Executives expend a great deal of effort to determine the optimal way to finance the operations of their businesses. This may involve bringing on outside investors, employing bank debt, or financing through cash flow. Once the money has hit the bank, they may wonder, what effect does the capitalization of my company have on the value of its equity?
A company with a simple capital structure typically has been financed through the issuance of one class of stock (usually common stock). Companies with complex capital structures, on the other hand, may include other instruments: multiple classes of stock, forms of convertible debt, options, and warrants. This is frequent in startup or venture-backed companies that receive financing through multiple channels or fundraising rounds and private equity sources.
With various types of stock on the cap table, it is important to note that all stock classes are not the same. Each class holds certain rights, preferences, and priorities of return that can confer a portion of enterprise value to the shares besides their pro rata allocation. These often come in two categories: economic rights and control rights. Economic rights bestow financial benefits while control rights grant benefits related to operations and decision making.
Economic rights:
- Liquidation preference
- Dividends
- Mandatory redemption rights
- Conversion rights
- Participation rights
- Anti-dilution rights
- Registration rights
- Voting rights
- Protective provisions
- Veto rights
- Board composition rights
- Drag-along rights
- Right to participate in future rounds (pro-rata rights)
- First refusal rights
- Tag-along rights
- Management rights
- Information rights
Originally published in the Financial Reporting Update: Equity Compensation, June 2019.