Canada: Tips For Startups – Understanding Debt vs. Equity Investments

Bootstrapping your startup is a great way to preserve founder value by building your business through your own time and expertise. The theory is that in time, the value that you create using your own blood, sweat and tears will multiply. However, not all businesses have the same needs at the same time, and eventually most need cash. Even if you are able to bootstrap your way to profitability, there may still come a point at which you need an infusion of cash in order to expand your business.

Aside from crowdfunding campaigns or other sorts of pre-sales, this cash infusion will most commonly involve seeking investors. Whenever this happens, it is important to understand the different options available to you for investor financing, and the pros and cons associated with each. Investor financing may come as either debt (where the company has specific obligations to repay the funds to the investor) or equity (where the investor becomes a shareholder of the company). And then there is convertible debt, where the company has specific repayment obligations, but the investor is able to convert the debt into equity at some time in the future.

Confused yet? Don't worry, it all makes more sense in practice.

True Debt

True debt is exactly what you think of as debt: one party lends money to the other, and the party borrowing has an obligation to repay the money to the lender. The debt will usually have some sort of interest, as well as terms around when and how it is to be repaid. Debt may be secured against assets, or in some cases guaranteed by a third party, such as a founder, when a startup without much in the way of assets is the borrower. Debt may also be unsecured, often in exchange for a higher interest rate due to the increased risk associated with default.

Generally, secured debt is considered to attract the least amount of risk for the lender, as it has an easily calculable return, and in the event the startup fails to perform, the debt is secured against assets. Lenders will also have priority on liquidation over shareholders, as debt precedes equity. However, if the startup is a homerun, a lender generally won't participate in the upside to the same degree as an equity investor may, as an equity investment will track increases in value of the company.

Convertible Debt

Convertible debt is a hybrid of debt and equity. Often issued as a "convertible note", convertible debt has the same attributes and options as true debt referenced above, but it also has a mechanism allowing the lender to convert the loan into an investment and participate in the potential upside. The conversion occurs at some future point, either at the investor's option, or upon a triggering event, such as an equity offering. At this point the debt is converted into equity shares.

Convertible debt has become a very popular vehicle at the seed stage for a number of reasons. In early stage startups, it is a great way to raise funds without having to decide on an exact valuation, or negotiate complicated share rights. This can be handy for founders wishing to avoid undervaluing the business based on the early stage of development. It also helps to avoid the need to engage in heavy negotiations when initial investors may be friends and family, which many founders are understandably reluctant to do. Angel investors often like this sort of investment as well, as they are often investing in an idea without proven revenues, which makes valuation difficult. Having a debt that is convertible upon an equity offering means the angel investor will get the benefit of a later investor's negotiation (such as an institutional or venture capital investor), after the founders have used the angel investment funds to grow the company. Even for later stage companies, a convertible note can work well as a "bridge loan" when a little bit of money is needed in advance of an equity offering intended to follow shortly.

The mechanics of conversion can vary as well. Some convertible notes will offer a discount on conversion. For example debt which is converting with a 20% discount means that a share offered for $1.00 will be converted for forgiveness of $0.80 of debt. This is intended to give the lender a bit of a bump in exchange for their early investment.

Another term beneficial to investors is a valuation cap, which provides a maximum pre-money value of the company at which the debt will be converted. What this means is that the company is agreeing to a minimum percentage of shares that the lender will be entitled to on conversion. For example, if there is $500k in convertible debt with a valuation cap of $5M, the lender will be entitled to a minimum of 10% of the shares. If the share offering in which the debt is set to convert provides a pre-money valuation of $10M, the lender would still be entitled to receive 10%, or $1M worth of shares, for conversion of their $500k in convertible debt.

Convertible notes will generally also have a maturity date, being the date on which the debt is due, and providing a drop-dead-date for conversion through an equity offering. If you are considering convertible debt, be careful to consider how each of the interest, discount, valuation cap and maturity date interact. Each is meant as a benefit to the investor, and can vary depending on the expected term of the debt, and the company's need for funds.

Convertible debt allows a company to receive a cash injection quickly and easily, without taking an immediate dilution while the company or idea is still only partially formed.

Equity

Equity comes in different forms, but the common theme in equity is that it represents an ownership stake. Although equity provides less certainty over repayment, it does offer a greater potential to participate in the upside in a profitable company, or in a future exit.

Preferred Shares

Preferred shares are the favoured form of equity for most sophisticated investors, whether venture capital firms, other institutional investors, or just those savvy in the modern realm of investment. Preferred shares are the most common form of security sold in a private company financing, particularly anything labeled as a 'Series' round of investment.

Because they represent an equity stake, preferred shares are riskier than debt (shareholder's rights to participate in any upside generally come after other business obligations such as repayment of debt), but can contain a number of different rights and preferences beneficial to the preferred shareholder over other shareholders. These rights can include preferential treatment on dividends, or additional payments on an exit or liquidation event of the company, approval rights over certain key business decisions, a seat on the board, and other business terms that investors may request. Preferred shares often also have the ability to convert into common shares in certain events, such as if the company decides to list on a public exchange (the fabled IPO).

Preferred shares are generally reserved for significant investments, as their terms tend to be relatively complicated, often quite specific to the investor leading the investment round, and heavily negotiated. It takes a significant investment of both time and money, so is only justified if the incoming investment is large enough. This is one of the reasons why early stage investors may gravitate towards convertible debt: the size of the company may not yet warrant an investment that would justify the cost of a full equity financing.

Stock options or warrants

Stock options and warrants are both securities that provide the holder with the right to buy shares at a later fixed date, or upon the occurrence of certain events, at a price that is either pre-determined, or based on a pre-agreed formula. While a company generally won't raise money simply by selling options or warrants, each can be used as an "equity kicker" to sweeten other deals, or otherwise act as incentives.

In the case of an investment, a warrant can be used to provide upside potential to a lender. Or it can be granted to an investor that is willing to put in some funds now, but needs some potential for more upside to make the entire investment more attractive.

In the case of a founder or other key employee, options can also be used to provide an incentive to continue to contribute to the company with the promise of future upside. Because options can come with all sorts of terms around vesting (when and how they may be exercised and what may trigger expiration/cancellation) and other conditions, they're less risky for the company than simply handing out shares.

Common shares

Common shares are the most basic unit of equity in a company, and generally the foundation upon which all other convertible securities are ultimately based. Common shares can also have various rights and privileges attached to them, such as voting and participation in profits, but they tend to rank behind other securities in terms of priority. For example, a common shareholder's right to participate would come after debt-holders and preferred shareholders. Founders contributing a great deal of sweat equity generally hold common shares, which are sometimes made subject to reverse vesting agreements. These reverse vesting agreements allow the company to repurchase the shares at some set price or calculation, if the founder leaves the company early. This is done in order to protect the remaining founders from carrying the dead weight of a non-contributing founder.

Common shares are generally also held by employees that are granted shares (or options) as part of their compensation. Some companies split their common shares into voting and non-voting varieties in order to keep participation and control separate, while others leave these concepts lumped together and deal with control by carefully considering the number of shares issued. Friends, family and angel investors often come in at the common share level as well, in order to be treated the same as founders; however, later stage investors will generally look for something more than common shares.

While selling common shares is generally a less expensive proposition than preferred shares, as the common shares come pre-packaged, there may still be other costs associated with a shareholders' agreement or other business agreements that coincide with the purchase of shares.

***

If you are looking to raise funds, there is no one-size-fits-all answer as to which structure is right for you, or for your investor. The key is to consider the various options and seek to balance the specific needs of the company with the risks and rewards available to the investor.

Whichever business relationship you and your investor ultimately decide upon, there will be important corporate structuring, tax and securities law issues to deal with, so make sure to seek legal advice early so that you understand the implications of any course of action.

The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.

© McMillan LLP 2016

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Michael E. Reid
Brandon Deans, Temporary Articled Student
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions