Every start-up founder should have a basic grasp of some of the ways they can secure financing for their company, so to that end let’s take a crash course on some familiar and some not-so-familiar ways to raise money. Shares are equity instruments. This means that in exchange for money, you trade away some ownership stake in the company. Shares can be extremely complex and highly variable bundles of rights. In some corporations, some of the shareholders are the sole decision-makers in the company, while others are passive investors “along for the ride”. Founders struggle to balance the need to attract as much equity investment as possible with the need to retain as much control as possible.
Common shares are a relatively simple and widely used form of equity security, especially in a corporation’s early growth stages. If only one class of common shares is issued, the interests of founders and investors are aligned with respect to voting rights, receiving dividends, and receiving a share of the remaining property upon liquidation of the corporation. Note that common shareholders are only entitled to the residual amount after preferred shareholders have received their share of dividends or property following liquidation. Additional protections can be included in a shareholder agreement (such as seats on the board of directors). Accurate valuation of the shares may require advice from an experienced financial advisor.
Preferred shares are a relatively complex equity security which provide further protections for investors. The rights attached to these shares are entirely up for negotiation, and can be tailored to the investor’s needs. The key question is, ‘what exact preference is being given to these shares over other shares?’ Preferences can relate to payment of cumulative dividends, payment of the initial investment plus unpaid dividends, preferences on liquidation etc. These features protect early investors from more powerful investors in future rounds of equity financing but can also be unattractive to those future investors and deter them from investing.
Share purchases are typically negotiated using term sheets like this.
Convertible loans are used when parties wish to defer issuing shares until a later date (typically in under a year), but the corporation requires funding to “bridge” the time until they can obtain long-term financing in the next equity round. Upon the next equity round, or once the loan matures, the investor will have the right to convert the loan into an equity stake in the company. It is especially beneficial for companies which believe they can hit their growth targets and raise a next equity round at a higher valuation. Before the loan is converted into equity, the investor does not have any shareholder rights. As a lender, the investor can seek a security interest in the assets of the company, which may require negotiating with existing lenders. It is essential to include clear (and realistic) goals and milestones about the next round of equity financing in the convertible loan agreement. If this is what you’re looking for, check out this convertible loan term sheet.
The Simple Agreement for Future Equity (SAFE) functions like a convertible loan in one way, in that the investor pays cash and will have the right to obtain an equity stake in the company at some later date. However, it is not a debt instrument. There is no accrual of interest, which is good for the company. There is typically no maturity date either. The investor takes the risk that the conditions for obtaining equity might not met, which means that the investor might not obtain equity, and may not have the right to be repaid either. The trade off is that the investor hopes to get the shares at a bargain price, based on expectations for future growth. The SAFE can have just a valuation cap, or just a discount, or both at once. Before using a SAFE, tax advice should be obtained about the availability of tax credits. If a SAFE sounds like the right thing for you, check out this Canada-specific SAFE.
- Consult an experienced financial advisor to establish a realistic valuation of your corporation.
- Determine how much voting control you are willing to give up when planning an equity raise.
- Use a term sheet to organize and negotiate the basics of your financing deal, and review this term sheet with your advisors before committing to specific terms.
Author: Sahil Kanaya