E&d Securities

Equity and Debt Securities
A Guide for Sustainable Entrepreneurs
SUSTAINABLE ENTREPRENEURSHIP PROJECT
Dr. Alan S. Gutterman
Electronic copy available at: https://ssrn.com/abstract=4256126

Equity and Debt Securities:
A Guide for Sustainable Entrepreneurs
Published by the Sustainable Entrepreneurship Project (www.seproject.org) and
copyrighted © 2022 by Alan S. Gutterman.
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and has also held senior management positions with several technology-based businesses
including service as the chief legal officer of a leading international distributor of IT

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from the University of Cambridge. For more information about Dr. Gutterman, his
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Equity and Debt Securities 1
§1 Introduction
A variety of outside investment sources may be tapped by a company depending on the

type and size of business and the projected growth of the company over the period that
the investors are expected to hold the securities purchased in the offering. In many cases,
the founders and senior managers of the company may have relatives, friends, neighbors
or business acquaintances that can serve as capital providers and/or provide leads to other
prospective investors. Alternatively, the company may look to various types of outside
investors including business partners, management-oriented investors, institutional
investors and venture capitalists.
Management should investigate the financing strategies of other companies involved in

similar lines of business. Many investors tend to specialize in a particular industry or
product line and management may be able to put together a list of persons and entities
that might be willing to review the business plan. Trade groups are another way to
network with potential investors and many industry associations are now sponsoring
regular financing forums that allow companies to make presentations to investors.
Service providers, such as attorneys, accountants, and commercial bankers, can also
provide assistance with introductions to investors. Alternatively, the company may turn
to a finder or broker to provide assistance in locating suitable investors.
When contemplating the need and desire to raise capital for use in launching a new
business or expanding an existing one, consideration must be given to the type of
securities that will be offered and sold to investors. Assuming that the business is
operating in the corporate form, a choice must be made between “equity securities”, such
as common or preferred stock, that provide investors with a true ownership stake in the
corporation, or “debt securities” that provide investors with enforceable contractual rights
against the corporation to recover the amount of capital advanced for use in the business
but no permanent ownership interest in the corporation. The choice between equity and
debt securities depends on a variety of factors, as described in more detail below, and
companies must choose carefully and pay close attention to the terms of the securities and
their impact on the business of the company, existing shareholders and anticipated future
financing needs and opportunities. Prospective investors will have their own preferences
based on how they wish to allocate their funds and balance their investment portfolios. In
many cases, the parties agree on a “middle ground” that involves the issuance of debt
securities coupled with rights in favor of the investor-debtholders to convert those
securities into equity and/or invest additional capital in exchange for an equity interest.
§2 Basic terms and concepts of corporate capital structure
Before discussing the key issues associated with equity and debt securities, it is useful to
have an understanding of certain basic terms and concepts relating to the capital structure
of a corporation:

Capital. The term “capital” is used to indicate the entire base of tangible and intangible
assets of the corporation or, more particularly, that portion of the assets of the 2
corporation, regardless of their source, which will be utilized for the conduct of the
corporate business and for the purpose of generating gains and profits which might be
available for distribution among the owners of the corporation. This expansive definition
of corporate capital includes cash and assets contributed by the ultimate owners of the
corporation; cash received from investors in the form of loans; funds generated from the
actual operations of the business and from appreciation in the value of the assets used as
part of the business; and financing received from non-investment sources (e.g.
commercial lenders).
The owners and managers of the corporation can choose from among a wide variety of
securities in developing an appropriate capital structure. At any given time, the factors
that must be considered in selecting the type of security may include the relative cost of
the financing to the business and the existing owners; the risks associated with the
security; and the degree of flexibility associated with any payment obligations under the
terms of the security.
Equity Securities. Equity securities, including common shares and preferred shares, are
the foundation of the corporate capital structure. Equity securities evidence the holders'
rights with respect to the long-term earnings and asset appreciation. Accordingly,
particularly in the case of common shareholders, such stakeholders may be more willing
to reinvest current profits in worthwhile investment projects that will ultimately increase
the value of the corporation. In contrast to debt securities, the capital contributed by
holders of equity securities typically is permanent, and the corporation is not obligated to
return to the shareholders any amounts that they have invested in the business. There is
no assurance that common and preferred shareholders will not suffer the loss of their
entire investment while other claimants (i.e., debtholders) recover all or a portion of the
capital that they provided to the corporation. So-called “straight” preferred stock, which
carries a fixed date for redemption of the shares and return of principal to the shareholder,
is a limited exception to the rule that equity securities are permanent capital.
Debt Securities. Debt securities are obligations of the corporation and are treated as part
of its liabilities. There are an unlimited number of types of debt instruments, ranging
from a simple non-negotiable promissory note containing little more than the
corporation's promise to pay to a capital note or other long-form instrument which
contains elaborate provisions with respect to defaults, remedies, security, covenants and,
in some cases, voting rights similar to those granted to shareholders. When referring to
debt securities, the principal amount owed is the “principal”; the date when repayment of
the principal is due is termed the “maturity date”; and the rate of interest being paid is
often called the “coupon rate”. Debt securities may be either long or short term,
prepayable (or callable), convertible into another security, subordinated to certain classes
of other creditors, and may even provide for participation in the earnings of the company.
As a general rule, debt securities are issued in denominations of $1,000 or multiples
thereof, and are quoted based on a percentage of the principal amount.

Convertible Securities. A versatile “hybrid” form of financing instrument is an equity

or debt instrument that allows an investor to change, or “convert,” the original security 3
into a different class of equity securities or into another form of corporate obligation.
These instruments are referred to as convertible securities. For example, it may be
possible to issue convertible preferred shares that provide an investor with a guaranteed
return of dividends for as long as the preferred shares are outstanding, as well as the right
to convert the preferred shares into common shares in the future in order to share in any
appreciation in the value of the underlying business.
A convertible security is really just an outstanding equity or debt security which has been
supplemented by a right, upon the occurrence of specified events to “convert” the original
security, without payment of additional consideration, into another type of security of the
issuer which has been specified in the terms of the original security. For example, a
convertible equity security may be preferred shares that can be converted into common
shares of the issuer. Some corporate debt instruments may include the right to convert
the outstanding principal and interest into common shares of the issuer. Whenever senior
securities are convertible into junior securities, it is referred to as downstream conversion.
However, it is also possible to provide that junior securities can be converted into a more
senior securities in what is referred to as an upstream conversion, although the conversion
usually must not impair the rights of the existing creditors of the corporation.
A conversion feature is a form of option, and it will have some value even though the
present market price of the underlying securities is below the option (“conversion”) price.
The conversion feature is a “sweetener” which can be used to enhance the attractiveness
of the security. For example, senior convertible securities (i.e., debt securities and
preferred shares) provide the following advantages to investors: a high degree of safety,
since they have a senior claim on the issuer's assets over the common shareholders; an
assured stream of fixed income which, at least in the case of convertible debt securities, is
insulated from declines in earnings which might have an adverse effect on the issuer's
ability to pay dividends to its common shareholders; and the opportunity to participate in
higher common stock prices if the market value of the residual security into which the
senior security is convertible appreciates.
Convertible securities are often sought by investors in growth companies where the
dividend rates on common shares tend to be low, since the debt portion of the instrument
or the “guaranteed” dividend payable on any preferred shares provides them with a
higher return then they would have been able to achieve had they purchased the common
stock. Convertible securities, particularly convertible preferred stock, also may be useful
to venture capital investors, who are not generally interested in a current return on
investment, but covet the protection and opportunity for potential appreciation offered by
convertibles.
Convertible securities also have several advantages to issuers:
(1) The interest rate on convertible debt almost invariably will be lower than if the
same issuer sold nonconvertible debt securities and the same can be said for the dividend

rate on convertible preferred shares in relation to preferred shares that do not have the
conversion feature. 4
(2) Assuming that the conversion price is set high enough, and that the issuer retains
a right to redeem or call the convertible debt, the issue can be an attractive vehicle for
obtaining permanent equity financing. If the market value of the common shares
underlying the original security increases to the point where it exceeds the conversion
price, the issuer can force conversion by calling the securities for redemption, thereby
eliminating the debt and clearing up its balance sheet. If the market value of the stock
does not increase sufficiently to result in conversion of the debt, the issuer will have
received the benefit of the proceeds of the debt offering to the scheduled maturity dates at
a relatively low interest cost.
(3) The sale of convertible securities, especially debt securities, permits the issuer to
tap institutional markets that are not allowed, or may not wish, to buy common stock
outright.
(4) By issuing convertible preferred stock, rather than “straight” debt or equity, the
company can obtain permanent capital and avoid the need to redeem the debt or equity at
a fixed date in the future.
Options. An “option” is just that; it is a right to purchase a security, usually common

stock, for a stated period in the future at a determined or determinable price. As a general
rule, the price (the “option price”) at which the holder of the option may purchase the
securities subject to the option will be higher than the current value of the securities. For
the option to have any long-term value to the holder, the market price of the securities
must increase above the option price plus any additional amount which the holder may
have paid in order to receive the option.
There are two general kinds of options; however, only one actually involves direct
financing for the company. The first kind of option is granted by the company itself, and
may cover either authorized but unissued shares or debt securities. A good example is
options which are issued to employees as a compensation device. Options may be issued
to outside investors by private companies, but the stock purchase rights which are granted
to investors by a public company are typically referred to as warrants. Although options
issued in combination with other securities, such as debt instruments, can improve a
company's ability to raise funding in the current time period, the eventual exercise of the
options will dilute the interests of existing shareholders and the earnings per share of the
company.
The second kind of option is a contract between two parties in the market relating to
outstanding shares of the corporation, which is not a party to the contract. One type of
contract is a “call,” pursuant to which the first party pays the second party for the right to
buy from the second party a specified number of shares of the corporation at a fixed price
at any time during the period set out in the contract. A second type of contract is a “put,”
pursuant to which the first party pays the second party for the right to compel the second

party to purchase from the first party a specified number of shares of the corporation at a
fixed price at any time during the period set out in the contract. Options on corporate 5
securities are now widely traded on several exchanges; however, these options do not
represent ownership claims against the corporations that issued the underlying securities,
nor rights against their shareholders.
Warrants. A warrant is similar to an option in that it evidences a right granted by the

corporation to the holder to purchase shares of stock or debt securities at certain times
and prices. As is the case with an option, the exercise price for a warrant, sometimes
referred to as the “strike price,” will often be higher than the current value of the
underlying securities. While warrants can be issued independently, they can be
distinguished from options by the fact that they are commonly issued in companion with
nonconvertible equity or debt securities in order to provide prospective investors with an
extra item of value that might convince them to purchase the principal security. However,
the issuance of warrants may not have the desired effect in inducing the investor to
provide funds to the issuer since, in a sense, the issuer's issuance of warrants is a “bet”
that it will not be as successful as the purchaser of the warrants expects it will be. If
management were more optimistic about the company's prospects, it would not issue
warrants, but rather would wait and sell common stock after the price has risen and rely
on alternative sources of financing, such as commercial loans or short-term debt
securities, in the interim.
While warrants are similar to convertible securities in that they permit the investor to
change the nature of the investment after the original purchase, there are significant
differences. Most importantly, while convertible securities merely provide the holder
with an opportunity to replace the security which the investor originally purchased, a
warrant issued in connection with another security allows an investor to supplement the
amount invested in the issuer (e.g., by increasing the holder's equity stake) without
affecting the claim which the investor otherwise has a result of the original security.
While warrants may appear to have less utility when the issuing corporation does not
have an available public market, there are still a number situations in which private
companies might well consider using warrants in their business strategies. For example,
warrants might be issued to certain promoters who incur additional risks (e.g., acting as a
guarantor for a loan to the issuer) on behalf of the corporation. Warrants also might be
issued as a form of additional compensation to major customers, distributors, and
suppliers, as well as to financial advisors, including underwriters who participate in the
corporation's initial public offering. Also, warrants might be issued to private investors
who provide debt financing when the corporation encounters difficulties with respect to
raising additional equity capital.
Warrants carry both advantages and disadvantages for the issuing corporation and its
shareholders. On the one hand, the issuance of warrants may permit the company to
complete a new financing in situations where capital raising opportunities were otherwise
limited. Also, unless the warrants can be exercised by surrendering the security (e.g.,
debentures) to which they were originally attached, thereby making the warrant

functionally similar to a convertible security, then the company would benefit from the
receipt of additional funds upon the sale of securities by exercise of the warrants. 6
However, warrant exercise will result in dilution to the interests of the current
shareholders, both as to control and with respect to future distributions. In addition,
warrant holders benefit from increases in value of the issuing corporation without being
exposed to the same risks as the current shareholders.
Distribution and Liquidation Priorities. While the capital received from various
sources is rarely segregated, and cash is essentially a fungible resource, there are clear
demarcations as to the legal claims that capital providers will have with respect to the
assets of the corporation upon the cessation of its business operations. The relative
priorities among the various financial stakeholders in the corporation are important to
understand most of the legal and business aspects of corporate financing, and can be
illustrated by reference to the order in which a corporation's assets would be distributed
upon liquidation in bankruptcy proceedings.
The secured creditors include all parties that have advanced funds to the corporation and
received a mortgage (i.e., security interest) on specific corporate assets, as well as certain
other parties who may have liens on the corporation's assets as a matter of law (e.g., a
landlord's lien for nonpayment of rent; an artisan's lien to secure payment for services
supplied in connection with a chattel (e.g., an automobile repair); and a warehouseman's
lien to secure the nonpayment of storage charges) or otherwise (e.g., a creditor's efforts to
satisfy an outstanding obligation by going to court may result in a judicial lien). Investors
in this group include secured debtholders who enjoy a senior position among corporate
investors. Their anticipated return on investment is generally limited to the amount
invested plus interest thereon; however, they enjoy a first claim against the assets pledged
as security for fulfillment of the company's obligations. As such, they trade at a lower
rate of return, relative to more junior securities, for the highest level of safety. If the
claims of a particular secured creditor exceed the value of their security interest (e.g., the
asset subject to the mortgage or other lien) the excess amount will be treated in the same
way as a claim of an unsecured creditor. Priority creditors have the first preference to the
proceeds of the sale of those assets that are not subject to mortgages or other such liens.
Priority creditors include the Internal Revenue Service, people with certain kinds of wage
claims, and people who have supplied services to the company in administering any
formal insolvency proceedings (i.e., bankruptcy).
Any cash or other assets left after satisfaction of the secured creditors and priority claims
goes to the remaining (i.e., unsecured) creditors of the corporation, pro rata according to
the amount owed to each. This class often includes investors who purchase unsecured
debt securities of the corporation. Like secured debtholders, the investment return of
unsecured debtholders is limited to the amount invested plus interest thereon; however,
the obligations of the corporation are not backed by a pledge of assets. Accordingly,
unsecured debtholders are within the lower priority class of unsecured creditors, and their
claims are junior to those of secured debtholders. This enhanced level of “risk” generally
leads to a higher interest rate on unsecured debt than on secured debt. This type of
unsecured debt is often referred to as “mezzanine finance” and includes subordinated

loans, participating loans and instruments that combine elements of debt and equity such
as convertible bonds and bonds with warrants. Non-investor unsecured creditors of the 7
corporation will include trade creditors (i.e., those persons who have previous supplied
goods and services to the corporation).
After satisfaction of all the claims of the various creditors, the remaining cash and assets
of the corporation will be distributed among the equity claimants; first to the preferred
shareholders, and then the remainder to the residual owners of the company, the common
shareholders.
§3 Equity offerings
Although at common law, and in the absence of any statute or agreement to the contrary,
all equity securities enjoyed equal rights and privileges, it is now the prevailing practice
to divide equity securities into two or more classes with varying rights, preferences and
privileges as to the payment of dividends, liquidating distributions, redemption,
conversion and voting rights. The corporate form provides a good deal of flexibility in
planning for the control and financing of the business and allows for the creation of
distinctions among investors that fall within the same category of securities.
The terms of any offering of equity securities will vary depending upon the
circumstances, including the stated needs and requirements of the prospective investor
group and the concerns of existing shareholders regarding the degree of control and
amount of their current economic interest which may need to be compromised in order to
secure the necessary financing. However, as a general rule, most financings will require
some negotiation regarding the following matters:
Voting Rights. The exact nature of any voting rights which are to be granted to the
holders of the new security should be clearly specified in the articles or certificate of
incorporation or bylaws and any related shareholders' agreement relating to the voting of
such shares. In the absence of any specific provision, voting rights will generally be
defined by relevant state corporation laws. If the securities will have some, but not full,
voting rights, any limitations should be clearly expressed and defined. The negotiation of
voting rights generally revolves around whether or not a specific group of security
holders will have the right to separately consider and approve certain actions by the
corporation, including the issuance of new securities; fundamental corporate changes,
such as mergers and acquisitions and dissolution of the corporation; and the election of
one or more members of the board of directors.
Dividend Rights. The timing and amount of any required dividend payments should be
considered. In addition to the “rate” of dividends, expressed as a percentage of the face
value of the security, the existence of any dividend preference and the “cumulative” or
“noncumulative” nature of the dividend should be described. The security may be given
a preference over other classes of shares with respect to payment of dividends, which
restricts the ability of the corporation to make dividend payments to junior securities,
such as common shares, prior to making the required payments to the holders of the new

security. The dividend preference may be “cumulative,” thereby requiring that the
corporation make up the amount of any fixed dividend which cannot be paid in a given 8
year due to the lack of any earnings and profits for that year or any other source of
dividends. The dividend preference may be “noncumulative,” in which case the dividend
is only payable if declared the board of directors.
Participation Rights. A security is said to be a “participating” instrument if it carries the

right to receive any dividends or distributions upon liquidation which are in excess of the
fixed amount of any preference attached to the security. A convertible preferred security
may have the right to receive payments equal to all dividends paid on the security into
which the subject security is convertible, determined as if the holder of the convertible
security actually held the number of shares issuable upon conversion of such security. A
convertible security may, in addition to any preferential amounts, be entitled to receive a
share of any remaining assets upon liquidation determined as if such shares had been
converted into the junior security.
A number of variations exist in determining the percentage of any distribution on a junior

security which will be paid to the holders of the senior security. For example, if the rights
of the holders of the senior security are based on a percentage of the dividends or assets
to be paid or distributed on the junior security, it should be made clear whether such
percentage is based on all amounts paid on the junior security or only on amounts paid
which exceed the amount which is equal to the amount paid on the senior security.
Redemption Rights. Many states corporation laws permit the issuance of classes of
shares that are redeemable as set forth in the articles or certificate of incorporation. The
price at which, and the period during which, the shares may be redeemed, whether at the
option of the corporation or upon the election of the shareholder, should be set forth in
the terms and conditions of the shares. A right in favor of the shareholder requires that
the corporation redeem the outstanding securities at a specified price and at a time or
times set forth in the instrument, thereby creating a “quasi-debt” obligation. A right in
favor of the corporation provides the existing shareholders with the ability to “refinance”
its capital structure on terms which may be perceived as being more favorable at some
future date.
Conversion Rights. If the security is convertible, the exact terms of conversion should
be described, including the rate of conversion; the effect of any shares splits or shares
dividends on the conversion rate; the effect of any recapitalization or issuance of
additional securities on the conversion rate; the period during the conversion rights must
be exercised; and the events, if any, which might require that the securities be
automatically converted. There are a number of variations that must be taken into
account, such as permitting the conversion rate to vary in relation to the time at which the
election to convert is made by the holder. For example, the corporation may issue an
equity security with dividend and liquidation preferences which may be convertible, at
the option of the holder, into common shares at a rate of two shares for every preferred
share, provided that the conversion occurs prior to a specified date. If conversion occurs
after that date, the rate of conversion is reduced to only one common share for every

preferred share. The effect of this type of provision is to provide an incentive for the
holder of the preferred security to convert those securities into common shares as soon as 9
possible, thereby removing the possible drain on the resources of the corporation created
by the need to make an annual dividend payment to the preferred holders.
Completion of an equity financing for a corporation generally raises the same types of
issues that exist whenever a corporation decides to issue new shares. The situation may
be complicated by the need to amend the charter documents to reflect the terms of the
security being issued to the investors. Counsel should be sure to comply with state
statutory requirements governing the conditions for valid authorization and issuance of
securities. In addition, as part of that process, it is likely that formal action will be
required by both the board of directors and by the shareholders of the corporation.
Federal and state securities laws apply only to the offers and sales of “securities.” It is
fairly clear that shares, both common and preferred, are considered to be “securities” for
purposes of the securities laws.
§4 --Preferred shares
The other type of equity security, preferred shares, is often similar in form to debt
securities. In many cases, the duration of the preferred stock extends indefinitely, and the
preferred shareholders do not, absent some special provision in the articles of
incorporation, have the right to the return of their investment at some definite time in the
future. Moreover, the failure to pay preferred stock dividends, a decision which is often
discretionary with a board of directors controlled by the common shareholders, does not
trigger any right on the part of preferred shareholders to demand repayment of their
investment, nor do preferred shareholders have the right to force the corporation into
liquidation over the objections of the common shareholders. These potential problems
for preferred shareholders have led to the development of various protective devices
described below (e.g., rights with respect to election of directors; redemption provisions;
affirmative and negative covenants and conversion rights) to ensure that the preferred
shareholders will be repaid the principal amount at some point in the future.
The basic form of preferred share is so-called “straight” preferred, which typically has the
following characteristics: s fixed and limited rate of return in the form of dividends; the
right to receive dividends equal to the amount set forth in the articles of incorporation
prior to any distribution to holders of common shares; the right to receive a preferential
amount on liquidation prior to any distribution to the holders of common shares, although
they may not have any right to share in the value of any remaining assets beyond the
amount of their preference; and the right to vote on changes or amendments to the
company's articles of incorporation which may have an effect upon any of the preferential
rights granted to such holders.
There are really a wide variety of forms of preferred stock that can be used to meet the
particular financing requirements of the corporation and the needs of the specific investor
group. Assuming that a corporation is issuing nonconvertible preferred shares,
possibilities include nonvoting noncumulative preferred stock; nonvoting fully

cumulative preferred stock; nonvoting partially cumulative preferred stock; adjustable

rate preferred stock; voting preferred stock; participating preferred stock; and redeemable 10
preferred stock. Of course, attributes of each of the aforementioned securities can be
combined to create a wider array of financing instruments. For example, investors may be
given significant rights to participate in management of the corporation and the economic
returns from the business through the issuance of voting preferred shares with full
participating rights and cumulative rights as to dividends accruing over the term of the
investment. In addition, each of these types of preferred stock instruments may carry a
conversion feature.
As noted above, there are several common devices that preferred shareholders may insist
upon in order to protect their investment and/or compensate them for the risks assumed in
making the investment:
Distribution Preferences. Straight preferred shares are quite similar to “straight” debt
instruments. However, preferred shares are junior to the rights of creditors, including the
holders of any debt securities, in any liquidation of the corporation and its right to receive
any dividends or liquidating distributions is restricted by law, whereas the obligation to
repay creditors must be fulfilled even if the corporation has little or no earnings or profits.
The liquidation preference typically granted to the holders of preferred shares is intended
to alleviate the concerns of investors with respect to the possible loss of their investment
and is also intended to insure that the holders of common shares are not otherwise able to
receive a return of their invested capital to the exclusion of the investors. However, if the
holders of the common shares believe that the ultimate value of their residual interest in
the assets of the corporation will exceed the preferential amount which might be owed to
the holders of the preferred shares, the use of any liquidation preference should not be
perceived as being unduly burdensome to the common shareholders.
Election of Directors. While preferred shares traditionally do not have the right to elect
directors, it is common to provide the preferred shareholders with rights to elect directors
if the corporation fails to make dividend payments. Once elected, the representatives of
the preferred shareholders should be able to monitor the corporation's use of assets,
although this may not be true unless the preferred shareholder has the right to elect a
majority of the board.
Redemption Provisions. Provision may be made for retirement of the preferred shares
at a specified point in time, sometimes through the use of sinking fund requirements
under which the corporation must periodically set aside the funds which will be required
to redeem the preferred shares. A mandatory redemption provision of this type should be
distinguished from a provision that gives the corporation the option to redeem the shares
at some specified price. In some cases, the preferred shareholders may be given the right
to “put” the shares to the corporation, a feature which achieves a result similar to that of
mandatory redemption and which turns the preferred shares into an instrument similar to
a demand promissory note. In any case, a failure by the issuer to meet its obligations with
respect to redemption, including any inability or refusal to set aside funds for future
redemptions, will generally constitute an event of default under the terms of the security.

Affirmative and Negative Covenants. Various covenants may be established to protect 11

the preferred shareholders from unwanted erosion in the corporation's asset base,
including restrictions on certain expenditures and distributions on the common shares,
and covenants regarding the maintenance of certain financial ratios (e.g., net worth,
assets-to-liabilities). If the corporation wants to take any action which violates one of the
covenants, it must solicit consents from the preferred shareholders. The preferred
shareholders will also generally have a right to vote on amendments to the corporation's
articles of incorporation and bylaws which may adversely affect their rights.
Conversion Rights. Indirect protection for the economic interests of the preferred
shareholders may come through the use of conversion rights, which would allow the
investors to convert their economic interest in the corporation into common shares or
some other type of security in those situation where they might consider it to be more
advantageous to them than simply continuing to hold the preferred shares. A conversion
privilege allows the holders of the preferred shares to obtain a portion of the long-term
growth and appreciation of the corporation's assets; provided that they are willing to
surrender their preferences. In most cases, there will be elaborate provisions designed to
protect the conversion privileges from dilution resulting from changes made in the capital
structure of the corporation, including the issuance of new shares.
§5 --Negotiation and documentation process
An investment transaction involves a good deal of preliminary planning and work for the
company and its counsel. For example, in some cases, the company may use the services
of a finder or broker to assist in locating suitable investors. In addition, the company will
generally prepare, with the assistance of counsel and any finder/broker, offering
documents that not only comply with applicable securities law requirements, but which
also serve as a powerful marketing tool for the company in its search for investment
capital. Once these initial steps have been taken, the investment process will generally
proceed as follows:
• Locating and contacting prospective investors;

• Evaluating and selecting one or more investment partners;
• Preliminary negotiations with investors regarding the terms of the proposed
investment, including the price to be paid, the form of investment instrument and the
other important terms of the financing, which are often summarized in a term sheet or
commitment letter;
• A thorough due diligence investigation by the investors regarding the business of the
company, its management and existing obligations;
• Preparation of the formal documentation necessary for completion of the transaction
and any ancillary agreements, including the investment agreement, which contains the
detailed terms of the financing and investment instrument; any shareholder or voting
agreements; employment agreements; stock option or purchase agreements for
employees; and any agreements relating to ownership and protection of the
company's intellectual property rights.

The consummation of the purchase and sale of the securities will occur at a closing 12
provided for in the investment agreement. Many investments will “close” simultaneously
with the execution and delivery of the investment agreement. Accordingly, there is no
technical need for a set of conditions designed to cover the time period between
execution of the agreement and a subsequent closing. Nevertheless, the investment
agreement will usually contain various “conditions precedent to closing” for both the
investors and the company. The conditions serve as a valuable checklist for insuring that
corporate formalities have been observed, that all business conditions have been satisfied
(e.g., completion of a loan agreement satisfactory to the investors), that all ancillary
agreements have been executed, and that all required consents and waivers, legal
opinions, closing certifications and stock certificates have been delivered.
The process of negotiating and documenting the terms and conditions of the investment
often set the tone for the long-term relationship which will exist between the management
of the company and the investors. All of the parties must be able to anticipate and
appreciate the continuously evolving needs and requirements of the company and draft
the documentation in a manner which provides management with sufficient flexibility
while, at the same time, protecting the legitimate interests of the investors. Although a
number of the documents used in the investment financing process have become
somewhat “standardized,” it is important that all of the special concerns which may arise
in a particular transaction are considered and reflected in the agreements.
§6 Investment agreement
The central legal document in the financing transaction is the investment agreement,
often referred to as the “shares purchase agreement. Not only does the investment
agreement serve as the detailed record of the substantive understanding between the
company and the various investors, it also provides a means for the company to disclose
all the business, financial and legal information that may be relevant to the transaction.
Although there is little disagreement over the general purpose of the investment
agreement, the specific terms and conditions of the agreement are usually subject to a
good deal of negotiation.
The legal effect of any investment agreement is similar to that of most commercial
contracts. The company's failure to comply with any closing condition will permit the
investors to refuse to close the transaction. With respect to breaches that occur after the
transaction has been completed, the appropriate remedy depends upon the circumstances.
For example, if it is discovered that the company made a material misrepresentation, the
investors might have the right to rescind the transaction. When ongoing covenants are
breached, the investors can usually seek specific performance and injunctive relief;
however, in some cases the remedies (e.g., the ability of the investors to elect a majority
of the directors or an adjustment in the conversion price) are self-executing.
The style and format of the investment agreement will vary depending upon the
preferences and experiences of the investors and their counsel, as well as the form of

investment agreement that may have been used by the company in prior financings. The
form and content of the investment agreement is often influenced by such things as the 13
type of investment instrument, the relationship of the investors to the corporation, and the
corporation's stage of development. For example, an early-stage financing involving
investors who are familiar with the corporation's managers will be relatively simple. On
the other hand, a more formalistic agreement might be used when the investment is made
in connection with a management buyout of a division of a larger business and financing
is being provided by institutional investors. If the offering is made by a corporation that is
already publicly-traded, the agreement will generally refer to information which is
available in the issuer's regulatory filings.
In some cases, the investment agreement may be quite short, resembling a subscription
agreement, and will include only a description of the securities and the closing
procedures, limited representations and warranties from the company, and representations
from the investors designed to perfect any applicable exemption from the registration and
qualification requirements of federal and state securities laws. More often than not,
however, the investment agreement will be a lengthy document that incorporates detailed
disclosures regarding the company and the terms of the investment instrument. As a
general rule, the content of the typical investment agreement can be divided as follows:
the description of the transaction, including identification of the investment instrument,
the manner of payment, and the date or dates of closing; representations and warranties of
the company, which will cover the company's financial condition, capital shares, assets
and liabilities, intellectual property, business plan and various other matters;
representations and warranties of the founders and other principal shareholders and key
employees of the company, which may also be incorporated into the representations and
warranties given by the company, as well as representations and warranties from any
selling shareholders; representations and warranties of the investors, most of which are
directed at compliance with applicable federal and state securities laws; closing
conditions which must be satisfied in order for the investors and the company to become
obligated to perform their obligations under the investment agreement; and miscellaneous
provisions, including notice requirements and the conditions for amending the investment
agreement.
The investment agreement will typically include a number of exhibits or appendices,

which will be attached to the main agreement and incorporated by reference into the
contractual understanding between the parties. Exhibits generally include a schedule of
exceptions to the representations and warranties that the company will be providing; a
schedule of investors that sets out a list of the persons and entities that are participating in
the transaction; a copy of the form of the company's articles of incorporation; and copies
of each of the various ancillary agreements to be entered into in connection with the
transaction.
§7 --Ancillary agreements
It is the rare occasion that the investment agreement is the only document required in
order to consummate the transaction. In most cases, there are a number of other ancillary

agreements which form an integral part of the transaction and which will be negotiated
separately as part of the process of completing all the documentation for the transaction. 14
For example, when the founders and investors have reached agreement on the
composition of the company's board of directors, it is typical to document that
understanding not only in the company's articles of incorporation, but also in a
shareholders' agreement, and in the investment agreement. As a general matter, the
actual placement of the terms and agreements has very little legal effect; however, there
may be practical advantages to segregating the agreements into two or more documents.
Amendments to charter documents. The terms of any equity financing instrument will
need to be described in the company's articles or certificate of incorporation and the
amended form of the articles becomes part of the agreement between the company and
the investors, even though it will not actually be executed by the parties. While the terms
of the investment security are the primary concern of the parties in most cases, counsel
must always tend to the other requirements that must be observed in drafting the articles
or certificate of incorporation and all necessary amendments thereto.
Warrants and options. In certain cases, the company may issues warrants and options
in connection with an equity or debt financing. If so, the documentation for the
transaction will include one or more documents setting forth the terms upon which the
investor may exercise their rights to acquire additional securities of the company.
Warrants may vary in length and complexity. In many cases, the company will use a
basic form of warrant to purchase common shares or preferred shares. This is particularly
appropriate when the company is in the start-up stage and investors have not requested
any special warrant features, such as registration rights or anti-dilution provisions. As the
company grows and the sophistication level of the investors increases the form of warrant
will likely become more complex.
Investors' rights agreements. Beyond the terms of the investment instrument, ancillary
agreements may be necessary to describe certain rights which the company is providing
to the investors and any affirmative or negative covenants regarding the operation of the
company's business once the financing has been completed. Using a separate investors'
rights agreement makes it easier to ensure that all the corresponding rights of various
groups of investors with respect to financial information and registration are consistent
and non-conflicting. Whenever there is a new round of financing, the rights given to the
new investors at that time can be integrated with existing rights by amending the
investors' rights agreement, thereby placing all of the rights into one master document. If
an investors' rights agreement is not used at the outset, each of the prior investment
agreements will need to be amended.
A separate master investors' rights agreement usually does not eliminate the need to
obtain the consent of prior investors to amend the agreement to include any new
investors, unless the agreement specifically permits subsequent amendments without new
consents for the limited purpose of adding new investors on a pari passu basis. Since new
rounds of financing will generally raise issues regarding control and voting power among
each of the investor groups, it is common to find that there will be a need to revise and

amend some of the actual substantive terms of the investors' rights agreement (e.g.,
percentage of the investors that may trigger a demand registration) whenever a new 15
financing is contemplated.
Many times the ancillary agreement will be limited to registration rights. In most cases,
investors will be granted the right to require, or “demand,” that the company register their
securities for resale under federal and state securities laws. Alternatively, investors may
simply be granted “piggyback rights” which allow them to register their shares as part of
a registration that the company is otherwise filing for other reasons (other than
registration of shares issuable under employee stock purchase or option plans). In those
cases where there is some agreement with regard to how shares held by the investors and
other shareholders will be voted during the term of the investment, a voting agreement or
voting trust generally will be utilized.
Certain investors may request special rights, particularly in the case of a corporate
partnering relationship in which the investor is seeking a preferred position with respect
to the company technology, products, or services. For example, a corporate investor
might bargain for preferred marketing rights with respect to the distribution of certain of
the company's current and future products. In lieu of an extensive agreement covering
investors' rights with respect to participation in management of the company, the parties
may elect to enter into a simple form of management rights letter that sets out the various
rights of investors with respect to consultation with management, participation in board
meetings and access to information. This sort of “side letter” may be used with major
investors that do not have the opportunity to designate a nominee to the board.
Founders' and employee agreements. In many cases, there will be additional

agreements relating to the founders and the employees of the company. For example, it is
common for major employee-shareholders to be bound by various restrictions on their
ability to transfer shares, including right of first refusal and/or co-sale agreements. Other
employee-related contracts and agreements may include: assignment of innovations and
non-disclosure agreements; non-competition agreements; repurchase agreements that will
come into play upon the occurrence of certain events, such as the termination of
employment; and an insurance trust agreement relating to key-man life insurance.
§8 Debt securities
While much of the capital raised by closely-held businesses from outside investors in the
private placement market comes in the form of an equity investment, consideration
should also be given to the use of debt securities. Debt securities without conversion
rights can provide companies with an opportunity to secure additional capital for the
business without diluting the ownership interests of the holders of equity securities.
Convertible debt securities can be used to attract capital from those investors looking for
more downside protection in the event the business is unable to meet its financial and
business objectives. While debt securities have different rights, preferences, and
privileges than equity securities, the process for completing a debt financing is very
similar to the steps that need to be completed for an equity investment.

Larger companies, including many public companies, have taken to issuing debt 16
securities to take advantage of favorable credit terms, including low interest rates, and to
avoid the uncertainties of attempting to sell new securities in the equity markets. The debt
securities issued by public companies are quite sophisticated and limited only by the
imagination of a company's financial officers and investment bankers. Traditionally, debt
securities in privately-held businesses were issued only to friends and family of the
founding group at the time the company was formed and to institutional investors as the
company matured. Debt securities issued to friends and family usually were converted
into common stock upon completion of the first round of outside funding from venture
capitalists or other professional investors. Debt securities issued to the institutional
investors were typically scheduled for conversion within 12–18 months in some form of
liquidity event, such as an initial public offering or acquisition. However, debt
investment financings have been much more common as companies struggled to stay
afloat after their initial equity investment capital evaporated. For example, the so-called
“bridge loan” is a transaction in which current investors provide the company with a
limited amount of funds, in the form of a loan, to keep the company going until a new
round of equity financing can be closed. Upon closing of the new equity financing, the
bridge loan is either repaid or converted into the securities issued in the new financing.
Investors participating in the bridge loan are rewarded for the increased risk through
warrants and options, as well as preferred terms on conversion of the loan amounts in the
equity financing.
Counsel for the issuer and counsel for the lender-investor in a debt financing transaction
perform many of the same functions that must be completed in connection with an equity
transaction; however, the nature of the instrument will dictate a slightly different
emphasis, as well as the need for specialized experience that might not be part of the
skills normally offered by counsel primarily engaged in equity offerings. For example,
company counsel needs to be conversant with laws and procedures relating to secured
transactions, as well the impact of the strict loan covenants and restrictions on the
company's business. Investors' counsel needs to be able to advise the client regarding the
rights of creditors under secured transactions and bankruptcy laws, particularly when the
investors also hold company equity securities. In addition, the company will generally
prepare, with the assistance of counsel and any finder/broker, offering documents that not
only comply with applicable securities law requirements, but which also serve as a
powerful marketing tool for the company in its search for investment capital. The
offering documents in a debt financing should include a detailed description of the
proposed terms of the debt securities; the projected cash flow over the term of the
instrument; and a legal discussion touching on creditors' rights and the covenants and
restrictions that will be put in place to allow holders of the debt securities to monitor the
use of their funds.
§9 --Nature of debt securities and debtholder’s interest
Debt securities are obligations of the corporation and are treated as part of its liabilities.
An investor who receives a debt instrument in respect of the funds advanced receives a

promise from the borrower to repay the face amount of the instrument. In addition, to
compensate the investor for advancing the funds, the debt instrument will include a 17
promise to pay interest on the amount outstanding prior to full repayment of the
obligation. The face amount of the instrument will be the amount advanced, unless it is
sold at a discount or at a premium. Repayment of amounts advanced will be scheduled
for a single time in the future or in periodic installments, unless the borrower has the right
to prepay (i.e., redeem) the obligation. Debt financing from investors is generally
available to all types of businesses, assuming that the company represents a reasonable
business and financial risk for outsiders. Owners and managers of a business need to
carefully consider certain factors before introducing debt securities to the capital structure
including business risks, financial risks, economic conditions, impact on management of
the business and potential returns for equity holders.
§10 --Types of debt securities
Types of debt securities and offerings include:
Simple promissory notes. A note is a shorter term obligation (i.e., shorter than ten
years), and can generally be distinguished from secured debt instruments (e.g., real estate
mortgage securities and equipment-backed securities) and debentures by the following:
promissory notes are usually payable to the order of a specific creditor; the obligation to
pay interest under a traditional promissory note is not represented by coupons; there is no
trust indenture or trustee involved in the issuance of traditional promissory notes; and
promissory notes are generally not publicly traded. In the private placement market, it is
common to refer to all debt securities, regardless of term, as notes. More complex debt
instruments are available for use by larger corporations, many of which tend to use debt
financing as an essential capital management tool.
Bonds. In the public market for debt securities, a common form of secured debt
instrument is a “bond,” which is a long-term debt security typically secured by all or most
of the corporation's assets and with a preference over the other creditors of the
corporation with respect to distributions of income, assets, and the proceeds from the sale
of assets of the corporation. Corporate bonds are generally repayable ten years or more in
the future, and will usually bear interest at a fixed rate, although it has become more
common to issue variable or adjustable rate bonds under which the interest rate will
change over the term of the security as the rates of comparable securities increase or
decrease. In order to allow the issuing corporation to relieve itself from the burdens of
the interest charges associated with debt securities, bonds will also often contain
provisions which allow the issuer to redeem the securities prior to their scheduled
maturity date, a right which can be quite valuable in the event that interest rates decline
over the original period of the indebtedness.
Real estate mortgage securities. Real estate mortgage securities are secured by the
pledge of a security interest on certain real estate that is owned by the corporation. The
pledge property can be limited to only a specific parcel of property or can include all of
the real property owned by the corporation at the time that the bonds are issued. In certain

cases, the security interest will extend beyond currently owned property to include any
additional real property acquired after the time that the bonds are issued. If the value of 18
the real estate pledge to secure the obligation increases following the date the bonds are
issued, the property may be pledged as security for additional debt securities, although
the rights of any “after-issued” securities will probably be subordinated to those of the
originally issued bonds. On the other hand, the pledge of a security interest on corporate
real estate will probably make it difficult for the corporation to issue any unsecured debt
instruments. In case of a large corporation, real estate mortgage securities will be issued
pursuant to an indenture or deed of trust.
Equipment obligations. Equipment obligations involve the issuance of various types of

securities secured by equipment. Equipment-based debt financing has historically been
used with respect to railroad rolling stock; however, it is frequently used in other
situations, such as with aircraft utilized by commercial airlines. Another equipment-
based debt financing arrangement involves the issuance of equipment trust certificates. In
this case, the pledged equipment is sold to a trustee, and the trustee leases the equipment
to the corporation. The corporation makes a substantial advance payment of rentals to the
trustee that is used by the trustee as a down payment for the equipment. As with the
“conditional sale” bonds, the corporation makes regular rental payments sufficient to pay
annual interest and amortization charges. The trustee is primarily liable for the payment
of the principal and interest due on trust certificates issued to the investors; however, the
corporation also guarantees payment. Equipment mortgage bonds are secured by the
pledge of a security interest on various forms of tangible personal property of the
corporation, such as furniture and equipment. Equipment mortgage bonds are often used
by corporations, such as railroads, with substantial investments in the equipment
generally utilized in the conduct of the business.
Collateral trust bonds. With collateral trust bonds, payment of principal will be secured
by a pledge of stocks, bonds, securities, notes and/or other intangible property rights
owned by the corporation. Even though the collateral property is deposited with a trustee,
the corporation usually retains the right to receive any dividend and interest payments
and to exercise the voting rights associated with any securities included in the collateral,
although these rights may revert to the trustee upon any default by the corporation under
its payment obligations. The attractiveness of collateral trust bonds will depend upon the
nature of the intangible property utilized to secure the obligations. Among the types of
property often pledged as collateral are the following: stocks and/or bonds of one or more
subsidiaries of the issuing corporation; stocks and/or bonds of one or more unrelated
corporations; prior lien mortgage bonds of the issuing corporation; obligations of the
corporation's customers; or any combination of these items. Collateral trust securities
permit the use of the credit of the holding company, which may be better known than the
subsidiary. Such securities also avoid after-acquired property clauses, and allow the
holding company to retain control over the subsidiary, at least prior to any default.
Debentures. The preferred position of the secured creditor or bondholders can be

contrasted to that of the holders of the most basic form of debt instrument, commonly
referred to as a “debenture.” Debentures are generally “unsecured” and the indebtedness

of the corporation evidenced by a debenture is backed solely by the overall financial

condition and creditworthiness of the corporation. Debentures are junior debt securities 19
of the corporation and debenture holders are unsecured creditors of the corporation.
Debentures do not have the additional comfort provided to bondholders by the pledge of
a security interest in all or a portion of the property or assets of the corporation to secure
the payment of the obligations of the corporation.
While, as defined, a debenture is broad enough to include an unsecured subordinated

promissory note, the term is typically used in the investment community to mean a debt
instrument that is issued under a “trust indenture.” A debenture can usually be
distinguished from unsecured subordinated notes by the fact that it usually is a “medium-
to long-term” (i.e., five to ten years) obligation, and the holders thereof are entitled to
periodic interest and, in some cases, principal payments. While debenture holders have
no better claim on the corporation's assets than general creditors, they typically are
granted priority over the holders of unsecured subordinated notes and, in some cases, the
corporation may issue two or more series or classes of debentures with varying rights to
payment among such series or classes.
Since debentures have only a junior claim on the assets of the corporation, they provide
the most attractive debt financing alternative for a corporation needing to raise additional
capital in the future. Short-term lenders are more willing to extend credit to a corporation
that has not pledged a portion of its assets to secure payment of prior claims and future
unsecured debt instruments also can be issued on the same priority as the rights of
existing debenture holders. The corporation will have the flexibility to issue secured debt
instruments in the future, assuming that the debenture holders do not place any
restrictions on the issuance of senior debt securities by the corporation.
Since they do not have the benefit of a security interest to protect their investment in the
corporation, debenture holders will generally require a higher rate of interest on the
obligation and may also impose more restrictions on the actions which might be taken by
corporate management, including the issuance of senior or pari passu debt securities
which may have the effect of diluting or subordinating their rights to the proceeds of any
sale of corporate assets which may be required in order to satisfy the claims of any
corporate creditors. While their “junior” position is the greatest disadvantage to potential
debenture holders, the enhanced ability of the corporation to issue a broader range of debt
instruments in the future may actually reduce the business risks associated with the
investment in the corporation.
Demand obligations. One of the simplest forms of debt security is the so-called
“demand note,” which provides the holder with the right to present the note to the issuer
for payment at any time following the date specified in the note (i.e., the note is payable
on “demand”). A demand note is commonly used when a corporation obtains short-term
loans from private investors, such as venture capitalists, in order for the corporation to
have sufficient capital to continue with the operation of the business until more
permanent financing can be arranged. When supplemental financing is obtained, the
holders of the demand notes will generally either seek repayment or will agree to convert

the notes into the securities issued as part of the new financing. In light of the risks
associated with a sudden call for payment, the issuing corporation will usually bargain for 20
deferring the first date upon which a demand can be made until a fixed date in the future.
For example, investors may be precluded from demanding payment for at least six
months following the date that the notes are first issued. Alternatively, the investors'
rights may not be effective until the occurrence of a specified event (e.g., failure to attain
a specified financial or operational milestone as of a certain date). Another method
commonly used to minimize the risks to the issuing corporation is to provide for some
“grace period,” such as 60 to 90 days, following the demand in order to allow the
corporation to raise the funds required to repay the notes.
Commercial paper. Commercial paper is short-term (e.g., 90 days), large denomination

(e.g., $100,000), notes issued by large, established corporations to finance seasonal
capital requirements or other projects of limited duration. Commercial paper is often
traded in the securities markets and is generally considered to be relatively low-risk,
although the interest rate, while lower than other fixed obligations, is still above that
offered on comparable Treasury obligations. In many situations, the commercial paper of
one corporation will be purchased by other corporations with short-term cash surpluses.
Convertible debt securities. Convertible debt securities allow the holder to elect to
convert the debt instrument into another security of the issuing corporation, generally an
equity security (e.g., common stock), by surrendering and canceling the indebtedness and
accepting that number of units of the other security as determined by the specified
conversion ratio. Most of the terms of convertible debt instruments are similar to
convertible preferred stock, although debtholders wishing to participate in the
management of the business will need to rely upon separate voting arrangements, rather
than rights that are usually given to holders of convertible preferred stock in the charter
documents. In addition to the conversion feature, convertible debt securities may have all
the other terms and preferences of other types of debt securities (e.g., secured by the
assets of the issuing corporation).
Other characteristics used to distinguish among debt instruments include things such as
variability of interest rates, flexibility of duration (i.e., options to extend the term of the
obligation) and combination of debt securities with preferred shares, options or warrants.
While all security holders, be they equity or debt holders, share some common interest in
the stability, growth and success of the issuer's business, there are clearly areas in which
their interests will differ. These differences account for a number of the provisions
commonly included as part of the terms of various debt securities. For example, the
redemption features often used in debt securities are a method for the equity holders to
reduce some of the burdens otherwise imposed on the business, such as interest charges,
mortgages and pledges of company assets and properties, by the issuance of debt
securities to investors. In turn, sinking fund requirements and covenants, both affirmative
and negative, are just two of the methods used by debt investors to ensure that the equity
holders do not increase the risk that funds will not be available for repayment of debt by
choosing business strategies which focus on long-term return objectives which can only

be enjoyed by the actual owners of the company. In addition, the holders of debt
securities, while concerned with management regarding the future growth of the 21
corporation's assets and earnings, are more focused on the corporation's ability to repay
specified amounts on the terms originally agreed at the time that the debt holders
advanced funds to the business. Therefore, they will have a preference for distributing
current profits rather than reinvestment.
The holder of a debt security is a creditor of the corporation rather than the owner.
Debtholders have no stake in the success of the business beyond recovery of the amount
invested at the time that the debt security was purchased and payment of the stated
interest. As such, the maximum return the investor can realize on the debt investment is
limited, subject to interest rate fluctuations in the case of variable rate obligations. On the
other hand, while the debtholders may not share in any extraordinary return enjoyed by
the common shareholders, they do enjoy priorities over the common shareholders with
respect to satisfaction of their claims against the issuer, particularly when the issuer is
involved in insolvency or liquidation proceedings. However, the priority of a specific
debtholder or class of debtholders may be expressly subject to the prior payment of other
debt. Debt securities normally give the holder no voice in the management of the issuer;
however, the failure of the corporation to comply with the terms of the debt security will
give the holder, or the trustee named in the indenture under which the securities are
issued, the right to take legal action, either to foreclose on any pledged property or to sue
for damages in breach of contract. In some cases, debtholders will also be permitted to
elect members of the board of directors. Also, as is the case with preferred shares, the
issuance of debt securities generally includes a number of affirmative and negative
financial and business covenants which are imposed on the actions of the corporation, all
of which taken together can have a material effect on the corporate managers' ability to
conduct the business in a manner that may adversely affect the debtholders.
§11 --General terms of debt instruments
As a general rule, the spectrum of corporate debt securities runs from a simple
promissory note, unsecured and subordinated to other debt instruments, at the most junior
end, to very elaborate senior corporate bonds, secured by all or most of the corporation's
assets and with preferences over the corporation's other creditors with respect to
distributions of corporate income, assets, and the proceeds from the sale of corporate
assets. Within this broad spectrum, a variety of different methods can be used to classify
debt securities, although it is most common to classify debt securities based on the key
features of the debt instrument.
The terms and rights of each debt security will reflect, in one way or another, all or most
of the various features and characteristics referred to below, although it is not strictly
necessary for each characteristic to be explicitly described or stated as part of the debt
instrument and accompanying agreements. For example, a basic debenture will typically
include the maturity date, the income terms (i.e., interest rate and timing of the interest
payments), the designation of the permitted payees of principal and interest, and the
manner of repayment. However, since debentures are unsecured, there is no need to recite

the junior position of the debenture holders to secured creditors, although it is common to
include subordination provisions relating to various future issuances of debt securities 22
and commercial loans. In addition, the purpose of the financing is generally not included
as part of the debenture, although the use of proceeds may be restricted in the various
covenants and agreements of the company included in the separate indenture or loan
agreement.
Debt securities provide the holder with a specified return in the form of an interest
obligation and a return of capital at the end of the term specified in the instrument.
Absent a conversion feature, debt securities generally have no right to share in any
appreciation in the underlying value of the business. With the obvious exceptions of
conversion rights and subordination provisions, the terms of any debt instrument issued
to investors are similar to those negotiated with commercial lenders.
Interest rate and payments. Interest may be set at a fixed rate or a provision may be
made for adjustment of the interest rate during the period that the debt is outstanding. The
rate of interest will vary depending upon the creditworthiness of the issuer, the security
given to the holders of the instrument and whether or not the instrument is convertible
into an equity security. Interest payments are typically made either on a monthly,
quarterly or annual basis and, depending upon the anticipated cash flow requirements of
the issuer, interest payments may be deferred for some period or, in exceptional cases,
interest payments may be deferred until the principal is paid. Interest will be payable on
the date or dates set out in the instrument. The debt holders will receive a return on their
investment in the form of income. Distinctions can be made among debt securities with
regard to how the income is computed (e.g., fixed rate or variable rate); the base upon
which income is computed; and the timing of income payments.
Repayment of principal. Issuers and investors can structure principal payments to suit
their specific requirements. Repayment of principal is often scheduled in quarterly, semi-
annual or annual installments commencing at a specified time during the term of the
instrument (e.g., four to six years). While it is possible to commence the principal
repayment schedule from the date of issuance of the security (e.g., annual principal
repayments with the first payment due one year from the date of issuance), it can be
expected that the corporation will bargain for some deferral of principal payments,
although the corporation would still be paying interest on a larger outstanding debt
balance. In some cases, the corporation may even be able to delay the repayment of the
entire principal amount until the date of maturity, at which time a single “balloon”
payment is made to the investors. In addition, while debt securities are typically repaid in
legal tender (i.e., cash), it is possible to provide for debt holders to receive other assets or
securities upon repayment of the instrument.
Conversion rights. Debt instruments may be given conversion rights that are similar to
those provided to the holders of convertible preferred stock. In some cases, the
debtholders will receive “straight” debt and warrants exercisable into equity securities
with the holder of the debt having the right to apply any outstanding principal and interest
toward the exercise of the warrants.

Prepayment. The debt instrument may provide the issuer with the right to prepay the 23
debt, albeit at a premium. Optional prepayment allows the issuer to refinance its
obligations in the event that interest rates have declined or, in cases where the debt
instrument can be converted into equity, permits management to extinguish conversion
rights which might dilute their interest in the company.
Subordination. Debt instruments are generally subordinated to bank and other

institutional borrowings, whether outstanding at the time that the debt instrument is
issued or incurred after the date of issuance. Subordination provisions dictate that no
payment will be made to the holders of the debt instrument until all of the obligations of
the issuer with respect to any such “senior” indebtedness have been fulfilled and
discharged. As a general matter, some amounts can be paid on the debt instrument so
long as no default has occurred on any senior indebtedness.
Series or classes of debt securities. As with equity securities, corporations may issue
two or more series or classes of bonds, perhaps pledging different assets as security for
each series or class, or providing that the holders of one series or class of bonds will have
a different priority (e.g., “senior” or “junior”) in relation to the other series or classes as
to the income or other proceeds from the use or sale of particular assets or properties.
The holders of any secured debt securities may have different ranks of preferences with
regard to the right to receive the proceeds from any sale of pledged property. Holders are
considered as being of the same “rank” if they are secured by the same quality of security
interest in the pledged property. For example, a security interest may be a “first,” or
senior, lien, or a “junior” lien.
Distinctions also may be made among the holders of secured debt securities on the basis
of the assets or properties that serve as collateral for repayment of the debt. For example,
the holders of a specified type of bond may be given a “first,” or “senior,” lien on certain
assets of the corporation. If the corporation defaults on its obligations under the terms of
the bond and the property pledged as security is sold, the proceeds will be applied first to
pay the amounts due to the bondholders with a “first” lien on the pledged property. If the
proceeds are insufficient to pay the entire amount owed to such bondholders, they
become unsecured creditors with respect to the balance owing to them. If the proceeds
are more than the amount needed to repay the senior bondholders, the balance will first
be applied to the payment of holders, if any, of debt securities with a “junior” lien on the
secured property and any remaining amount will be applied to satisfy the claims of
unsecured creditors. In addition, it is possible to create other preferences and priorities
among debt holders, including holders of the same general type of debt security, by using
subordination clauses and other provisions.
Covenants. Debt financings often involve extensive affirmative and negative covenants
and undertakings on the part of the issuer, many of which go far beyond those that are
generally included in any equity financing arrangement. In fact, many debt financing
agreements include covenants that are substantially similar to those found in commercial
loan documents.

Events of default. Any default by the issuer with respect to the payment of principal or 24
interest may create certain rights in the holders of the debt instrument, including the right
to accelerate the payment of outstanding indebtedness and, in some cases, the right to
elect one or more members of the board of directors. Other events of default might
include a breach of a representation or warranty; violation of an affirmative or negative
covenant; default under any other debt instrument; and insolvency or bankruptcy.
Depending upon the circumstances, the issuer may be given some period of time to
“cure” a default before the debtholders can exercise their rights.
Security. The most common distinction among debt instruments is between unsecured
securities (i.e., debentures) and secured securities (i.e., bonds). With regard to secured
debt instruments, reference is often made to the assets pledged, or commitments made, to
support satisfaction of the issuing corporation's duties and obligations (e.g., real estate
mortgage securities and equipment-backed securities). In many cases, investors will
purchase unsecured debt instruments, such as when the investment is being made by one
or more of the founders or by venture capitalists purchasing some form of convertible
debt instrument. Institutional investors will usually prefer some type of security interest
in material assets of the issuer, although the interest may be subordinated to that of any
commercial lenders.
“Secured” debt securities are distinguished by the fact that the obligation of the
corporation to repay the amount of any principal is secured by the pledge of a security
interest in specific property or assets of the corporation. If the corporation defaults on its
obligations under the terms of the security and the pledged property is sold pursuant to
the security interest, the proceeds will be applied first to pay the principal amount due to
those holders of debt securities with a “first” lien on the pledged property. If the
proceeds are insufficient to pay principal, the holders become unsecured creditors with
respect to the balanced owing to them. If the proceeds are more than the amount needed
to repay the holders, the balance will first be applied to the payment of holders, if any, of
debt securities with a “junior” lien on the secured property and any remaining amount
will be applied to satisfy the claims of unsecured creditors. There are advantages and
disadvantages to secured debt instruments. A corporation with a relatively poor credit
rating can preserve its access to debt financing through the pledge of property as added
security for repayment of the loan. Interest charges generally will be lower than would be
the case if the corporation raised the same amount of capital through the issuance of
unsecured debt instruments. The ability of the corporation to secure additional debt
financing may be impaired since a portion of the assets of the corporation would no
longer be available to satisfy the claims of new lenders.
Maturity date. “Short-term” debt securities have a maturity date that falls within one
year from the date of issuance. “Medium-term” obligations typically will extend
anywhere from one to five years following original issuance. “Long-term” obligations
have maturity dates which are more than five years after the original issue date, and often
extend for as long as thirty years in the case of large corporations. In other cases, the
maturity date of the securities may be extended by mutual agreement between the issuing

corporation and the debt holders. There are no strict guidelines that are used to
determinate whether a debt security falls within one or the other of the categories referred 25
to in the text. For example, a large corporation may well consider a ten year bond to be a
medium term obligation, at least in relation to its other outstanding debt, while a small
corporation may not be able to interest investors in purchasing debt securities which do
not mature within five years. Investors tend to compare the economic terms of debt
securities of similar corporations with comparable maturity dates and, as such, the
“market” tends to define “short-, medium-, and long-term” for purposes of new debt
issuances.
Designation of payee. Another method for distinguishing debt instruments is the manner
for determining the payees of principal and interest. There are two general options that
are available: registered and coupon. In many cases, holders will have a choice of either
option with respect to the same issuance, and either form can be exchanged for the other
at the request of the holder. When such an exchange privilege exists, the security is
sometimes referred to as “interchangeable” or “exchangeable.”
Registered securities are probably the most convenient form for issuing and
administering debt securities. Such a security bears the name of the owner, who is also
registered as the owner of the security on the registry books maintained by the registrar
for the issue. The principal, upon maturity, and interest, on the interest dates, are paid to
such registered owner at the address specified in the registry books.
A certificated registered security is considered to be a “negotiable instrument” under the

Uniform Commercial Code (“UCC”), and can be transferred by delivery of the certificate
with a duly executed assignment either on the security itself or by separate instrument
and registration of the transfer on the registry books. Simply registering the transfer on
the registry books effects transfers of uncertificated registered securities.
Registered securities provide a number of administrative advantages for the issuing

corporation, the trustee and for the security holders. For example, the registration
procedure eases the burden of transferring ownership of the securities, and also enhances
the safety for purchasers concerned that they will be entitled to the rights bargained for as
part of the transfer. In addition, the fact that the names and address of the security holders
are centrally maintained on a registry makes it easier to deliver any required notices to
the security holders. Finally, registered securities facilitate savings in manpower costs,
storage costs and human effort. In many ways, the procedures for record ownership and
transfer of certificated registered securities are comparable to those used for shares.
Coupon securities provide that principal amounts shall be payable to the bearer thereof,
and that each installment payment of interest shall be made to the bearer of the respective
interest coupons upon presentation thereof upon their respective due dates and are
registered as to principal (i.e., principal is payable to the registered owner), but the
interest is payable to the bearers of the respective interest coupons. The ownership of a
certificated coupon security and/or coupons will be transferred by delivery thereof.

Ownership of an uncertificated coupon security is transferred by registration of the

transfer. A certificated coupon security is negotiable under the UCC 26
If coupon or bearer securities are used, the identity of the owners will often be unknown
to the issuing corporation, any trustee, and the other security holders. This can create a
number of administrative problems. For example, the redemption of the securities cannot
be effected without the publication of notices. Also, difficulties may be encountered in
locating a sufficient number of security holders to take effective action or to compel the
trustee to act under certain circumstances.
Debt structure and funding provisions. While, in most cases, the entire principal
amount of the financing is made available to the company at the time that the transaction
initially closes, it is possible to structure the debt on a contingent drawdown basis. Such
an arrangement would provide for advances to the company by the debt holders at
specified times during the period of the loan. For example, a portion of the total principal
amount may be advanced to the company when the securities are first issued. Thereafter,
further advances, up to the maximum amount of the debt securities, could be requested by
the company upon satisfaction of specified performance objectives. This allows the
investors to use their capital for other purposes, often in a safer investment, until the
company has demonstrated its ability to meet its performance objectives. It also provides
an incentive to the company's managers to achieve the goals established at the time the
securities are issued. Some investors require that management shareholders make
additional equity capital contributions to the company whenever funds are advanced to
the company under the terms of the debt arrangement. Such a requirement is intended to
give the managers added incentives, due to the increase in the amount of their own capital
that is “at risk,” and also increases the amount of the margin on the investors' loans.
Purpose or objective of financing. In some cases, debt securities can be identified by

the business purpose or objective of the financing, such as the construction or
improvement of the issuing corporation's facilities.
§12 --Debt securities versus preferred stock
A choice is often made between the use of debt securities and the preferred stock
described above in financing the business. While there may be only slight economic
differences between debt securities and “straight” preferred stock, distinctions arise in
several areas: fixed payment obligations; permanence of capital; investors' rights; cost of
financing; management and control; and tax and accounting considerations.
Fixed payment obligations. Investors with an interest in receiving current income from
their investment will generally have a preference for debt securities over preferred stock.
This is because the payment of interest on debt securities is a full and unconditional
obligation that must be satisfied regardless of the financial condition of the issuer. On the
other hand, the corporation and managers may prefer that the obligations to the investors
as to current payments be in the form of dividends, since the payment of dividends is

typically left to the discretion of the board of directors, and subject to various statutory
limitations. 27
Permanence of capital. While it is possible to have a debt security without a fixed

maturity date (called a “consol”), in almost all cases the principal amount due under a
debt security will become due and payable on a specified date or dates in the future. This
feature of debt securities can be most attractive to investors, particularly since, absent
some provision for a sinking fund or mandatory redemption, preferred shares generally
have an indeterminate duration, just like common stock, and the corporation has no
obligation to repay the amounts contributed by the preferred shareholders until the
business is liquidated. The issuance of preferred shares allow allows the corporation to
retain the flexibility to issue new debt securities in the future, since prospective lenders
consider the preferred shares to be part of the equity cushion available for the protection
of their investment. The continuing ability to issue debt securities allows the corporation
to take advantage of the benefits of the leverage which can be achieved through
borrowings at a lower cost than the expected return from the investment and use of the
borrowed funds.
Investors' rights. Investors generally appreciate the greater rights as creditors they
would have if they acquire any debt securities of the issuer. For example, if the
corporation defaults on its obligations with respect to debt securities, the holders will
have certain rights against the corporation and its assets. On the other hand, failure of a
corporation to pay dividends on its preferred shares typically will not trigger any rights in
favor of preferred shareholders to foreclose on the corporation's assets, although the
preferred shareholders may increase their participation in the management of the
corporation by election of directors. The advantages of being a creditor for the investors
may be diminished, if not eliminated altogether, by the fact that banks and other financial
institutions may require that the investors subordinate their rights to receive payments of
principal and interest to the right of the bank or financial institution to receive payments
in respect of its loan.
Cost of financing. Absent tax considerations, investors usually are satisfied with a lower
return from debt securities than from equity securities of the same company, since the
level of risk associated with holding a debt instrument is lower than would be the case if
the investors purchased equity securities. Corporate investors may be an exception to this
generalization, since the value to such investors of the deduction on dividends received
(i.e., 85% of dividends received are not taxable) frequently means that they will be
willing to accept preferred stock bearing dividends at a rate which is lower than the
interest rate on debt.
Management and control. Debt securities generally offer the managers of the issuer the
benefit of preserving control. Since debt securities ordinarily carry no voting rights, an
increase in debt does not disturb the voting power of present shareholders of a
corporation, at least during periods that the debt securities are not in default.

Tax and accounting considerations. The issuance of debt securities usually results in
significant tax savings for a corporation, because the interest paid on the debt is 28
deductible in calculating federal income tax, whereas dividends payable on common or
preferred stock are not deductible under current laws. This distinction may be less
significant for start-up companies, which may well have sufficient losses so that the
interest deduction is not that important. Accounting considerations may also lead some
corporate investors to prefer debt securities in making their initial investment, since a
significant equity position may cause the investor to be required to consolidate the
financial results of the issuer with those of the investor's other operations.
§13 --Legal considerations
Completion of a debt investment financing generally raises the same types of issues that
exist whenever a corporation decides to issue new shares. Counsel should be sure to
comply with statutory requirements governing the conditions for valid authorization and
issuance of securities. In addition, as part of that process, it is likely that formal action
will be required by both the board of directors and by the shareholders of the corporation.
In some states, the corporation may include a provision in its articles or certificate of
incorporation granting holders of debt securities voting and other shareholders' rights.
Most states authorize corporations to borrow and to issue bonds, notes, and other
obligations. State corporation statutes generally provide that a corporation has the power
to make contracts and guarantees, incur liabilities, borrow money, issue its notes, bonds,
and other obligations, and secure any of its obligations by mortgage or pledge of any of
its property, franchises, or income. Some statutes provide that debt securities may be
convertible into or include the option to purchase other securities of the corporation. The
power to issue debt securities also would be subject to any restrictions that the
incorporators may have placed in the articles of incorporation.
Unless otherwise restricted by law or the articles or certificate of incorporation, debt

securities generally may be issued in exchange for money, other tangible or intangible
property, or services performed for the issuer. Several jurisdictions prohibit the issuance
of bonds in exchange for services to be performed or for money or other property to be
delivered to the corporation. Cases have upheld the issuance of bonds for the purpose of
securing an antecedent debt. In addition, it has now become a common practice for
corporations to sell bonds at a “discount” (i.e., below par or face value), provided that the
bonds are issued to promote legitimate business interests and the discount price has been
reached through arm's-length negotiations and represents the best price that the
corporation could obtain.
Securities laws, both federal and state, are also an area of concern when issuing debt
securities. While it is fairly clear that shares, both common and preferred, are considered
to be “securities” for purposes of the securities laws, the analysis of promissory notes and
similar debt-type instruments is somewhat different. There is an extensive library of
commentary and case law on how to determine whether a particular promissory note is a
“security” and thus covered by the securities laws. Some have argued that a note issued

in a commercial transaction is not a security while a note issued to a person making an

investment should be considered a security. However, the US Supreme Court has 29
rejected this distinction and other approaches to the issue in favor of the so-called “family
resemblance” approach which begins with the presumption that every longer-term note or
evidence of indebtedness is a security unless it bears a strong family resemblance to notes
that clearly do not constitute “securities”, such as home mortgages, notes in consumer
financing transactions, unsecured bank “character” loans, short-term notes secured by
receivables or other business assets, an open account indebtedness converted into a note,
and notes for commercial bank loans for current business operations.
Other areas of the law that may be relevant when issuing debt securities are the
provisions in the UCC relating to “negotiable instruments” and “secured transactions”
may be applicable, especially when repayment of the obligations by the issuer is secured
by liens on all or a portion of the assets of the issuer. Guarantees, if any, are governed by
the law of suretyship and, of course, bankruptcy laws may become relevant if the issuing
company becomes unable to meet its obligations with respect to payment to the debt
holders. Finally, federal income tax treatment of dividends and interest payments can
have a significant impact on the decision to issue debt securities, at least in those
situations where the amount of financing is relatively large and dividend/interest
payments will be substantial in relation to other aspects of the corporation's budget.
§14 --Term sheets and commitment letters
If the investor and the issuer determine, after preliminary discussions, that an investment
is desirable, they will attempt to reach an agreement in principle on the primary terms of
the investment. The handshake “agreement” between investor and entrepreneur is usually
set forth in a written term sheet or letter of intent. Some investors prefer to characterize
this document as a commitment letter. In most cases, the parties use their preliminary
understanding to reflect their mutual agreement regarding the key financial and legal
terms of the transaction in order to serve as a basis for drafting the definitive documents;
and in some cases, to impose enforceable legal obligations upon the parties, such as
requiring payment of expenses in the event the transaction does not close or prohibiting
negotiations by the company with other parties pending completion of the proposed
transaction.
The length and content of the term sheet may vary depending upon the style of the
investor and the specific circumstances surrounding the transaction. Negotiations
generally begin with a basic form of term sheet that covers the major terms of the debt
instrument. Specific issues to be covered include the type of instrument; the aggregate
principal amount of the debt securities to be sold in the offering; the minimum investment
amount (i.e., unit price, such as promissory notes in $100,000 denominations); the
interest rate; the repayment schedule; conversion features (if any); material covenants;
events of default and consequences; and due diligence and other closing conditions.
§15 --Investment agreements

As is the case when a company is issuing equity securities, the central legal document in
any debt financing transaction is the investment agreement, often referred to as the “note 30
purchase agreement.” Not only does the investment agreement serve as the detailed
record of the substantive understanding between the company and the various investors,
it also provides a means for the company to disclose all the business, financial and legal
information that may be relevant to the transaction. Although there is little disagreement
as to the general purpose of the investment agreement, the specific terms and conditions
of the agreement are usually subject to a good deal of negotiation.
The style and format of the investment agreement for a debt transaction will vary
depending upon the preferences and experiences of the investors and their counsel, as
well as the form of agreement that may have been used by the company in prior
financings. Other factors include the relationship of the investors to the corporation and
the corporation's stage of development. However, as a general rule, the content of the
typical investment agreement for a debt transaction includes a description of the
transaction, representations and warranties, closing conditions, notice procedures and
governing law/dispute resolution provisions and exhibits and schedules.
A description of the transaction will typically include an identification of the debt

securities that are to be issued to the investors; the manner of payment; and the date or
dates of closing. Specific provisions covering representations and warranties can be
broken out as follows: representations and warranties of the company, which will cover
the company's financial condition, capitalization, assets and liabilities, intellectual
property, business plan, authorization of the financing transaction, and various other
matters; representations and warranties of the founders and other principal shareholders
and key employees of the company, which may also be incorporated into the
representations given by the company; and representations and warranties of the
investors, most of which are directed at compliance with applicable federal and state
securities laws. The agreement will detail the closing conditions that must be satisfied in
order for the investors and the company to become obligated to perform their obligations
under the agreement. Finally, the investment agreement for a debt transaction will
typically include the same types of exhibits and schedules that normally accompany a
stock purchase agreement in an equity financing transaction, such as a schedule of
exceptions to the representations and warranties provided by the company; a schedule of
investors that sets out a list of the persons and entities that are participating in the
transaction, including the principal amount of the debt securities to be issued to each
investor; a copy of the document(s) (e.g., note or debenture) that will serve as evidence of
the company obligations to the investors; and copies of any ancillary agreements to be
entered into in connection with the transaction.
The legal effect of the investment agreement in a debt transaction is similar to that of
most commercial contracts. The company's failure to comply with any closing condition
will permit the investors to refuse to close the transaction. With respect to breaches that
occur after the transaction has been completed, the appropriate remedy depends upon the
circumstances. For example, if it is discovered that the company made a material
misrepresentation, the investors might have the right to rescind the transaction. When

ongoing covenants are breached, the investors can usually seek specific performance and
injunctive relief, although in some cases the remedies (e.g., the ability of the investors to 31
elect a majority of the directors or an adjustment in the conversion price) are self-
executing. Of course, if the company defaults in its obligation to repay the principal
amount and any accrued interest, the investors will have the rights of a creditor as
provided by law, as well as specific remedies included in any security agreement.
§16 --Ancillary agreements and documents
It is the rare occasion that the investment agreement is the only document required in
order to consummate the debt transaction. In most cases, there are a number of other
ancillary agreements which form an integral part of the transaction and which will be
negotiated separately to complete all the documentation for the transaction. Among the
documents that may be required are the following:
Promissory notes and security agreements. The most important ancillary documents in
any debt financing transaction are the promissory note evidencing the indebtedness, as
well as any security agreement covering the collateral provided by the company to
provide comfort to the investors that their loans will be repaid. Common examples of
these documents include a subordinated and secured promissory note; a secured and
guaranteed note; a promissory note and security agreement; and a deed of trust, mortgage
and security agreement.
Secured debt instruments will require the use of some form of separate security
agreements between the issuer and the investors which will provide, among other things,
for the various rights and obligations of the parties in respect of the assets or properties
pledged as security in the event there is a default under the terms of the underlying
obligation. When a security agreement is used, the parties must also prepare and execute
a financing statement that includes UCC-1 forms which can be properly recorded with
the designated governmental authorities to provide notice to all other potential company
creditors of the security interest of the investors.
Subordination agreements. Subordination agreements are generally required from each

of the investors in a debt financing transaction in situations where the company has loans
outstanding from a commercial lending institution. In cases where there is no existing
commercial debt, investors may be asked to agree in advance that they will subordinate
their position as a creditor of the company in order to allow the company to obtain
working capital from a commercial lender. Absent such an agreement, the consent of
each of the investors will be required in the event that a commercial lender requires
subordination agreements in the future.
Guaranty agreements. Some investors may require guarantees from individual or

corporate shareholders of the company. The guarantees would take effect in situations
where the corporation was unable to perform its obligations under the terms of the note.
Institutional investors generally require guarantees from corporate parents of the actual
issuer of the debt securities and the form of guaranty can often be quite extensive,

including a wide range of representations and covenants from the guarantor. A simpler
form of guaranty will be used when the loan is made as part of small bridge financing and 32
the guaranty is provided by an individual founder.
Indentures and deeds of trust. Debt instruments issued by large corporations with
securities traded in public markets are often issued under the terms of an indenture,
sometimes called a trust agreement or deed of trust. The most common example of the
use of an indenture is the issuance of real estate mortgage securities pursuant to a
mortgage trust indenture between the issuer (“mortgagor”) and a trustee or trustees
(“mortgagee(s)”), usually a bank or other financial institution. The trustee assumes
responsibility for the protection of the rights of mortgage bondholders, a group that is
often very numerous and widely dispersed. The indenture may be “closed-ended,” which
means that there is a limit as to the amount of bonds to be issued thereunder, or “open-
ended,” which means that there are no limitations on bond issuances. When the indenture
is open-ended, it will usually provide for authentication by the trustee of the initial issue
or issues merely upon the request of the issuer and for authentication of additional bonds
of later series, usually under supplemental indentures, on the basis of property additions,
retirement of prior liens, refunding of bonds outstanding under the indenture, or deposit
of additional cash equal to the principal amount of the bonds authenticated. Indentures
may also be used in connection with the issuance of debentures. As debentures do not
involve any liens, pledges, or mortgages, the debenture indenture has no granting clause,
and there is also no problem with respect to equal and ratable security for a series of
issues. As such, debenture indentures usually will be “closed-end,” and there will be
separate indentures for each issue of the debentures. Although debentures lack the
protection afforded through the use of collateral and security, debenture holders generally
will be the beneficiaries of various agreements and covenants set out in the indenture.
Consents and waivers. Consents or approvals from various parties, including the
directors and shareholders of the company, are generally required prior to the issuance of
equity securities. In all cases, the issuance of debt securities should be formally approved
by the directors of the company through resolutions that set out a general description of
the terms of the securities. While the offering of debt securities may not technically
require consents from shareholders, unless the offering also involves equity securities that
might be issued upon conversion of the debt securities or exercise of related warrants, it
is typically the case that consents will need to be obtained from existing lenders. Lender
consents should not be dismissed or taken lightly. While lenders are generally pleased to
see an infusion of permanent equity capital, absent redemption provisions that might
impair the ability of lenders to have their debt serviced in a timely fashion, banks and
other financial institutions will closely scrutinize debt offerings. The company should be
prepared to demonstrate that it will be able to continue timely payments on the loan
outstanding to commercial lenders. In addition, most commercial lenders will require that
payments on debt securities issued to investors be subordinated to the rights of the
commercial lender, particularly while the company is in default with respect to its
payment obligations under the loan agreement with the bank.

Legal opinions and closing certificates. Investors in a debt financing transaction will
typically require a legal opinion from company counsel covering most of the same issues 33
that arise in connection with an offering of equity securities. In addition, debt financings
raise a few special issues that will need to be considered when crafting the opinion,
including compliance with existing contracts and agreements; and the enforceability of
the debt instruments under relevant creditors' rights and secured transactions laws.
Investors will also request a wide range of closing certificates prepared and executed by
officers of the company. While the standard certifications will cover most, if not all, the
issues of concern to equity investors, counsel of the investors may request specific
confirmation that the company has complied with all financial and business covenants in
existing agreements that the company may have with commercial lenders.
§17 --Post-closing activities
Once the debt financing transaction is completed, the company and the investors must
observe post-closing rituals. Most of the same issues that arise in connection with the
offering of equity securities will apply following a debt financing, including the need to
maintain various records and monitor the financial performance and condition of the
company. In addition, since debt instruments generally provide for ongoing obligations
to make partial payments to the investors, as well as a comprehensive set of affirmative
and negative covenants, special attention will need to be paid to compliance with the
restrictions imposed on the company. In many cases, the company will be required to
provide investors with regular reports that cross-reference each of the agreed covenants
and list any compliance issues that may require waivers from the investors.
Depending on the circumstances, the company and its counsel may need to generate other
forms and documents during the period that the debt securities are outstanding. For
example, if the securities are redeemable, a notice of redemption should be prepared
when the company is prepared to call the outstanding bonds or debentures. In addition, if
the company has issued coupon securities, it may be necessary to prepare an indemnity
bond in the event a couple is lost or destroyed. Some investors will also require that the
company prepare and execute an officers' certificate verifying the company's compliance
with covenants and restrictions included in loan-related documents. Such a certificate
can also serve as the means for seeking and obtaining waivers from the investors in the
event that the company is not in compliance.
§18 Role of counsel
A key element in the development and maintenance of a successful relationship between

management and the members of the investment group is careful crafting of the legal
structure of the investment transaction. In general, any commitment to provide permanent
investment capital is, or should be, a long-term commitment to support a company. As
such, the businesspersons and attorneys involved in negotiating and implementing the
investment transaction must bring to the process the sensitivity to the changing and
different objectives and requirements of the business and its principal participants.

The legal documents must foresee the evolution of the enterprise over the period of time
that the investor is willing to remain involved with the company. In the case of a start-up 34
company, this means the difficult period during which development of technology and
products occur all the way through to the time that the company either “goes public” or
becomes a viable acquisition candidate. Not only do the investment documents represent
a charter of the legal rights of the parties spanning the growth cycle of the business, but
they also set the tone of the relationship between the manager and the investors, serving
as a guide for resolution of their differing interests. Despite the increasing
standardization of the investment process, it remains highly individualized, with each
transaction reflecting a particular chemistry between the managers and the investor. Each
set of documents should be tailored to reflect the unique combination of styles and
interests involved.
Counsel working with businesses on financing activities, often referred to as “company

counsel”, must be familiar with corporate, tax and securities laws. Company counsel may
be involved in assisting management in preparing the necessary disclosure documents for
review by potential investors and lenders, assisting in the negotiation of the terms of the
financing and in rendering the legal opinions required for the financing process to be
completed. Company counsel will need to provide substantive advice on securities
matters and the tax consequences of choosing a given form of financing instrument.
In addition, company counsel may provide assistance in the financing process with the
initial assessment of the client's business and determination of the available forms of
financing, including advice regarding the alternative methods of financing which might
be used and their advantages and disadvantages. In many cases, company counsel may
be able to put the client in contact with various sources of financing, including bankers,
other commercial lenders, venture capitalists and investment bankers, and may also be
called upon to assist in preparing and reviewing the client's business plan and any related
disclosure documents, including appropriate financial statement, cash-flow statements
and projections. In particular, counsel should be sure that the client is aware of the legal
consequences associated with making any statements to potential financiers.
Company counsel should advise the client regarding the proper method for conducting
the offering in order to be sure that the requirements of federal and state securities are not
violated. Company counsel should make sure that the client has followed all of the
necessary housekeeping procedures which means, at least in the case of a corporation,
that the minute books and corporate records have been maintained, that all of the
necessary qualifications and licenses are in place and that the charter documents permit
the corporation to issue the appropriate financing instrument. Company counsel should
assist the client during the negotiation process in understanding the meaning and effect of
all of the warranties, covenants and default provisions included in the documents, as well
as the adverse consequences of the obligations and restrictions which might be imposed
on the business. Finally, company counsel may be required to deliver one or more legal
opinions regarding the business and its owners as a condition to completing the financing.

As a general rule, investors will seek to minimize the time and expense of closing the
financing by insisting that counsel draft the legal documents, thereby ensuring that all of 35
the terms and conditions required by the investors have been included in the form
satisfactory to the investors. However, even in those cases where the documents are
drafted by the investors' counsel, the business representatives of the investor should read
and carefully review the initial draft, not only to ensure that the documents conform to
the agreement reached with the company, but also to allow the representatives to be able
to discuss provisions which might be troublesome or confusing to members of the
management team.
In some cases, company counsel may actually create the first draft of the investment
documentation. The important point is that either investors' counsel or company counsel
should be allocated primary drafting responsibility and the other counsel's role should be
limited to commenting on the efforts of the drafter. In those cases where the non-drafting
party has a strong preference for the use of specific provisions, it may be useful for that
party to send a copy of the provisions to the drafter for inclusion as part of the
documentation.
Once the initial drafts have been circulated, an effort must be made to keep the
transaction progressing toward a rapid closing, assuming that the investors have
completed their due diligence and are willing to make the investment in a timely fashion.
A schedule should be prepared which covers the drafting and revision of all of the
documents, satisfaction of applicable regulatory requirements, and circulation of the final
drafts for signatures by all of the investors.
Both the investors' representatives and members of the management team should guard
against any undue delays caused by differences between counsel for the investors and
counsel of the company, since delays not only tend to increase the expense of the
transaction, but also may adversely impact the relationship between the principals.
Among the most common problems areas are attempts by counsel to change or
renegotiate the basic business terms of the transaction without the consent of the
principals; disagreements on immaterial points of law; excessive rewriting of sections of
the investment documentation without modification of material legal or business
elements; time-consuming arguments regarding content and style of the investment
documentation; and delays in collecting comments from other lawyers in situations where
there are more than one or two investors.
A number of methods can be used to attempt to control the potential problems with
counsel. For example, the principals should instruct their counsel not to begin
negotiations with opposing counsel until they have discussed any potential points of
disagreement with their clients. In many cases, the principals will conclude that a
particular point is not materially significant to the transaction and that it makes no sense
to incur legal expenses in attempt to redraft the provision. Some investors will restrict the
amount of legal research that may be done on a specific issue, requiring counsel to obtain
approval from the client before research on a particular point of law. Also, time-
consuming arguments regarding the content and style of the documentation can be

avoided by having the principals present at the time of the discussions between counsels,
thereby ensuring that time will be spent only on matters that are material to each of the 36
parties.
References and Resources
The Sustainable Entrepreneurship Project’s Library of Resources for Sustainable Entrepreneurs relating to
Finance is available at https://seproject.org/finance/ and includes materials relating to the subject matters of
this Guide including various Project publications such as handbooks, guides, briefings, articles, checklists,
forms, forms, videos and audio works and other resources; management tools such as checklists and
questionnaires, forms and training materials; books; chapters or articles in books; articles in journals,
newspapers and magazines; theses and dissertations; papers; government and other public domain
publications; online articles and databases; blogs; websites; and webinars and podcasts. Changes to the
Library are made on a continuous basis and notifications of changes, as well as new versions of this Guide,
will be provided to readers that enter their names on the Project mailing list by following the procedures on
the Project’s website.
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Equity and Debt Securities

A Guide for Sustainable Entrepreneurs

SUSTAINABLE ENTREPRENEURSHIP PROJECT

Dr. Alan S. Gutterman

Electronic copy available at: https://ssrn.com/abstract=4256126

About the Project

The Sustainable Entrepreneurship Project (www.seproject.org) engages in and promotes

About the Author

Dr. Alan S. Gutterman is the Founding Director of the Sustainable Entrepreneurship

Electronic copy available at: https://ssrn.com/abstract=4256126

Electronic copy available at: https://ssrn.com/abstract=4256126

Equity and Debt Securities 1

A variety of outside investment sources may be tapped by a company depending on the

Management should investigate the financing strategies of other companies involved in

§2 Basic terms and concepts of corporate capital structure

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Convertible Securities. A versatile “hybrid” form of financing instrument is an equity

Convertible securities also have several advantages to issuers:

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Options. An “option” is just that; it is a right to purchase a security, usually common

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Warrants. A warrant is similar to an option in that it evidences a right granted by the

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Participation Rights. A security is said to be a “participating” instrument if it carries the

A number of variations exist in determining the percentage of any distribution on a junior

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cumulative preferred stock; nonvoting partially cumulative preferred stock; adjustable

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Affirmative and Negative Covenants. Various covenants may be established to protect 11

§5 --Negotiation and documentation process

• Locating and contacting prospective investors;

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The investment agreement will typically include a number of exhibits or appendices,

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Founders' and employee agreements. In many cases, there will be additional

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§9 --Nature of debt securities and debtholder’s interest

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§10 --Types of debt securities

Types of debt securities and offerings include:

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Equipment obligations. Equipment obligations involve the issuance of various types of

Debentures. The preferred position of the secured creditor or bondholders can be

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of the corporation evidenced by a debenture is backed solely by the overall financial

While, as defined, a debenture is broad enough to include an unsecured subordinated

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Commercial paper. Commercial paper is short-term (e.g., 90 days), large denomination

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§11 --General terms of debt instruments

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Subordination. Debt instruments are generally subordinated to bank and other

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A certificated registered security is considered to be a “negotiable instrument” under the

Registered securities provide a number of administrative advantages for the issuing