3. Dealmaking with Debt and Equity

In this section, we briefly discuss to what extent the traditional financing instruments (debt and common equity) can accommodate the needs of the entrepreneur and the investor with respect to the three major deal elements:

  • Division of financial return
  • Dynamic allocation of control
  • Path to exit

 The following table maps some important characteristics of debt and equity financing to the three deal elements:

 

Common stock (one-share-one-vote) Straight debt
Division of financial return
  • With common stock, all shareholders have the same preference. They receive the same treatment w.r.t. dividends, information, etc.
  • Common equity is a residual claim on the firm's earnings. Regular dividend payments cannot be legally enforced.
  • Because equity is a residual claim, shareholders fully participate if the firm does well. They often lose everything if the firm fails. Consequently, shareholders have a strong incentive to work hard and to maximise the value of the firm.
  • Shareholders usually have the right to participate pro-rata in future rounds of financing to make sure that they can maintain their relative ownership stake in the company.
  • The claims of the debt holders have seniority over those of the shareholders. Debtholders receive their contractually fixed interest (or coupon) and notional payments first. 
  • Debt is a contractual claim. The firm has to make the contractually agreed payments. 
  • Because the debt payments are contractually fixed, the debtholders do not participate if the firm does well. Therefore, debt offers the investors no upside participation. If the firm fails, however, also the debt holders generally suffer (credit risk).
Dynamic allocation of control
  • The shareholders are the owners of the company. Shareholders elect the board of directors and they vote at the shareholders' meeting (among other things).
  • With one-share-one-vote, each share has the same voting power. Consequently, majority shareholders decide and minority shareholders have limited influence on material decisions.
  • As long as the ownership structure does not change, the voting power does not change either. So the allocation of power is not dynamic.
  • Debt holders are not owners of the company.
  • They usually have no say in the daily operations of the business. 
  • However, the debt covenants typically give the debt holders a say (approval right) in major corporate decisions such as asset sales or M&A deals.
  • In principle, control shifts to the creditors if the firm fails to fulfil its contractual obligations and files for bankruptcy. 
Path to exit
  • With common equity, there is no clear path to exit if the firm is privately held. Shareholders participate in a liquidity event only if the board of directors and the shareholder meeting agrees to such an event. 
  • So for a minority shareholder, it is not clear if and when there could be such a liquidity event.
  • In the case of a liquidity event, shareholders then participate pro-rata. Each share receives the same payoff.
  • With debt, there is a clear path to exit. The firm has a contractual obligation to make the debt payments, including the repayment of the notional. 
  • The debt claim has preference over the equity claim, also at the time of exit/liquidation.
  • No participation in the upside (i.e., if the exit is very lucrative).
  • Participation in the downside (i.e., when the exit value is lower than the debt outstanding).

  

The table shows that none of the traditional financing instruments can fully accommodate the needs of the entrepreneur and the investor discussed before. The table also shows, however, that many of the elements are there. It's just that they are sometimes part of a debt-like financing instrument (e.g., preferred return) and sometimes part of an equity-like financing instrument (e.g., control, participation in the upside). So our task going forward will be to structure financing instruments that pick the desired elements from the debt and the equity world. This is what we will do in the following course sections.

Before turning to this, however, it is important to say a few words about common stock.