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Raising money to get a new business off the ground has proven to be one of the most challenging obstacles an entrepreneur must overcome. Generally, initial capital is contributed from an entrepreneur's own resources or family and friends. However, additional funding is often required to help operate and develop the business. Further, a startup company's financing needs will inevitably changeas its business matures, as will the startup's ability to attract and secure investors and lenders to fund its business. Thus, a startup company should explore the various financing options and capital raising considerations discussed below at various stages in its life-cycle.
The following is a high-level summary of the material covered in Chapter 3 Capital Raising of a new book Startup Law 101: A Practical Guide edited by lawyer Catherine Lovrics. Chapter 3 of Startup Law 101: A Practical Guide was contributed by Wildeboer Dellelce LLP lawyers Rory Cattanach, Al Wiens, Davia Wang and Patricia Good. Startup Law 101: A Practical Guide was published by, and is available for purchase online from, LexisNexis Canada.
Understanding the Concepts of Debt and Equity
Startup companies typically have two main options to raise capital: debt or equity financing.
Debt financing allows startups to borrow money from a variety of lenders, including shareholders, financial institutions, funds and wealthy individuals. Raising capital through debt financing does not result in the lender retaining any ownership interest in the business. Rather, the business becomes obligated to repay the borrowed funds when the loan comes due. Additionally, the lender typically earns interest on the principal amount lent to the company, which may be payable at a range of rates. Since the ability to finance by incurring debt can be challenging for new businesses, stringent provisions in favour of the lender are often incorporated as terms of the loan to mitigate the risk of unsatisfied repayment obligations.
Conversely, equity generally refers to an ownership interest in a business or asset, which can also be understood as a financial claim to the capital of a business or asset. Through equity financing, a business raises capital by selling shares of the company to investors in exchange for money. The advantage of equity financing is that investors are not entitled to have their investment repaid. Instead, shareholders acquire an ownership interest in the business and may realize a return on their investment upon selling their shares. Shareholders can also profit in the success of the business if and when management declares and distributes dividends.
A private company may only issue equity by selling its shares to purchasers that meet specific criteria to qualify as a private transaction, as discussed further below. However, a company may wish to raise greater amounts of capital by selling its shares more broadly to the public. A company that sells its shares to the public and becomes a public company will consequently be exposed to disclosure obligations owed to its public investors under the reporting provisions of the Ontario Securities Act (the "OSA").
Businesses may also utilize hybrid instruments that have elements of both debt and equity financing to raise capital. For example, in addition to common shares, corporations can issue preferred shares that offer preferential treatment to its holders. Preferred shareholders often have a first right to any dividends and a priority claim to residual assets upon dissolution of the business over holders of common shares. However, similar to debtholders, preferred shareholders typically do not have voting rights. Alternatively, some entrepreneurs seek a middle ground between equity and debt financing through convertible debt. This is simply a debt obligation that can be turned into equity at a future time.
Issuing Equity Securities to the Public
Any trade in securities that would constitute a distribution is governed by the OSA, which requires the issuer of a security to either file a disclosure document (referred to as a prospectus) with its applicable securities regulator or have an exemption from the prospectus requirement that it can rely on. A prospectus is a legal document which involves disclosure of extensive information regarding, among other items, the issuer, its business and the particular securities for sale under the prospectus. A prospectus is required to contain full, true and plain disclosure of all material facts with respect to the issuer in order for potential investors to be able to make a reasonably informed investment decision.
An initial public offering ("IPO") is the process by which a private company offers its securities to the public for the first time resulting in it becoming a public company. Going public can increase a company's access to capital and provide for improved liquidity as the business becomes increasingly more marketable. In an IPO, the regulator's receipt for approval of the prospectus is also indicative of the company becoming a "reporting issuer." However, the process of going public and the reporting obligations and regulatory requirements associated with operating as a public company can be challenging, time-consuming, expensive and requires a capable team of experts including management, lawyers, underwriters and auditors.
Each time a reporting issuer intends to issue shares to the public, a prospectus must be filed; however, there are certain exemptions from such prospectus requirements. Given that the prospectus regime can be costly and time-consuming for small and mid-size issuers, the exemptions are especially useful in allowing these businesses to participate in the distribution of securities without filing an onerous disclosure document. Among the various prospectus exemptions, the private issuer exemption and the family, friends and business associates exemption are particularly attractive to startups and small issuers. Additionally, the crowdfunding exemption that came into effect in Ontario in January 2016 is designed to allow Canadian companies, in particular startups and small and mid-size issuers, to raise capital online via a registered funding portal.
Liquidity Events: Selling and Amalgamating
In addition to an IPO, two other types of liquidity events include selling a business or amalgamating with another business.
Selling a business allows shareholders of a private company to monetize the value created and retained in the company. There are many factors to consider when selling a business including the structure of the transaction. A share sale involves the acquisition of all of the issued and outstanding shares of a company resulting in the purchaser assuming all assets and liabilities of the business. Alternatively, an asset sale allows the purchaser to select the specific assets that it wishes to purchase and liabilities it will assume, effectively excluding unwanted assets and liabilities. Thus, purchasers generally favour an asset sale, whereas vendors tend to prefer a share sale. Additional factors to consider in selling a business include the tax treatment of the parties, confidentiality and dealing with the exchange of sensitive information, third party and regulatory consent requirements to a change of control, structure of the purchase price and earn-out arrangements, non-competition restrictions and compliance with applicable legislation.
An amalgamation is the combination of two or more corporations to form a single corporation. From a legal perspective, the amalgamated corporation is a continuation of the amalgamating corporations. The amalgamated corporation retains the rights and obligations of each of its predecessor corporations; the assets and liabilities of each predecessor corporation flow through to the amalgamated corporation. Canadian corporate statutes provide for different types of amalgamations and there are numerous requirements to be considered. Generally speaking, the shareholders of the predecessor corporations become the shareholders of the amalgamated corporation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
