While much of the capital raised by closely-held businesses from outside investors in the private placement market comes in the form of an equity investment, consideration should also be given to the use of debt securities. Debt securities without conversion rights can provide companies with an opportunity to secure additional capital for the business without diluting the ownership interests of the holders of equity securities. Convertible debt securities can be used to attract capital from those investors looking for more downside protection in the event the business is unable to meet its financial and business objectives. While debt securities have different rights, preferences, and privileges than equity securities, the process for completing a debt financing is very similar to the steps that need to be completed for an equity investment.
Larger companies, including many public companies, have taken to issuing debt securities to take advantage of favorable credit terms, including low interest rates, and to avoid the uncertainties of attempting to sell new securities in the equity markets. The debt securities issued by public companies are quite sophisticated and limited only by the imagination of a company’s financial officers and investment bankers. Traditionally, debt securities in privately-held businesses were issued only to friends and family of the founding group at the time the company was formed and to institutional investors as the company matured. Debt securities issued to friends and family usually were converted into common stock upon completion of the first round of outside funding from venture capitalists or other professional investors. Debt securities issued to the institutional investors were typically scheduled for conversion within 12–18 months in some form of liquidity event, such as an initial public offering or acquisition. However, debt investment financings have been much more common as companies struggled to stay afloat after their initial equity investment capital evaporated. For example, the so-called “bridge loan” is a transaction in which current investors provide the company with a limited amount of funds, in the form of a loan, to keep the company going until a new round of equity financing can be closed. Upon closing of the new equity financing, the bridge loan is either repaid or converted into the securities issued in the new financing. Investors participating in the bridge loan are rewarded for the increased risk through warrants and options, as well as preferred terms on conversion of the loan amounts in the equity financing.
Counsel for the issuer and counsel for the lender-investor in a debt financing transaction perform many of the same functions that must be completed in connection with an equity transaction; however, the nature of the instrument will dictate a slightly different emphasis, as well as the need for specialized experience that might not be part of the skills normally offered by counsel primarily engaged in equity offerings. For example, company counsel needs to be conversant with laws and procedures relating to secured transactions, as well the impact of the strict loan covenants and restrictions on the company’s business. Investors’ counsel needs to be able to advise the client regarding the rights of creditors under secured transactions and bankruptcy laws, particularly when the investors also hold company equity securities. In addition, the company will generally prepare, with the assistance of counsel and any finder/broker, offering documents that not only comply with applicable securities law requirements, but which also serve as a powerful marketing tool for the company in its search for investment capital. The offering documents in a debt financing should include a detailed description of the proposed terms of the debt securities; the projected cash flow over the term of the instrument; and a legal discussion touching on creditors’ rights and the covenants and restrictions that will be put in place to allow holders of the debt securities to monitor the use of their funds. To learn more about helping your clients with debt financings, see the new Business Counselor’s Training Materials on the subject (see §155:287) and the new slide deck presentation on debt financing (see §155:286), both available in Business Transactions Solution on WESTLAW.