One of the most important parts of a company’s life cycle is its first equity financing. Startups have numerous options for how and when they decide to take this momentous step, with different strategies offering different advantages and potential pitfalls. Navigating these options is critical to the success or failure of an initial equity financing and can determine the future of the startup. We asked business lawyers Daniel Zuniga and John Norman of Cassels to walk us through the ins and outs of early stage funding and detail the pros and cons of every scenario a startup founder can face during this crucial time.
Considerations for Startups When Contemplating their First Equity Financing
Among the various milestones that a start-up achieves, completing an equity financing, such as a Series A round, is one that many founders look forward to most. It is the company’s first real injection of capital and conveys a certain degree of legitimacy to their business. Things begin to feel a lot more “real” and suddenly the sleepless nights, instant noodles, and eighty-hour work weeks all feel worth it. For these and other reasons, founders may be tempted to jump at the first opportunity they have to onboard an investor. It is important for founders to recognize, however, that completing an equity financing will have fundamental ramifications on their business and will impact the remainder of the company’s life cycle.
Completing an equity financing too early may necessitate or result in a premature valuation of the company. Obviously, the higher the valuation the better, as it both minimizes the dilutive effect of the financing on the founding team and sets a benchmark for the pricing of future equity rounds and any future acquisitions. It is often best to delay setting a valuation through the use of financing alternatives.
Traditional Sources of Funding:
In an attempt to stimulate business activity, government agencies offer funding in the form of grants and subsidies to small businesses. Grants are usually either entirely or partially non-repayable and can bridge a company financially while the company prepares for a larger financing. For ease of accessibility, the Government of Canada has created a “Business Benefits Finder” tool, which connects small businesses with the appropriate grants and subsidies for their business needs. Non-dilutive financing results in funding to the company without the issuance of additional equity. This not only does not dilute the founders’ equity, but it also shows future investors that the company is able to source “free” money to stimulate its growth without diluting existing shareholders.
The company should evaluate whether traditional debt financing through a financial institution would adequately address their funding needs. Financial institutions require a track record of success, and for early stage start-ups, often collateral to secure funds. For companies without significant assets, this collateral may need to be in the form of a personal guarantee of the founders.
Convertible debt financings allow the company to raise money without issuing any equity immediately to investors. Instead of equity, the investors are issued convertible promissory notes or debentures that convert into equity upon the company completing a qualifying equity financing. The investors in the convertible debt financing are treated as early investors in the qualifying equity financing, and the principal amount of their “loans” and any accumulated interest converts into the same equity being offered under the qualifying equity financing. Two common features to attract investment by way of convertible debt are:
- a valuation cap which establishes a maximum valuation that may be used when determining the price per share at which the convertible debt can be converted; and
- a pre-determined discount (as a percentage) from the price per share in the qualifying equity financing.
Depending on the respective negotiating positions of the investor(s) and the company, convertible debt can be secured or unsecured and accrue an agreed upon rate of interest for the duration of its term or until converted.
Simple Agreements for Future Equity (SAFEs)
SAFEs are generally considered a more “company friendly” alternative to convertible debt. SAFEs were initially introduced in 2013 to provide a cost-effective source of financing for early stage start-ups. As the name suggests, these are simple agreements between investors and the company for future equity. The agreements are generally standardized, resulting in lower transaction costs for the company. Upon signing the SAFE, the company immediately receives the investor’s funds, but the investor does not receive equity until the occurrence of a qualifying equity financing.
While negotiations can vary, there are generally four variables to consider when negotiating a SAFE:
- the valuation cap which sets a maximum valuation at the time of issuing the SAFE to determine the price per share of the conversion;
- a pre-determined discount (as a percentage) from the price per share in the qualifying equity financing;
- a “Most Favoured Nation” clause which, if applicable, will automatically incorporate into the SAFE any provided to other investors in subsequent financings that are more favourable than those contained in the SAFE; and
- pro rata rights entitling the investor to maintain their proportionate ownership of the company.
If the company elects to undertake a SAFE financing, they must choose to use a pre-money SAFE or a post-money SAFE. There are a few differences to consider between these instruments, the most important of which being that post-money SAFE incorporates the shares to be issued pursuant to the SAFE financing in the conversion formula of the SAFEs. This leads to additional certainty for both the SAFE investor and the company as to the amount of equity to be issued by the company in respect of each investment.
When preparing for an equity financing, founders should take an objective look at their company from the perspective of a potential investor. There are a number of characteristics about a company that may discourage investment or shift negotiation leverage towards the investor.
Investors want their risk to be aligned, as much as possible, with that of the founders and the key management team. Therefore, they will generally want to see founder compensation structures that are heavily weighted toward equity in the company, with modest cash salaries. Investors will want the management team to be highly incentivized to increase the value of the company, and in the process, the investor’s shares.
A clean organizational structure and strong corporate governance documents can be indicators to an investor of the management team’s business acumen and ability to lead a company. Further, the company should have agreements in place to, among other things, force the sale of shares by any legacy founders, and thereby avoiding any “dead equity” on the company’s capitalization table. Without the proper agreements in place, a legacy founder could leave the company yet retain a large percentage of the shares of the company.
Negotiating the Financing
Once the founders exhaust the company’s alternative sources of financing and determine that they are ready to proceed with an equity financing, they need to decide what they are willing to sell to an investor.
A Seed or Series A round will normally involve the issuance by the company of Seed preferred shares or Series A preferred shares. As the name indicates, preferred shares entitle the holder to receive benefits that are in priority to holders of common shares. The extent of these benefits will turn on the negotiation strength of the parties.
For instance, preferred shares will have a priority of payment at the time of liquidation. Upon the occurrence of a liquidation event, which can often include the company being purchased at less than the value attributed to it during the preferred share financing, the preferred shareholder may have the option to either convert their preferred shares into common shares, or receive their liquidation preference payment, usually being equal to the amount of their original investment. If the liquidation preference payment is selected, this is to be paid out in priority to any other payments made to any of the common shareholders.
Investors in a Seed or Series A round may also negotiate for increased control over certain aspects of the company. Two common methods used to achieve this are: (i) board participation; and (ii) voting rights. Board participation can vary from simply having a representative of the investor “observe” board meetings and report back to the investor to having one or more board nominees elected as members of the board of directors of the company. Investors will also normally seek to be given certain approval rights, referred to as “protective provisions”, which would require a specified level of approval (e.g., “a majority of the preferred shareholders”) with respect to certain material actions by the company.
Founders should seek the appropriate professional advice (legal and otherwise) when considering whether to undertake an equity financing. When selecting an investor, the company is not only receiving funds, but also a long-term business partner. This makes it of the utmost importance to properly structure the financing and the company’s governance documents as they will serve as the foundation of the investor-company relationship going forward.
Daniel Zuniga is a partner in the Business Law Group at Cassels and serves as Co-Chair of the High Growth & Venture Capital Group. Daniel has extensive experience in advising both start-up and high growth companies, private equity and venture capital firms with respect to the formation, organization, financing, sale, and acquisition of start-up and high growth companies, particularly in the technology sector. This expertise includes the organization of companies to venture-backed standards, non-dilutive financings, angel and seed investments, Series A and other preferred share financings, and exit transactions.
John Norman is an associate in the Business Law Group at Cassels. His practice focuses on general corporate and commercial law, with particular expertise in advising high growth companies with formation, organization, financing, and mergers & acquisitions.