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Are you already a well-versed entrepreneur or just starting ?  Either way in this section we invite you to swipe through our knowledge base pertaining to a diversified panel of terms, definitions and practical scenarios. We welcome your valuable input and your comments.

What are Convertible Notes, an Anti-Dilution Provision or Preferred  Shares ?

Convertible Notes

Convertible notes are frequently used by startups to raise capital. One of the reasons companies use convertible notes to raise capital (rather than sell stock directly) is it is possible to raise money through the issuance of a convertible note without setting a valuation on the company. Instead, that valuation question is suspended or avoided until a later date (typically, when more money is invested; this subsequent fund raise is usually defined in the convertible note as a “qualifying financing”). On a qualifying financing, when the subsequent money is raised and the valuation is set, the convertible notes then convert into stock at the valuation set in the qualifying financing or at a discount to that valuation.


An anti-dilution provision is a provision in an option or a convertible security, and it is also known as an “anti-dilution clause.” It protects an investor from equity dilution resulting from later issues of stock at a lower price than the investor originally paid. These are common with convertible preferred stock, which is a favored form of venture capital investment.


In venture capital investing in particular, dilution is a concern for preferred shareholders, as a later issue of stock at a price lower than their current shares would dilute their total ownership. Anti-dilution clauses prevent this from occurring by adjusting the conversion price between preferred stock and common stock. These clauses are also known as preemptive rights, subscription privileges or subscription rights.

As a simple example of dilution, assume that an investor owns 200,000 shares of company which has 1,000,000 shares outstanding. The price per share is $5, meaning that the investor has a $1,000,000 stake in a company valued at $5,000,000. The investor owns 20% of the company. Next, assume that the company enters a new round of financing and issues 1,000,000 more shares, bringing the total shares outstanding to 2,000,000. Now, at that same $5 per share price, the investor owns a $1,000,000 stake in a $10,000,000 company. Instantly, the investors ownership has been diluted to 10%.

Anti-dilution clauses prevent this from happening, keeping the investor’s original ownership percentage intact. The two common types of anti-dilution clauses are known as “full ratchet” and “weighted average.” With a full ratchet provision, the conversion price of the existing preferred shares is adjusted downwards to the price at which new shares are issued in later rounds. Very simply, if the original conversion price was $5 and in a later round the conversion price is $2.50, the investor’s original conversion price would adjust to $2.50.

Preferred shares are a hybrid between debt and equity, which means they resemble both stocks and bonds. Unlike common stock, a preferred share does not make the stockholder a partial owner of the corporation. Preferred shareholders cannot vote at the annual shareholder meeting and, therefore, do not influence the company’s strategic decisions. Preferred shareholders are entitled to receive a fixed annual dividend. These preferred dividend payments have legal priority over dividends payable to common shares. Until the company has honored all preferred payments, it cannot legally pay any money to common shareholders; hence the name “preferred stock.”

source : Investopedia

Refinancing your business; What are the options available ? A closer look at Senior and Mezzanine debt.

Debt Recapitalization

In a debt recapitalization, an owner simply goes to the bank and asks for a loan in the company. Based on the net tangible assets, future cash flows and ability to meet future financial covenants, the bank would provide a certain amount of debt that could be distributed to the owner through various mechanisms, such as a dividend. The amount of debt provided (in the form of either senior or mezzanine financing) would depend on the qualitative and quantitative characteristics of the business.


  • A business owner will retain 100 percent ownership of the company.
  • The process is relatively quick – typically three to four months – because owners need only negotiate with the bank.
  • This type of financing can be done confidentially, with minimal disruption to the operations of the business.


  • Personal guarantees will very likely be required by the bank as secondary security for the additional debt obtained. So, even though the business owner has taken cash out of the business, risk still remains with the personal guarantees. Owners need to assess whether they can afford this extra debt.
  • There will be increased reporting required by mezzanine and senior debt providers.
  • Additional debt on a business will increase the stress cash flow, since lenders will require sufficient cash to cover the debt servicing requirements. This can affect a company’s ability to grow.

Mezzanine Debt

Mezzanine debt is the middle layer of capital that falls between secured senior debt and equity. This type of capital is usually not secured by assets, and is lent strictly based on a company’s ability to repay the debt from free cash flow. It is usually a great way for growing businesses to bridge the gap between what conventional banks will lend against assets, and the total value of a new project or acquisition. A company owner should consider mezzanine debt instead of equity when the business is producing stable free cash flow, since this allows him/her to obtain financing without issuing equity and diluting the ownership of the business. Mezzanine debt can be used as a financing source for corporate expansion projects, acquisitions, recapitalizations, management buy-outs (MBO) and leveraged buy-outs (LBO).


Mezzanine debt is more expensive that senior debt, but less expensive than equity. The cost for this type of financing is in the range of 13% to 25%. Senior banks usually view mezzanine financing as equity for the purpose of calculating debt covenants. This is because the repayment of mezzanine debt is subordinated to the repayment of senior debt, but ranks above any repayments to equity holders.


The preference of payment to debt holders is an important concept to understand. As a general rule, senior banks always get paid first, then mezzanine lenders, then preferred shareholders, and then common shareholders. Participants in MBO or LBO transactions need to understand their position in this repayment line-up. The risk of repayment increases as you move down the line, which is why mezzanine debt commands a higher interest rate for its holders.

source: investopedia

If you are contemplating raising money through the issuance of convertible notes, you might be wondering – what is a valuation cap?

Convertible notes are designed to convert into equity of the issuing company upon a subsequent financing (usually referred to in the note as a “qualified financing”; e.g., when the company raises more than $1M dollars in new capital). Without a cap or discount, the notes would typically convert into the issuing company’s equity in the subsequent financing at the same price as the equity issued in that financing.


Numerical Example: $25k convertible note with $5M cap, 20% discount


Let’s do numerical example ignoring any accrued interest:

You invest $25k in a startup’s seed round using a convertible note with a $5M cap, 20% discount


Example 1.

At the Series A, the startup raises money from a venture capital firm that invests at a pre-money valuation of $10M with a per share price of $5.00

IF we apply the discount, the price per share would be $4.00/share ($5.00 times (1 minus 20%)) IF we apply the cap, the price per share would be $2.50/share ($5.00 times ($5M cap divided by $10M pre-money valuation))

THUS the cap would apply and the note would convert at $2.50/share which gives 10,000 shares of Series A Preferred Stock ($25,000 divided by $2.50/share). On paper, your 10,000 shares at $5.00/share are worth $50,000 which is an unrealized return of 100%.

Example 2.

At the Series A, the startup raises money from a venture capital firm that invests at a pre-money valuation of $6M with a per share price of $5.00

IF we apply the discount, the price per share would be $4.00/share ($5.00 times (1 minus 20%)) IF we apply the cap, the price per share would be $4.1667/share ($5.00 times ($5M cap divided by $6M pre-money valuation)).

THUS the discount would apply and the note would convert at $4.00/share which gives 6,250 shares of Series A Preferred Stock ($25,000 divided by $4.00/share). On paper, your 6,250 shares at $5.00/share are worth $31,250 which is an unrealized return of 25%

sources : startuplawblog, fundersclub

Business valuation is at core if any financial transaction. How do you valuate yours ? 

Valuing a company is hardly a precise science and can vary depending on the type of business and the reason for coming up with a valuation. There are a wide range of factors that go into the process — from the book value to a host of tangible and intangible elements.

Here are some of the common methods used to come up with a value.

  • Asset valuation
  • Capitalization of income valuation
  • Owner benefit valuation
  • Multiplier or market valuation
 Asset Valuation

Asset valuation is used when a company is asset-intensive. Retail businesses and manufacturing companies fall into this category. This process takes into account the following figures, the sum of which determines the market value:

  • Fair market value of fixed assets and equipment (FMV/FA) – This is the price you would pay on the open market to purchase the assets or equipment.
  • Leasehold improvements (LI) – These are the changes to the physical property that would be considered part of the property if you were to sell it or not renew a lease.
  • Owner benefit (OB) – This is the seller’s discretionary cash for one year; you can get this from the adjusted income statement.
  • Inventory (I) – Wholesale value of inventory, including raw materials, work-in-progress, and finished goods or products.
  • Capitalization of income valuation

This method places no value on fixed assets such as equipment, and takes into account a greater number of intangibles. This valuation method is best used for non-asset intensive businesses like service companies.

In his book “The Complete Guide to Buying a Business” (Amacom, 1994), Richard Snowden cites a dozen areas that should be considered when using Capitalization of Income Valuation. He recommends giving each factor a rating of 0-5, with 5 being the most positive score. The average of these factors will be the “capitalization rate” which is multiplied by the buyer’s discretionary cash to determine the market value of the business. The factors are:

  • Market conditions
  • Length of time the company has been in business
  • Length of time current owner has owned the business
  • Degree of risk
  • Profitability
  • Location
  • Growth history
  • Competition
  • Entry barriers
  • Future potential for the industry
  • Customer base
  • Technology

Again, add up the total ratings, and divide by 12 to come up with an average value to use as the capitalization rate. You next have to come up with a figure for “buyer’s discretionary cash” which is 75% of owner benefit (seller’s discretionary cash for one year as stated on the income statement). You multiply the two figures to determine the market value.


  • Owner benefit valuation

This formula focuses on the seller’s discretionary cash flow and is used most often for valuing businesses whose value comes from their ability to generate cash flow and profit. It uses a fairly simple formula — you multiply the owner benefit times 2.2727 to get the market value. The multiplier takes into account standard figures such as a 10% return on investment, a living wage equal to 30% of owner benefit, and debt service of 25.


  • Multiplier or market valuation

EBITDA – This approach finds the value of a business by using an “industry average” sales figure as a multiplier. This industry average number is based on what comparable businesses have sold for recently. As a result, an industry-specific formula is devised, usually based on a multiple of gross sales. This is where some people have trouble with these formulas, because they often don’t focus on bottom line profits or cash flow. Plus, they don’t take into account how different two businesses in the same industry can be.

source : smetoolkitbusinesspartners

Turning ideas into cash generating operation is a mix of ingenuity and perseverance. Financials interpretation is part of the process.

Free Cash Flow (FCF) 

Free cash flow (FCF) is a financial metric that includes cash flow generated from operations, minus annual capital expenditures required to sustain the business (maintenance capex). It is a key metric used by buyers to evaluate a business. Free cash flow is sometimes calculated on an after-tax basis. However, most buyers calculate free cash flow before tax, because their tax structure may be different than the target company for sale

While free cash flow theoretically excludes changes in net working capital, these changes can greatly affect the real cash generated by a business. Free cash flow is not only impacted by company’s revenue and profitability, but also by how the balance sheet is managed. If the business does not manage its net working capital assertively or is undisciplined with capital expenditures, then free cash flow can be considerably lower than net earnings. Buyers often review the quality of earnings, which is essentially the difference between reported earnings and the free cash flow of the business.

Some use EBITDA and FCF synonymously, but technically this is incorrect. EBITDA doesn’t take into account the requirement for sustaining capital expenditures or changes in working capital. Both the investment in working capital and sustaining capex is a real cash outflow that impacts the business going forward, and should be considered by buyers. This doesn’t mean that EBITDA isn’t a useful metric for valuing business, but rather that other metrics such as EBIT and free cash flow may be more useful to determine what the actual future return on the investment will be

Working Capital (WC)

Working capital (WC) is a measure of current assets minus current liabilities on a company’s balance sheet. When conducting due diligence on a transaction, historical working capital is analyzed on a monthly basis for two to three years in order to understand the appropriate level a business needs to support its operations.

When cash is excluded from working capital, the resulting amount is called non-cash working capital (NCWC). Fluctuations in NCWC are examined by the buyer to determine what type of additional investment is required to sustain the business. The average NCWC is usually funded using an operating line, but smart buyers will require that a certain level of NCWC be included as part of the deal, since it represents additional cash that the business would require to operate immediately post-transaction.

The appropriate level of working capital required to sustain business operations is one of the most debated areas between buyers and sellers. Buyers will require that the business deliver a set working capital amount as part of the negotiated purchase price, and the final amount due on closing will be reduced on a dollar for dollar if the peg is missed. Therefore, sellers need to come to the negotiating table ready with an estimated level of working capital that is required to support the business.

Keep in mind that working capital changes every day, so the balance at negotiation must be the estimated amount at closing, rather than the amount reported on the last month’s financial statements. Sellers will audit working capital 90 to 120 days post-transaction to make sure the final closing number is accurate. Therefore, it is best to provide the most accurate estimate available including liability accruals which are often missed. Most buyers will include a working capital holdback to allow for any adjustments in working capital post-transaction. One must focus on the following areas when determining an appropriate working capital target:

  • Research normal levels of WC for the industry;
  • Calculated WC as a percentage of sales year over year
  • Identify special terms that may cause the WC to vary from normal levels;
  • How significantly does inventory vary on a month-to-month basis?
Key Differences

The key difference between these two figures is that working capital provides a snapshot of the present situation, while cash flow is a measure of the company’s ability to generate cash over a specific period of time

Free Cash Flow vs Operations Cash Flow investment prospective

Free cash flow and operating cash flow are sometimes used to define a ratio that is useful when comparing competitors in the same or comparable industries.

Free cash flow is a measure of financial performance, similar to earnings, and its use is considered one of the non-Generally Accepted Accounting Principles. It measures the cash flow available for distribution to all company securities holders.

The calculation used to determine free cash flow is net income plus amortization and depreciation minus change in working capital minus capital expenditures. Operating cash flow is calculated in the same way, omitting capital expenditures.

Having secured investment for your venture implies a long-term partnership with the investor that is governed by the Shareholder Agreement. How are the voting rights distributed ?


A. Statutory Voting     (1 Share = 1 Vote proportionally distributed)

Statutory voting is a corporate voting procedure in which each shareholder is entitled to one vote per share and votes must be divided evenly among the candidates or issues being voted on.


If you owned 50 shares and were voting on six board position, you could cast 50 votes for each board member, for a total of 300 votes. You could not cast 20 votes for each of five board members and 200 for the sixth.


B. Cumulative Voting (1 Share = 1 Vote  disproportionally distributed)

Cumulative voting is the procedure of voting for a company’s directors; each shareholder is entitled one vote per share multiplied by the number of directors to be elected. This is sometimes known as proportional voting. This is advantageous for individual investors, because they can apply all of their votes toward one candidate


If you own 50 shares and are voting on six board positions, you can cast 300 votes for one director and none for the five other directors, 20 votes for each of five board members and 200 for the sixth, or any number of  other combination

Example of voting calculation formulas for a board of directors 

If 1 Share = 1 Vote      Formula: S * X  / D+1

S – total number of votes

X – number of Directors you want to elect

D- Number of directors up for election


You Own: 500 shares

Nr. of directors up for election: 10

Nr. of directors you want to elect :3

(500*3) / (10+1) =136.36

Conclusion – so you need 137 Shares in order to make sure your board member gets elected.

Bottom line: Cumulative voting can be beneficial to minority voters because they can use all of their votes for a single candidate, improving the chance that they can get at least one sympathetic member on the board; statutory voting ensures that their votes get spread out amongst several candidates, making it less likely that any one of them is elected.

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