Early Stage Valuation

CHAPTER 3Capital Structure

Alexander DavieandAntonella Puca

The capital structure of an early stage enterprise (ESE) is typically the result of multiple layers of financing rounds, which are negotiated independently and may involve different investors. At the inception stage, financing is provided by the founders and their immediate personal circle of relationships in exchange for common stock in the company. As the company builds its operations, additional rounds of financing take place, which typically involve the issuance of multiple classes and series of preferred stock with different rights and preferences. For most ESEs, debt is not a significant part of capital structure. When present, debt financing tends to have equity features and be in the form of short-term bridge loans that are expected to convert into preferred stock or be repaid at the time of a forthcoming equity round. An ESE may also engage in the issuance of equity-like instruments such as stock options and warrants. Stock options can provide an effective way to reward employees and establish a competitive compensation system to attract and retain talent without deploying cash resources. Warrants may be used to enhance the value of a preferred stock issuance or as an add-on to attract convertible bond investors.

This chapter presents an overview of the financial instruments that can be found in the capital structure of an ESE, with a special focus on the rights and privileges that are associated with preferred ...