This is the 3rd of a business startup series. See the first installment of this series: Incorporating your business: Record books and why using a lawyer makes sense and the second instalment: You’ve Just Incorporated Your Business – so now what?
Please note, the following general information applies only to businesses located in the Province of British Columbia, as legal requirements in other jurisdictions may vary.
In previous articles, I explored the recommended ways to structure and organize your startup. However, as a startup, you still might be wondering about different options to help raise funds to launch your exciting new product, app or service. This article helps identify a few different ways you can consider and a few key pointers that startups may not realize in their growth phase.
Using Your Own Funds
Typically, you and your partner(s) may need to put up your own funds to get your startup formed and the ball rolling. At the time of incorporation, most accountants will suggest setting a nominal value for the shares that each founder subscribes for, since a brand new company has no inherent value to start. So, if your company needs more funds to take care of immediate expenses, rather than subscribing for additional shares, you can account for those funds as a shareholder loan.
The benefit of allocating funds given to a company as a shareholder loan is that when the company makes enough money to pay back such loans, it gets repaid without any tax consequence to the shareholder (in other words, the repayment of the shareholder loan is not treated as income to that shareholder). If the repayment instead occurs via declaring a dividend, the shareholder would need to report such dividend income in their personal tax return and pay the applicable tax on such amount.
Sometimes, especially if the company is expected to hold onto the cash for more than a year, it may be appropriate for the company to pay interest on the shareholders’ loans, which is often appropriately evidenced by a promissory note being issued by the company in favour of the shareholder.
One important consideration often overlooked by startups is that given unsecured creditors, including shareholders, are all treated the same at the time of a bankruptcy or insolvency event, it may be prudent for the company to grant security to the shareholder for its loan and register a general security agreement in favour of the shareholder. This ensures that if the company fails, at least the repayment of the shareholder loan can be treated in priority to other unsecured creditors. Otherwise, Canadian bankruptcy legislation generally prohibits a company from prioritizing certain unsecured creditors over other unsecured creditors, which means shareholders cannot get paid back in priority to other debts. However, if the company obtains bank financing or other type of arm’s length financing in future, financial institutions may require the shareholder to subordinate any such security to their own interest.
Friends and Family
If investing your own funds into your startup is not enough to achieve your dreams, the next place you may turn to is a friend or family member. This may be by way of issuing debt or equity.
In cases of debt, the friend or family member may be comfortable providing the startup with an unsecured or secured loan, with or without interest, and payable on demand or periodic payments over time. Before accepting any cash, it is prudent to advise the friend or family member to obtain their own independent legal advice, as often relationships can be destroyed or severely strained if things do not go according to plan. From a complex loan agreement to a convertible promissory note, there exists a number of different options to evidence the loan, and choosing the one that fits the transaction would depend on the comfort level, sophistication, and savviness of the lender and the needs and requirements of the company borrowing the funds.
When it comes to issuing equity, this is where special attention needs to be provided to applicable securities legislation.
In British Columbia, the general legal proposition is that you cannot issue shares in a private company unless you qualify for one or more prospectus exemptions as outlined in National Instrument 45-106 (“NI 45-106”). Typically, most companies would qualify as a ‘private issuer’ and thereby rely on one or more private issuer exemptions listed in Section 2.4(2) of NI 45-106. The caveat for startups is that ‘family member’ and ‘friend’ are not colloquial terms in the context of securities legislation, and therefore you will need appropriate legal advice to ensure that the people you are issuing shares to are in fact individuals that qualify under an appropriate exemption. We recommend consulting the BCSC’s Private & Early Stage Businesses page to learn more about the general compliance requirements.
Accredited Investors/Private Equity
Startups often like the idea of pitching to third-party investors who may already have significant expertise, resources and networks to help grow their business. While the process is often extremely competitive, it is incumbent on the company to ensure applicable securities requirements are met, as described previously. Categories of prospectus filing exemptions exist for accredited investors and others, and usually such investors would dictate the terms and form of investment in a term sheet provided to the company for review by their legal counsel. It is important to review the term sheet carefully as this often forms the basis of the relationship, and any confusion may cause long-term damage to the company especially if the company is more successful than was originally anticipated.
Other Key Tips for Startups
Here are some other helpful tips when considering raising capital as a startup:
- When raising capital, I often recommend to startups that less is better. The smaller number of shareholders you have to deal with, the easier it becomes with the management and controlling costs of the startup. From signing annual consent resolutions to waive the auditor requirements to holding annual general meetings and dealing with potential disputes, the logistics of dealing with a large number of investors, especially if they invested small amounts, can be daunting.
- Of course, having a robust and clear shareholders’ agreement in place is strongly recommended in all cases where more than one shareholder is involved.
- Companies need to be mindful of not stepping outside of the ‘private issuer’ exemption under NI 45-106 by having too many shareholders as it may affect their ongoing compliance and disclosure requirements.
- It greatly reduces the costs of resolving potential issues when founders ensure to get appropriate legal advice before they embark or commit to one or more ways of raising capital.
- Some large banks have dedicated teams that work with startups in the tech space. While startups may think getting bank financing at an early stage may be an insurmountable task, these banks may have a way to help startups help finance their vision cost-effectively, while ensuring their equity remains untouched.
- As discussed in previous articles, raising capital requires a good company share structure and organization of corporate records. If you didn’t go through a lawyer when setting up your company, ensure those corporate records get reviewed and rectified prior to issuing any shares in your company.
- When issuing shares to an investor, consider whether they are voting, non-voting or a preferred class of shares. Each may have unique attributes as defined in the Articles of the company, and investors may have different requirements. Typically, voting shares hold the value of the company, so issuing non-voting shares to a shareholder may come with little to no benefit to the investor. Potential investors should always seek appropriate legal, accounting and financial advice prior to making any investment in a startup.
Conclusion
While this article doesn’t attempt to deal with all the possible ways for startups to seek investment, it aims to provide some general guidance on what founders may want to consider when deciding the best approach to take in launching their product, service or app. Sometimes companies may think the best approach is to only offer shares, when issuing a form of debt is often overlooked.
In the final article in the startup series, we’ll look at some exit strategies, including share and asset purchase agreements.