Here are some questions that I have been asked on Convertible debentures.
Gary, how much does a real VC try to yield when doing equity line financing? Are the warrants a vessel that can be arbitraged? Also can the Preferred Shares be another vessel for arbitrage? What about stages of financing by the VC? If so how can a company win?
Whoa, I will do my best but please understand I am not a financial expert in any shape of the imagination. Like someone once said, “All I know is what I read in the funny papers. (filings)
Company’s win by not being so desperate to give the company away and to make sure they VC is reputable and has more success stories than losers. Of course I doubt any VC loses money from what I have read and experienced.
Typically, a financier (VC) = (VC) is the epitome of proficiency at skillfully negotiating to putting up as little money as possible for the greatest yield at the lowest risk possible. These negotiators can enhance a VC’s yield by boundless and compounded ratios by skillfully injecting certain well-written phrases in the clauses. This is what companies have to be especially aware of when proofing the proposed financing terms.
However, most VC’s desire a rate of return to be a minimum of 30% but after the contract and wording, it can be generally greater than 30% compounded. This means that if the investment is not liquidated within a relatively short time, 3-5 years, then the target rate of return likely will not be met. It my business experience, I have found that a 30% gross margin it the absolute bottom percent to being profitable. Lower than a 30% gross margin (Yield) typically do not make a profit.
As far as arbitrage it is a legal trading strategy like shorting, leveraging or hedging one like security against another in a company. The most notable aspect of this trading strategy is that it tends to be most profitable during volatile conditions, while having relatively low risk. Another words short the common and purchase the preferred or the warrant. Cover then do it all over again.
Now VCs love warrants for the upward side even though I have read Adjustable Warrant clauses also that are based on the stock price. Again, you have to read the terms of the entire financing to get a feel for arbitraging, hedging, or shorting.
Warrants are a simple vessel to enhance a VC’s yield on any investment or financing. A warrant usually gives the VC the right to purchase more of the same class of shares already being purchased for a set period of time, usually three to seven years. So by acquiring a warrant, the VC may obtain the gain on a greater number of shares without increased cash outlay. Most do not realize that a VC does not have to put up money and the financing terms are written to limit the amount of money they have to put up. Welcome to what I call the “stock shock” after reading some financing terms.
Now an effective VC will gain a greater percent of the increase in value of the company per share it buys by warrants. I will try to clarify this by an example: if a VC receives a warrant to later purchase one share of stock for every share purchased, the effective return can be doubled for the VC. If the warrant term is long enough, it can be exercised at times when the shares can immediately be sold and the cash exercise payment immediately retired.
Some times there is a "net issue warrant" in the financing. Now this permits attacting the SEC Rule 144 holding period of the warrant to the net issued shares. Simply put, if the warrant is held for the holding period, when it is net exercised, the shares acquired will be immediately offered for sale without registration under the Securities Act. The “net issue warrant” holder is entitled to a number of shares with a fair market value equal to the difference between the fair market value of the shares purchasable upon exercise of the warrant and the exercise price for those shares.
For instance, if the warrant permits the purchase of 1000 shares of common stock at $1.00 per share, and at the time of exercise of the warrant the shares are trading at $2.00. Thus the VC has a double out. So instead of the warrant holder paying any cash to exercise the warrant, they can request the company to simply issue the VC 500 shares of common stock. Thus the VC get the 500 shares of stock, which will have a fair market value of $1,000, which is the increase in value of $1.00 per share multiplied by the 1000 shares purchasable under the warrant. So with a net issue warrant, a VC can attact the SEC holding periods and never pay for the stock. I believe this is right.
Confusing I know, but hey after you read the financing terms on so many stocks you would be surprised how a VC can capitalize on putting up as little money as possible in the terms. Another slick move a company should watch for is the particular wording that the warrant as a right to purchase preferred stock and not common. This captures in the warrant the anti-dilution and price protection provisions for the preferred stock. Now the warrant underlying shares are still higher on the priority list than the common.
But the warrants can also help the VC because they can use warrants to reduce the effective per share price of their investment without triggering anti-dilution and price protection provisions of previous investors or scenarios. Of course, we all should know by now these anti-dilution formulas typically provide that if the company sells stock at a per share price less than the conversion price of the preferred stock, regardless of how this happens, then the holder of the preferred stock is entitled to a greater number of shares upon conversion of the preferred stock. This is the ACC killer of shareholders but this reduces the per share purchase price paid by a VC and protects him somewhat against a reduction in his percentage holdings of the company. However, we know that if this is not put in check this is the advantage to the VC to make a ton of money on the fall of the share price.
The company has to watch out for the wording of these VC protections. Almost all these protections are universally based on the sale of stock at a price less than the VC paid, or the issue of warrants or options at an exercise price less than what the VC paid for his stock.
Remember without or should a company limit these VC protections, the market does not suffer as much dilution. Mainly because this situation most often benefits the common stock, the company and the shareholders. A company needs to understand that reducing dilution of the VC is an advantage thus forces the VC to assist and be motivated to help get exposure for the company.
Stages of financing, I believe, is referred to as “Split Closings.” This is merely another trick of the VC that both enhances yields and reduces risk. A split closing is when the VC determines the total amount he wishes to invest but negotiates with the company to pay it in two or more installments. This is very, very common in the OTCs so the VC tries to put up as little money as possible. All they want is the first stage really. After the first stage, if they play it right that will be all they need to make unbelievable yields at shareholder expense. Plus the VC’s obligation to invest the subsequent installments is contingent upon the company achieving certain pre-negotiated milestones. Most Companies may not reach those milestones so the initial investment should be sufficient to fund the VC will what it needs. Of course, the VC’s advantage here is that they gave just enough capital for the company to reach certain milestones.
Basically, in this type of scenario it is in the VC’s best interest for the milestones not to be met. If the milestones are met, the VC has to put up more money and must invest in the second round. However, on the other side of the coin, by delaying when the VC has to invest, this enhances the overall yield on the initial investment. In other words, prior to putting up anymore money there is increased value, yet all of the money is not invested at the beginning of the investment period. Thus the VC can foresee what they are going to have to do in the near future. If the VC can properly negotiate the milestones management, the company will reflect an increase in company value so that there is a built-in gain on the stock during the second installment. IF NOT, the VC will not be required to put any more money and the initial is all they really needed.
SO as you can see a split closing or staging the finance also reduces VC risk because if the company does not achieve the VC’s negotiated milestones, then the VC can say well we are disappointed or it may not have been as good an investment as expected. Now the company and VC set back down at the negotiating table because the VC can or has ceased investing in the company, thereby the VC has limited the exposure to their money in the first round investment, and NOW can renegotiate the price and terms of the second installment.
Now this does not even bring into the equation of “Liquidation Preferences” and “Participation Rights” should the company fail. Whether by the company’s fault or not. Yet, a VC’s yield, if they are able to get the wording of the financing terms in their favor, can be enhanced by causing a greater percent of the company's increase in value to be allocated to the VC's shares rather than to other shareholders. This can be accomplished by causing an early liquidity event such as a public offering, redemption, recapitalization or sale of the business.
Now maybe you can see another advantage to the VC on a downward movement in share price aside from the normal rhetoric that is infamous with financing terms. They are going to gain a yield either way.
Again, this is just the way I understand it and most of what I have learned is based on the financing where the company was extremely careless in protecting itself and its shareholders. However, they gave the company to the VC and the VC is strictly in it for the money, whichever way they can best capitalize on the market. A lot of times it does not matter about fundamentals anymore after the initial just how well can they play the stock with as little risk as possible.
Hey, I could be wrong but there is surely enough of this out there in the OTCs to justify this opinion.
Gary Swancey
