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Funding your start-up: Stages and types of financing

financingStages of financing

There are a number of issues start-ups need to consider to be able to effectively raise capital. Focusing your efforts on developing your products or services and establishing strong and efficient leadership are essential in preparing your start-up for the increased scrutiny of prospective investors. In addition, entrepreneurs often overlook or fail to appreciate how important it is to structure initial rounds of financing with later rounds (and more sophisticated investors) in mind.

The typical first stage of financing is called the “seed financing”. This refers to the very first capital injection into your start-up and usually comes from you (as the founder of the start-up), your co-founders, and friends and family. The seed financing often occurs pre-revenue and is typically used for product development and market research. At this stage, your start-up will likely focus on developing projects intended to showcase the viability of your business venture to prospective investors.

The next stage of financing is sometimes referred to as the “series A financing”. Even after progress has been made in the development of your start-up’s products or services, and discussions have begun with potential customers and clients, expenditures will often exceed generated revenues. This is where funding from the series A financing will step in to fill the gap. A series A financing will typically involve accredited investors or venture capitalists, but may include strategic partners or government agencies, such as the Business Development Bank of Canada or, in the case of exporters, Export Development Canada.

Subsequent financings may be required if your start-up is unable to generate enough revenue internally to fund its operations. Each of these rounds of financing may be called the “series B financing”, “series C financing”, and so-on. As with the series A financing, each subsequent financing will typically involve accredited investors, venture capitalists and/or government agencies. Traditional lenders, such as banks, will be cautious of providing traditional loans until your start-up has a reliable revenue stream.

When your start-up has attained sustainable profitability, you may continue to seek investment through “expansion financings”. Additional capital from expansion financings is often used to expand your start-up’s business into new markets, new products or new services. This funding typically comes from venture capitalists, traditional lenders, strategic partners or even through a public offering of shares.

Types of financing

At a basic level, a company will raise capital by: (i) issuing equity securities, such as common or preferred shares; (ii) borrowing money or issuing debt; or (iii) issuing hybrid securities, such as debt that is convertible into equity. Generally speaking, equity grants ownership in the company and debt grants a contractual right to a return of funds, being the principal amount (the initial amount borrowed by the start-up) and interest on the principal amount.

1. Debt financing

Debt financing by banks and other traditional lenders

Debt financings with traditional lenders are typically completed by way of a secured or unsecured loan. For early stage start-ups, in most instances, the lender will require both: (i) security for the loan (which would often be a registered interest in all of the company’s assets as collateral); and (ii) guarantees from each of the shareholders. The form of security for the loan will depend on how the loan is payable. Loans may be payable on a specified maturity date, payable in installments or payable on demand. Loans intended to finance the cost of operating your start-up (often called “operating loans”) are typically payable on demand, whereas loans intended to finance the cost of expanding your business (often called “term loans”) are typically payable in installments.

Debt financing by shareholders and other individuals

Shareholders and other individuals may choose to provide loans to your start-up on terms and conditions similar to those described above. Banks and other traditional lenders will typically require that most, if not all, secured debts provided by shareholders or other individuals are subordinated in favour of the security held by such bank or other traditional lender. This means that the banks would be able to take possession of the collateral before the shareholders or other individuals. It is important to note that if capital is raised from venture capitalists or government funding agencies, such investors will likely require that their investment is not used to repay debt owed to shareholders or other individuals, but instead to develop and expand the business of the start-up.

2. Equity financing

Equity financings are completed by the sale of a company’s shares. The class of shares, and the attributes of those shares, will often be created as part of the financing and will be tailored to the specific requirements of the investors. An equity investment into a private, start-up company is a risky investment, because the securities being purchased have no guarantee of future liquidity or value. Therefore, such investments typically come from friends and family, accredited investors, venture capitalists or strategic partners.

When engaged in an equity financing or otherwise issuing securities, a start-up must comply with applicable securities laws. Non-compliance with these laws can have significant consequences.

3. Hybrid debt/equity financing

Hybrid financings typically involve debt instruments that are convertible into shares. Common examples of these are convertible loans, which may be in the form of convertible debentures or promissory notes that provide for the conversion of the principal and interest into shares if certain events occur. Some examples of conditions that would trigger a conversion from debt to equity are if an equity financing is completed with gross proceeds to the start-up being above an agreed amount or the completion of a sale of the start-up to a third party.

By Jeremy Busch-Howell, Associate and Nathan Montgomery, Associate, McCarthy Tétrault

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McCarthy Tétrault LLP

McCarthy Tétrault is a Canadian law firm that delivers integrated business law, litigation services, tax law, real property law, labour and employment law nationally and globally.McCarthy publishes a series of blogs to share information with companies to help them comply and manage their businesses. On the Inside Internal Controls blog we will share some of those blog posts sharing their expertise among others, in the areas of Competition/Anti-trust, Corporate and Commercial Law, Intellectual Property, Privacy, Environmental Law, Technology and Litigation. Read more
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