Canada: Investing In The Tech Start-Up Industry: Convertible Debentures Versus Direct Equity Investments

Global tech start-ups had one of their biggest deal-making years in 2014. In Canada, "there are currently 10 times as many start-ups and entrepreneurs as there used to be, and 10 times as many angel investors who are trying to create value".

Funding for tech start-ups is often staged in "financing rounds" requiring the company to meet performance milestones. Silicon Valley start-ups that raise $1.0 million on the first round are expected to raise close to $6.0 million the second round within two to three years. In Canada, financings of this size typically required an eight year commitment. But experts note that this is changing as U.S. venture capital firms get more exposure to the quality of Canada's start-ups. With a high premium on technology, the market opportunity is finally being matched by large investments. So how can you invest in a tech start-up?

Equity investment

A company may issue equity (either common or preferred stock) in exchange for financing. The share price is determined upon a pre-money valuation. An equity investment may be exemplified as the following:

  • The start-up has a pre-money valuation of $100,000 with 100,000 shares outstanding (with a share price of $1 per share).
  • An investor makes an investment of $10,000 and receives 10,000 shares.
  • The post-money valuation is $110,000 and the new investor owns 9% of the company.

Sophisticated investors typically insist on preferred stock for additional rights such as board seats and veto rights. Although an accurate agreed-upon valuation may be tricky in the direct equity investment model, sophisticated investors are likely to negotiate a more favourable valuation. However, depending on timing, equity investment may not be the preferred option. Founders may risk substantial dilution while angels can face tax consequences. However, tech start-ups should remember that investors have ancillary value as well; they may bring value in the forms of both business experience and expertise.

Convertible debentures

Experts in the field agree that the issuance of debentures for financing has never been more prolific. Debentures mix features of both equity and debt financing. They are simple, both cost and time efficient and do not require a valuation. It can sometimes be too early to put a value on a tech start-up's potential. Debentures allow investors to postpone valuation to later rounds of financing.

A debenture is essentially a loan (a debt obligation) that can be turned into equity. The principal of the debt plus all accrued interest under the debenture generally converts into equity upon the occurrence of future financing and offered to new investors at a price typically equal to the price of, and on the same terms and conditions as, the shares that are offered to the new investors. If the next round of financing does not close before the debenture's maturity date, the debenture must be repaid. An investment by way of a debenture may be exemplified as the following:

  • An angel investor invests $100,000 in a start-up pursuant to a convertible debenture.
  • The terms of the debenture allow for an automatic conversion after a qualified financing of $1,000,000.
  • When the next round of funding occurs at $1,000,000, the investor's debenture will automatically convert to equity.
  • With a share price of $1 per share, the initial investor can use the $100,000 investment to purchase 100,000 shares.

Depending on their terms and conditions, debentures can be advantageous to founders. They may allow founders to defer the value of the company by increasing the company's valuation beyond the amount of the debenture financing thereby possibly reducing dilution in ownership.

Every tech start-up will require a different financing structure. Factors such as cost, valuation and control are highly negotiable terms. However, whether you are an angel or founder, maintaining focus on the company's growth and entrance into the booming tech start-up market is a step forward in helping you land the next big thing.

The author would like to thank Carole Gilbert, articling student, for her assistance preparing this legal update.

Norton Rose Fulbright Canada LLP

Norton Rose Fulbright is a global legal practice. We provide the world's pre-eminent corporations and financial institutions with a full business law service. We have more than 3800 lawyers based in over 50 cities across Europe, the United States, Canada, Latin America, Asia, Australia, Africa, the Middle East and Central Asia.

Recognized for our industry focus, we are strong across all the key industry sectors: financial institutions; energy; infrastructure, mining and commodities; transport; technology and innovation; and life sciences and healthcare.

Wherever we are, we operate in accordance with our global business principles of quality, unity and integrity. We aim to provide the highest possible standard of legal service in each of our offices and to maintain that level of quality at every point of contact.

Norton Rose Fulbright LLP, Norton Rose Fulbright Australia, Norton Rose Fulbright Canada LLP, Norton Rose Fulbright South Africa (incorporated as Deneys Reitz Inc) and Fulbright & Jaworski LLP, each of which is a separate legal entity, are members ('the Norton Rose Fulbright members') of Norton Rose Fulbright Verein, a Swiss Verein. Norton Rose Fulbright Verein helps coordinate the activities of the Norton Rose Fulbright members but does not itself provide legal services to clients.

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.

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