Capital Restructuring: When Simpler Is Better

Author:Mr Charles Fletcher
Profession:Taylor Vinters
 
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Many privately backed companies go through several financing rounds and find they end up with a very complex capitalisation structure, with various classes of preferred shares, ordinary shares and deferred shares, not to mention employee incentives and debt instruments. A new funding round is a good opportunity to restructure and simplify this legacy.

In this article we'll look at the problems a complex capital structure can cause, and how to create a more suitable structure. We'll also examine the possible drawbacks.

WHY IT'S A GOOD IDEA TO RESTRUCTURE

A convoluted capital structure is not only more difficult to understand and manage; it can also leave some shareholders unfairly disadvantaged.

Founders, employees and management tend to find themselves with ordinary shares or common stock. This can leave them lower down in the pecking order and misaligned with any realistic exit, if there are tiers of shares with rights to preferred returns of capital ahead of them. The same can apply to existing investors holding junior classes of preferred shares.

Existing shares may also have anti-dilution rights that could prejudice a proposed funding round.

A complex structure may also lead to unbalanced control. For example, the voting rights of junior classes of shares could outweigh their economic interest - they might hold 60% of the shares, which could represent only 10% of the value. Each class of shares will usually have its own class rights, which makes transactions difficult.

Investors are likely to have layers of shareholder rights from many rounds of investment documentation (including consent rights), making it difficult to ensure proper governance and processes. Some investors may have written off the company, but been slow to make decisions, give consents, pass resolutions or form quorums. And there could simply be too many investor directors, making the Board unwieldy.

All this can deter external investors or potential acquirers, who find the capital structure hard to comprehend.

PUTTING A SIMPLER STRUCTURE IN PLACE

Creating a simpler structure can help avoid the drawbacks described above, and make future management easier. However the process does need to be carefully planned, evaluating the existing arrangements and analysing the tax implications for the company and shareholders.

Let's look at the typical elements involved.

Consolidating share classes

If you can obtain the necessary consents (special resolution plus class approvals)...

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