conversion will affect the company’s existing owners (e.g. the founders) and not the incoming investors.
Once you’ve agreed the company’s pre- or post-money valuation, and the amount the investors will invest, you can calculate the investors’ post-closing ownership. This is fixed. For example, if a company raises $5 million on a pre-money valuation of $15 million, the new investors will want to own 25% post-closing ($5m + $15m = $20m and $5m is 25% of $20m).
The investors’ post-closing ownership is determined on a ‘fully-diluted basis’, i.e. it assumes all convertible securities – including any CAREs – will already have been converted. The shares for that conversion need to come from somewhere and, with the incoming investors’ ownership percentage fixed, there’s one group set to see their ownership percentage drop: the existing owners.
Continuing on from our previous example, the CARE was issued for a $500,000 investment with a 30% discount. Now imagine the company subsequently raised $5 million on a pre-money valuation of $15 million. The CARE would automatically convert to a 3.6% ownership. Without the CARE, the existing owners (i.e. the founders) would have had a post-closing ownership of 75%. But with the CARE, and the need to accommodate the CARE’s conversion, they instead find themselves with a post-closing ownership of only 71.4%.
Only 3.6% variation?!
Now, you’re probably thinking: that’s a pretty minor difference and definitely worth it to get the upfront CARE investment that ultimately led to the Equity Financing. And you’re probably right. The CARE investor took a risk on the company when others wouldn’t, so it seems entirely reasonable that they should benefit; even if that’s at the slight expense of the existing owners.
The trouble is, this example involves one CARE of a reasonable size (compared to the size of the Equity Financing), which is why the outcome seems acceptable. The story can be very different if the company issues a larger CARE (or a larger sum across multiple CAREs), or agrees to excessive discounts, or fails to close a meaningful Equity Financing. These problems can combine to cause the existing owners far more dilution than expected. Perhaps so much so that the incoming investors may fear the founders won’t own enough of the company post-closing to be sufficiently incentivised.
This is not meant to cause ‘CARE scare’ (heh), but is simply a word of warning for founders to ensure they fully understand the implications of each and every CARE before signing off on it.
When will the conversion happen?
The default position under the CARE is that any Equity Financing – no matter how small – will trigger an automatic conversion. Alternatively, you may want to consider including a ‘Minimum Equity Raise‘, i.e. a minimum amount that must be raised for the conversion to be triggered.
A Minimum Equity Raise can provide flexibility and comfort to both the company and the CARE investor alike. For the investor, it helps avoid a premature conversion before the company is able to raise a meaningful amount (a higher raise may maximise the benefit from their discounted conversion). For the company, it provides freedom to raise smaller equity rounds if needed (e.g. friends and family rounds) without the burden of a conversion.