Fundraising in the time of Corona

Business interruptions caused by COVID-19 have damaged the balance sheets of many businesses.  Many have had to undertake emergency fundraising.  More than 20 equity raisings have been announced by S&P/ASX300 companies since February.  These include a $169 million raising by Southern Cross Media, $700 million by Flight Centre, and NAB’s 3 billion placement, the largest of the COVID-19 related raisings to date.

In the current uncertain environment, commentators identify emerging trends reminiscent of the global financial crisis.  First, the structural advantage innate to wholesale investors is amplified, as capital raising companies seek the low-doc, faster moving benefits that wholesale investors can offer.  Many offerings are discounted, and wholesale investors can move quickly to snap up perceived bargains.

Investors however still need to do the same scrutiny of companies in which they plan to invest.  In particular it is important to analyse why a company is fundraising – whether the company needs the funds for short-term survival, or is looking at longer-term growth.

From a company’s point of view, the type of finance raised will depend on several factors.  In particular, the phase of the company will dictate to an extent its needs: a start-up company would be advised to eschew debt finance if possible; whereas debt might be the best option for a mature company to operate through the period of interruption brought on by COVID-19.  The market conditions will also clearly affect the type of fundraising; and how and when lockdown restrictions are lifted will affect business operations for different sectors.

This paper looks at some of the characteristics of common fundraising structures and how the choice of structure is influenced by prevailing business conditions.  The types of fundraising considered are:

1. Equity Capital
2. Debt
3. Hybrids – Convertible Notes

Fundraising Regulatory Issues

Fundamentally, there are high regulatory overheads associated with any share issue.  Some of the important laws affecting how a body corporate may raise funds include:

1. Disclosure documents

Chapter 6D of the Corporations Act requires companies to issue a disclosure document before issuing securities.  A common example of a disclosure document is a prospectus.  However, chapter 6D also outlines several important exceptions to this requirement, for example, where the investor is a sophisticated or professional investor, or a senior manager of the company.  The exceptions are particularly important for smaller companies, which do not typically have the resources to produce a formal disclosure document.  In addition, a proprietary (pty) company is prohibited by law from fundraising in any setting in which a disclosure document is required.

2. Australian Financial Services Licence

It is important to ensure that companies that do not have an Australian Financial Services Licence (AFSL) do not engage in conduct requiring an AFSL, such as advising or dealing in relation to financial products.  Because the issue of securities in a body corporate will typically involve both these things, the law gives relief where a body corporate issues securities in itself and (in relation to any advice given) the following are satisfied:

1. the advice is general in nature and recorded in a document; and
2. the advice is given only to wholesale clients.

 

Hawking provisions

Securities issues must also comply with the hawking provisions in the Constitution Act.

Specifically, a person must not offer financial products for issue or sale in the course of, or because of, an unsolicited meeting or telephone call.  ASIC considers a meeting or telephone call to be unsolicited unless it takes place in response to a positive, clear and informed request from a consumer.  However, the prohibition does not apply where the relevant offer is made to sophisticated or professional investors.[1]

Equity Capital

Equity capital, or share issue, is the default way in which startup, early stage and many other businesses (including listed entities) raise capital.  Because shares are both securities and a financial product, the above rules will apply to any issue.  An ordinary share is an equity instrument, and so payments made to the investor in the form of dividends are not tax-deductible.  Also, because ordinary shares are structurally subordinated instruments, if the company becomes insolvent, it would be unusual for there to be any significant return (or, any return at all) to ordinary shareholders.

A variant of equity is preference shares.  A preference share is “preferred” in some way over other shares in the company, typically with respect to repayment of capital or dividends.  A preference share can often be converted into an ordinary share, and can also be redeemable i.e. repurchased by the company, usually by paying the purchase price plus unpaid accrued dividends.

Preference shares are often favoured by early stage businesses, because they give investors a quasi-debt-like interest in the company through cumulative dividends.  While a preference share will usually not be considered “common equity” under international accounting standards, for legal purposes a preference share is not regarded as debt.

Although, as discussed above, there are relatively onerous regulatory requirements for fundraising, recent relief to facilitate rapid fundraising, especially for listed companies, includes:

• A capacity uplift of new share placements to 25% (previously 15% of issued equity); [2]
• For ordinary shares, a waiver on the 1 to 1 cap on non-renounceable entitlement offers;
• Waivers allowing issuers to request 2 consecutive back-to-back trading halts (ie up to 4 trading days) to allow preparation for and implementation of capital raisings;
• Relief to companies that have experienced up to 10 days (previously 5 days) of suspension in the preceding 12 month period to enable low-doc placements, entitlement offers and share purchase plans, without requiring issue of a cleansing notice.

Some of the advantages to the company of raising equity compared to debt (which is discussed below) are:

1. the investor assumes all the investment risk;
2. the cash raised can be used for rapid growth and reinvestment; and
3. investors may potentially provide access to key business contacts.

However, equity also means that the founders must share ownership, control and profits of the business with investors, and the only way to regain control is to buy back the equity, which, in a profitable business, will usually in the long-term be costly.  In the current environment, however, the shorter-term advantages of equity fundraising are tempting to cash-strapped businesses, particularly for listed companies, given the recent regulatory changes.

Debt

The company borrows money from a third party – usually a private investor or a financial institution.  Often, the debt may be secured by the company granting security over its assets.  The defining characteristic of debt is that is must be repaid.

When a company takes on financial (or any) debt, insolvent trading rules become relevant i.e. the company must be able to pay its debts if and when they fall due.  If a company cannot pay, then it is insolvent.

Because many businesses are experiencing cash-flow interruptions due to COVID-19, the risk of insolvency is heightened for businesses who have taken on debt.  In response to this risk, temporary changes have softened the insolvency trading laws.  For example, the period of compliance for Statutory Demands and Bankruptcy Notices has been extended to six months.  In addition, directors are for the next six months relieved of their duty to ensure no insolvent trading by the company (although not for blatant breaches).  However such “softening” does not affect the fundamental risk of debt, but merely defers the time of payment, and these changes may lead to sleeper insolvent companies effectively trading while insolvent under the old rules, even though legally compliant under the new measures.

Debt is a higher risk strategy, especially for early stage businesses which are not yet profitable because debt can only be repaid from refinance, or from proceeds of share issues.  However, equity investors are usually loath to provide capital to repay debt; and, typically, companies with high debt will usually find it harder to attract equity.

The advantages of debt, compared to equity, are that the founders retain control and ownership of the company, and, once debt is repaid, there is no ongoing obligation.  For a company that is generating reasonable profits, debt is often the lowest cost option for the company to raise finances, because debt is generally tax-deductible, whereas equity is not tax-deductible, and there is no sharing of profits.

Hybrids – Convertible Notes

There are many types of ‘hybrid’ or ‘third way’ securities.  One of these is a convertible note.  Some characteristics of a convertible note are that:

1. it is a debt instrument i.e. the company borrows funds from the investor;
2. the investor can convert or exchange the note for shares in the company, customarily at a share price that is at a discount to market value. Market value is determined by agreement or by a third party valuation; and
3. payments made to the noteholder may be tax-deductible (because those payments are an expense of the business).

This is analogous in some ways to a preference share, however the key difference is that a convertible note is a debt instrument for legal purposes, and commonly must be repaid unless the investor elects to convert.  This means noteholders will typically have influence over the company which is disproportionate to the value of their notes.  For example, if a noteholder invested $100,000 in a $1 million startup company, that investor would on maturity be entitled to request loan (and interest) repayment; and could (despite only holding a 10% investment) force the company into winding up if it did not have cash funds available at that time.

Convertible notes are therefore attractive to investors because they put the investor in the preferred position of creditor, while allowing to convert to equity if the entity turns out to be high performing.

Commonly, notes can be issued with a defined conversion discount and/or a valuation cap.  In some cases both of these options are defined, and the investor is entitled to which ever gives the greater equity return.

For example, if notes are issued at a 20% conversion discount, then if the share value at the time of conversion is $5, then the noteholder pays $4 per share (80% of $5), and hence receives more shares for its $100,000 investment.  If the notes were issued with a valuation cap of $2 million, and the company is valued at the time of the conversion at $5 million, then the note holder receives equity based on the $2 million cap, rather than $5 million, (so the price per share would be 2/5 or 40% of $5), a significantly better return for the noteholder’s initial investment, but also resulting in a significantly greater dilution factor to existing shareholders’ equity.

This means:

• If the share value increases significantly by the time of the conversion, then the investor will generally derive more benefit more from a valuation cap than a discount rate. Conversely, if the share value has risen only slightly, then the greater benefit will generally be derived by applying the discount rate.
• The lower the valuation cap, the higher the investor’s potential equity return in a high performing company.

Conclusions

We are seeing some vigorous fundraising in these fraught times.  Despite the temptation to look at the short-term benefits, the longer term ramifications of the type of fundraising should be considered, including control and ownership, and liability to the investors.  As always, companies must remain compliant with the statute and regulations, and be aware of temporary changes and their potential consequences.  Legal advice as to the most appropriate type of fundraising and how to remain legally compliant is paramount.  Keypoint Law is presently advising clients undertaking all of the above fundraising structures.

 

[1] Corporations Act s736(2)(a) and (b).

[2] as long as the equity issue is accompanied by a pro-rata entitlement offer or a follow-on share purchase plan offer at a price equal to or less than the placement price.