Debt and equity financing are two ways that companies raise finance. We have discussed the difference between the two types of funding and the pros and cons thereto. We know that companies raise finance in via these two routes, but how exactly does the money come in through these routes into the company?
Money comes into the company via these two routes i.e. debt and equity through ‘instruments’. These instruments are nothing but contracts that tell you the rights and obligations that come in exchange for the investment brought into the company.
The two investment routes have different ‘instruments’ i.e. debt and equity instruments. Also there is a third category which is a mix of these i.e. debt and equity instruments commonly known as hybrid instruments. Following is a brief overview of various instruments commonly used in a VC fundraising process.
Equity Instruments
- Equity shares
- They are common shares of a company that is a given to an investor pursuant to the investment
- They have voting rights and have a say in the running of the company
- They come last in the hierarchy (waterfall order) of preference i.e. if the company were to be closed and its assets sold, they would be the last in the order to get the proceeds of the sale
- Preference Shares
- These are shares that have a certain preference vis-à-vis equity shares
- They have preference in receiving dividends and in case of liquidation to receive the proceeds before equity share holders
- They usually do not have voting rights, but in some cases based on the agreement with the company, they may have voting rights
- Most investors(VC) are given a variant if these shares when they invest in a company
Debt Instruments
Bonds
- When large companies and Governments want to raise debt to meet their liquidity needs, they issue bonds to the public. The people who buy these bonds are called bondholders.
- The bonds promise a fixed interest rate (coupon rate) for a fixed period (maturity period) and at the end of the fixed period return the principal amount or the value of the bond
- Debentures
- These are debt instruments wherein companies issue debentures to raise loans
- The debenture holders are promised an interest for fixed period and then the principal amount is returned at the end of the period known as maturity date
- The debentures are usually issued to raise finance for a specific project or a venture
- Debentures are more common debt instruments for private companies to raise finance
Convertible Instruments
These are called convertible or hybrid instruments as they can be converted from one instrument to another. The most common types of convertible instruments are those that can be converted from debt to equity. There are variants in convertibility such as partial convertibility, full convertibility and compulsory convertibility and optional convertibility. There are many instruments under this category, however, the discussion shall be limited to the most common type of convertible instruments.
- Compulsorily Convertible Preference Shares (CCPS)
- CCPS are the most common convertible instruments issued in VC fund-raising process
- Most investors are issued CCPS which can be later converted to equity shares at any given time at the option of the investor
- The convertibility ratio is 1:1 i.e. for every preference share held, a common equity share is offered at the time of convertibility
- The investors prefer CCPS so that they get to enjoy the advantage of holding preference shares over ordinary shares
- Though, preference shares holders are not allowed to vote (in most jurisdictions), they sometime negotiate for voting rights and in that case preference shares will be treated as “as converted” to equity shares.
- 2. Convertible Debentures
- These instruments are initially issued as debt instruments and then the issuer and the holder have the option to convert either the whole or part of the debentures into debt at a pre-fixed ratio i.e. if you hold one debenture (think of debentures as shares) you may get one share or two depends on the ratio, when you are due to convert or choose to covert (compulsory vs optional convertibility)
- These instruments may benefit both parties as for the holders, it assures them a fixed interest for a certain period and then they have an option to convert to shares, which may be a good proposition if the company is doing well
- Also, the convertible proposition may also help the company find lenders who may see this as a good proposition
- Non-Convertible Debentures (NCD) are pure debt instruments that offer no convertibility to shares. When the company completes the debt obligations of the issued debentures, it is called ‘redemption’.
The stage, financial health and long-term goals determine which instruments are appropriate to the company’s strategy of raising funds.
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