Startup equity offerings are predominantly C corporation stock, limited liability company (LLC) membership units, convertible debt and a relatively new structure called a simple agreement for future equity (SAFE). This article covers the fundamentals of each of these securities, as well as their advantages and drawbacks for investors. We will explain the basics of preferred stock and LLC units first, as they are straight, immediate equity. Straight equity is more common than convertible debt and SAFE in traditional angel investments under Regulation D, although SAFE might be much more common in startup offerings.
If you are new to private securities, your investment portfolio probably consists mainly of public company stocks (equity-based securities), corporate and municipal bonds (debt-based securities) and various mutual funds (bundles of public stocks and/or bonds). If your portfolio is growth-oriented, the public stocks in your portfolio are likely shares of common stock, rather than preferred stock, because common shares offer the potential to earn greater returns when the companies behind them are consistently profitable. If your portfolio is income-oriented, you may favor preferred stock, for reasons we’ll explain below.
At this time, the only kind of corporation that can raise capital via equity crowdfunding is the traditional C corporation. Subchapter S corporations, the newer flow-through entities that many small companies organize under, are effectively barred from participating in Title III equity crowdfunding, because (1) the number of S corporation stockholders is limited to 100, while the number of C corporation stockholders is unlimited, and (2) S corporations can issue only one class of stock, whereas C corporations can issue any number of classes—the two major categories of which are common and preferred.
When founders incorporate their company, they issue common stock to themselves. Common stock is considered “pure equity,” as it entitles shareholders the right to vote on management issues at annual shareholders’ meetings.
Aside from voting, common stock is the type of equity offering that is most directly tied to actual profitability and growth of a corporation. Common stockholders may or may not receive dividends when the company is profitable, depending on management’s decisions about distributing profits. But most investors—at least those whose portfolios are allocated more for growth than for fixed income—focus on stock price more than dividends, as capital gains depend solely on the price per share. Common stock prices fluctuate freely with the performance of the company: In a period of sustained profitability and growth, the price per share normally climbs. (Share prices of stock in public companies are reported daily, while the share price of a private company is not generally known until shares are transferred, which might be seldom.)
Preferred stock is considered a more conservative investment, as the price per share does not fluctuate as freely as that of common stock in the public stock exchanges. So preferred generally offers less opportunity for capital gain. But if you are investing in a startup or early-stage company, where the risk of failure is high, preferred stock offers other advantages, such as liquidation preferences. Most deal terms allow angel investors to convert their preferred shares to common shares when the company achieves certain milestones.
In the public stock market, preferred stockholders usually receive dividends (depending on the terms of the stock issue) when the company is profitable, and those dividends tend to be higher than for common stockholders, which makes preferred stock more attractive for retirees whose portfolios are allocated more for income and wealth preservation than for capital growth. The yearly dividends for preferred shares are usually fixed, such as 8.5 percent of the price paid per share; while the dividends for common shares, if any, are tied to the company’s performance each year, and then only after the fixed dividends are paid to the preferred stockholders. If the company goes bankrupt or dissolves (two forms of liquidation), preferred stockholders almost always have a claim to company assets ahead of common stockholders (but behind bondholders and some creditors). If enough assets are available, preferred stockholders will recover the amount of their investment and sometimes an annualized total return (but no more).
On the other hand, preferred stockholders generally do not have direct voting rights, so it’s not considered “pure” equity.
Preferred stock prices for public companies are reported daily just as for common stock, but preferred prices—because the investment is more conservative—are less responsive to general market volatility.
Founders and managers of startups and early-stage corporations generally offer preferred stock rather than common stock when they raise equity capital. For one thing, it lets them maintain a certain degree of control over the company because preferred shareholders do not generally have voting rights (although they may have a representative member of the board of directors who is elected from the class of preferred shareholders). For another, investors often insist on buying preferred shares because of the preferences in the event of failure, as well as the chance to convert to common shares under certain conditions.
Think of it this way: Preferred stock for startup companies can be a win-win for both the founders and the investors. The founders retain control, since preferred shares have few or no voting rights. On the flip side, preferred shareholders have better protections against downside risk, thanks to liquidation preferences, but also tend to enjoy the upside if the company succeeds later on, as the shares can be converted to common stock.
For that reason, if you invest in preferred stock in an equity crowdfunding deal, pay close attention to conversion rights. The downside of not being able to convert to common stock is that the amount of money you can earn in the event of an acquisition (another form of liquidation) will be limited. In the event that the acquisition price is low, then preferred shareholders get their investment back and common shareholders might get nothing much. But in the event that the acquisition price is very high, then preferred shareholders still get their investment back and common shareholders have a gigantic pie to slice up. So make sure you have an option to convert preferred to common shares in the event of an acquisition.
A private company may issue different classes of preferred stock in successive rounds of equity financing, where each class has a unique set of rights, preferences, and other terms. The classes are typically known as Series Seed Preferred, Series A Preferred, Series B Preferred, and so on.
The corporate structure has evolved into a powerful way not only to finance an enterprise but to govern it as well. From a shareholder’s point of view, this highly evolved structure has the effect of making corporate governance fairly uniform, understandable and predictable.
The same structure that gives a corporation those advantages, however, also gives it disadvantages in the context of equity crowdfunding. For one thing, it is also rigid from the point of view of founders of startups, where they want to keep governance highly centralized in order to empower leaders to make quick decisions and pivots. Not only that, but the diffused corporate structure of governance, with its board meetings, shareholder notifications and votes, reporting requirements, and double taxation (first on profits and second on dividends), can be prohibitively expensive for lean startups. That is why many startups and early-stage companies operate as sole proprietorships, partnerships, limited liability companies, and other simpler, more flexible structures that allow centralized governance and are less costly to operate. Of those simpler entities, only the LLC provides liability protection for investors and can sell shares via equity crowdfunding.
The LLC is a relatively new legal entity, first created in Wyoming in 1977. It combines the personal liability protection of corporations with the flow-through tax advantages of partnerships and S corporations. (In fact, the flow-through tax treatment is only one of the various taxation options that LLCs may select, but it is the most common.)
Owners of LLCs, whether they are founders or investors (and whether the investors are active in running the business or passive), are known legally as members of the LLC, and their equity is called membership interest or units. An LLC can have an unlimited number of members and can issue various classes of membership interest.
Most states allow two major types of LLCs: member-managed and manager-managed. Member-managed LLCs function much like a general partnership, where all members participate in the management of the company. In manager-managed LLCs, much like limited partnerships, one member (or a small committee of members) makes the most important decisions, while all other members are passive and have limited or no participation in management. In this respect, manager-managed LLCs are an alternative to old-style limited partnerships (in which general partners run the company and limited partners do not), with added liability protection—in addition to more flexibility in other areas of governance.
Regarding liability protection, all LLC members, including both active and passive investors, are not personally liable for acts and debts of the LLC. This “veil” of personal liability protection is not absolute: The LLC veil can be pierced under the same circumstances that a corporate veil can: when an active member commits fraud, fails to deposit taxes withheld from employee wages, treats the LLC as an extension of his or her personal interests, and so on. Of course, a member can personally guarantee a debt of an LLC and be on the hook, which is common for new companies, but the veil is otherwise a strong one and generally safeguards personal assets from business risk.
An LLC’s operating agreement establishes the internal governance of the entity. Operating agreements are similar to corporate bylaws, but they are much more flexible and unorthodox than bylaws. Also, LLCs do not rest upon centuries of legal precedent and standardization as do corporations; thus, it is really the operating agreement alone (without that comprehensive legal framework) that creates the “constitution” for how an LLC is governed.
An LLC operating agreement should include how the company is managed and how it allocates profits and losses among its members. Unfortunately, too many startup LLCs do not include that information, or do so inadequately, and those LLCs present a challenge for investors, especially with respect to evaluating deal terms and conducting due diligence.
Management may decide that different classes of membership interest receive different proportions of profits and losses. So if you invest in an LLC membership unit that represents 2 percent ownership, it is possible that you would receive less than 2% of the profit or loss. But in the long term, you might consider that trivial relative to the increase in value of the unit, in the event of an exit whereby you earn a large gain on your investment.
The operating agreement also establishes whether the LLC is member-managed or manager-managed, which is an important distinction in the context of equity crowdfunding. As we mentioned earlier, generally in a member-managed LLC, all members—including passive investors—can vote on major decisions that, according to the operating agreement, require such a vote. In a manager-managed LLC, only the designated managers—which may be members or nonmember employees—can vote. An LLC that intends to raise capital via equity crowdfunding must be manager-managed if it does not want to allow hundreds or thousands of passive members, mostly strangers, to vote. Keeping track of many dispersed members so that they can be contacted each time a vote is required would be an administrative burden.
The tax advantage of LLCs is that the company itself typically does not pay income tax, because company profits and losses flow through to the individual members (including passive investors), usually in proportion to their ownership interest (known as their distributive share). That income must be claimed on their individual tax returns. By contrast, C corporation income is said to be taxed twice, once on the corporate tax return and again when income is distributed as dividends on the stockholders’ tax returns. (If an LLC has more than 100 members, it may lose the ability to pass income through to members. LLCs can elect to be treated as C corporations for tax purposes, but that is rare.) Thus, LLCs and their owners avoid that so-called double taxation.
A distributive share of LLC losses (which are to be expected in the early years of a startup) can be deducted from investors’ taxable income on their individual tax returns, because losses flow through just as income does. Each year the LLC issues a tax form, typically a Schedule K-1 (similar to corporate 1099-INT forms), to each member showing that member’s distributive profit or loss. Remember, when dealing with tax issues, a loss might be a good thing, since it can be deducted from other income and reduce your overall tax obligations for that year.
There are two minor hitches to this tax advantage. First, passive members (those who are not active in running the business) can deduct flow-through losses only from passive income such as interest, dividends, certain rents and royalties and pensions.
The second hitch relating to the pass-through tax advantage is that an LLC’s operating agreement may provide that yearly profits and/or losses will be distributed to members not in proportion to their ownership interest. Such a provision would affect not only your pass-through income and loss for tax purposes but also your ultimate calculation of return on investment. Talk to your personal accountant before you invest in an LLC, to fully understand whether a loss can be used on your tax return, what income can be offset by a loss, and how an LLC’s profit might affect your tax situation.
In the context of equity crowdfunding, there are three kinds of drawbacks to LLCs: tax-related hassles, lack of incentive options for employees and barriers to future venture capital and IPO financing.
The first problem with LLC income taxation, from the investors’ point of view, is that members must pay income tax on flow-through profits even if none of the profits are actually distributed. In other words, the company may earn a profit in 2020 but use it to pay expenses in 2021, or it may keep it in the bank, to be used for future business development. In that situation, members do not receive any portion of the income but still must pay their distributed share of income tax on the profit. (By contrast, C corporation stockholders pay income tax on dividends only when they actually receive the cash.) This problem can be overcome by designating, in the deal that investors make when they buy LLC membership, that each year the company shall distribute enough of the profit for members to at least pay income tax (if the company makes a profit).
The good news is that if the LLC is earning a profit, the membership units are probably gaining value. If the LLC investment turns out to be a home run, then all this tax rigmarole might seem trivial.
Another drawback of LLCs is the difficulty of giving employees equity incentives such as options on membership interests (similar to corporate stock options). In entrepreneurial businesses, employers often pay employees with options, as well as cash, in order to motivate them toward strong growth. This in turn aligns those motivations with investors’ interests. So, the ability of the company to grant options to employees is important for investors as well as the company itself. Corporations can grant options to employees fairly easily and with favorable tax consequences. But for LLCs, granting options is complex, and the tax consequences are not necessarily as favorable.
Another drawback is that LLCs present certain liquidity and exit barriers for investors, because (1) venture capitalists typically do not want to invest in LLCs since many of their limited partners, such as pension funds and nonprofit organizations, do not want flow-through income, and (2) only corporations can go public. An LLC can still be acquired by another company, but that possibility may be limited by the difficulty of swapping LLC units for stock shares in a merger-oriented acquisition.
It is possible for an LLC to convert to a C corporation when the need to raise venture capital or issue incentive options to employees becomes more urgent than preserving the flow-through tax advantages and flexible management structure. In fact, converting the form of entity is quite common. If planned well, such a conversion is possible to accomplish without too much expense, disruption of the business operation or adverse tax consequences in some states (e.g., California and Delaware).
But businesses that expect to grow quickly, especially in the technology and healthcare industries, know that they will eventually need to raise venture capital—and they eventually hope to go public—so they typically incorporate initially, rather than convert from an LLC.
Which of the two kinds of straight-equity securities—stock or LLC units—is a more attractive investment? Actually, that is the wrong question. The right question is whether the company is operating under the structure—either corporate or LLC—that will best help it achieve its goals, and whether the company has clarified in its equity offering documents how investors will share in the profits and gains. “Both corporations and LLCs can present simple or complex offerings—corporations by the nature of their various classes of equity, and LLCs by the nature of their operating agreements,” says New York securities lawyer Vanessa J. Schoenthaler. “So I don’t think the form of entity itself should be the primary concern to investors when evaluating an investment opportunity. I think a good rule of thumb, for all investors, is that if you can’t understand the issuer’s corporate structure and the rights and obligations associated with the security that the issuer is offering, then it’s probably not a good investment opportunity for you.”
In step 5 we explain the most common terms and conditions of straight-equity offerings that you will find on crowdfunding sites.
Convertible debt is actually a hybrid of equity and debt. Whether this type of equity offering is issued by a corporation or an LLC, convertible debt starts out as a loan to the company from the investor in the form of a note that can be traded later for shares of stock or LLC units. Some convertible notes give investors the option to convert to equity, while others require investors to convert, typically on the occurrence of some specific future event that involves a valuation and/or transfer (e.g., a round of equity financing or acquisition). When properly structured, convertible notes give investors the best of both worlds: liquidation preferences if the company becomes insolvent, capital gain if the company grows and gets acquired. It also presents an important advantage for issuers, especially startups that are pre-revenue, which we will explain.
The ultimate objective for investors, when they buy into the deal, is to end up with equity instead of debt.
The basic mechanics of convertible debt are easy to understand, but then the variables can get complex. Let’s say you invest $1,000 in Startup City, Inc. in an equity crowdfunding deal whereby the issuer promises to pay you x percent interest every month and then repay your principal in three years. If, at any point before the maturity date (within three years), a group of angel investors or a VC fund invests in Startup City, you have an opportunity to convert your $1,000 note, plus accrued interest if any, into Startup City stock. So far, the concept is simple. The fact that an angel or VC wants to buy stock means they believe the company has strong growth potential.
But how many shares will you receive for your $1,000? Looking at it another way, what is the price per share at the time of conversion? That is the primary question to be answered in the convertible note, which—like a term sheet for straight equity—lists all the terms of the investment. This is where it gets complicated.
The reason it’s complicated is that when you invested, the valuation of the company was not discussed. The valuation was probably very difficult to calculate at that time, because the company did not have enough revenue or other metrics to use as a basis for the calculation. And that is the beauty of convertible debt for entrepreneurs: The company can attract investors without having to propose a valuation.
The deal you made when you invested did not specify a conversion price per share, because it was impossible at that time to forecast when another round of financing would occur, how well the company would perform in the meantime, and, thus, what price per share the later investors would agree to pay (and price is ultimately based on valuation).
The price per share that you (and other early, convertible-debt investors) pay to convert is derived from the price that later, straight-equity investors pay when they buy straight equity.
Let’s say this later round of investment comes two years after you invested, Startup City has become profitable, and the new investors agree to pay $1 per share of preferred stock, valuing the company at $4 million. Would you be satisfied paying $1 per share for 1,000 shares? Heck no. Early investors took a much greater risk than later investors, investing when the company was not yet profitable. You should be rewarded for taking a big risk and providing seed capital to the company when it wasn’t so attractive to angel investors, not be penalized by having to pay as much for stock as the angels who waited until the investment wasn’t as risky. This fairness issue is typically resolved in one of two ways: (a) discounts from the price that later investors pay, and (b) caps on the price that earlier investors pay. These are explained more fully in Chapter 10 of our book, Equity Crowdfunding for Investors.
One of the keys to a successful investment in convertible debt is assessing the possibility that the issuer will, if the business is successful, attract future rounds of straight-equity financing. Without that possibility, it’s just a loan.
A SAFE is kind of like convertible debt without the debt. It was created in 2013 for seed-stage startups by Y Combinator, a high-tech accelerator. SAFE is essentially a warrant entitling investors to shares in the company (typically preferred stock) if and when it next raises “priced” equity capital, is acquired or files an IPO. Investors must understand that a SAFE is not an ownership of a current equity stake in the company and is only converted if—and only if—the triggering event outlined in the SAFE happens. This also means investors likely have no voting rights.
This is an updated version of an article originally published on March 30, 2016.]
©All Rights Reserved. June, 2020. DailyDAC™, LLC d/b/a/ Financial Poise™
Dave Freedman has worked as a journalist since 1978, primarily in the fields of law and finance. He is a co-author of Equity Crowdfunding for Investors: A Guide to Risks, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms (Wiley & Sons, 2015). He currently analyzes turnaround stocks for DailyDac.com. Dave has also written extensively…