It costs thousands of dollars to put in place this firm foundation. Failure to do so properly can cost you millions of dollars in lost valuation in a financing and exit transaction. Jurisdiction of incorporation: most significant advantage of Federal (CBCA) incorporation is cross-Canada name coverage. Canadian incorporation is advantageous due to CCPC $750,000 capital gain exemption and access to government assistance (e.g., 35% SR&ED tax credits). Classes of shares: at time of incorporation, typical share structure is single class of common, voting shares without par value. Founder shares are often issued for nominal consideration. Board of directors: companies should bolster the independence and expertise of their board of directors and board of advisors in advance of seeking Angel and VC financing. It is more challenging today to attract directors due to heightened liabilities associated with being a director. Share Structure: If you only have one class of shares, then all shareholders must have the right to vote, the right to receive dividends and the right to share in the property of the company upon a wind-up of the business. If you want shareholders to have different rights, then you need multiple classes of shares (either more common or a class of preferred shares). Shareholders: The “ owners ” of the company. Vote to elect directors and make other fundamental decisions about the company. Right to receive dividends as and when declared by the directors. Directors: Charged with the management of the company. The law imposes a number of duties on directors: 1. act honestly, in good faith and in the best interests of the company. 2. act with the care, diligence and responsibility of a reasonably prudent person. Officers: Manage the day-to-day operations of the company (e.g., President, CEO, CFO, etc.)
The standard financing path of a tech company: founders Friends and family government grants (e.g., Telefilm; IRAP) SR&ED credits Angels Venture Capital Strategic partners Be mindful of “ hooks ” associated with government grants, such as need to maintain IP in Canada.
1. Equity: Raising money through the sale of shares or other securities. Existing shareholders' share ownership is diluted through the issuance of new shares to the investor. Investor return comes through sale of the shares at a price higher than the initial purchase price. Usually thought to be a riskier form of investment given that there is no guarantee that the value of the shares will increase. 2. Debt: Borrowing money for use in the business. Debt financing can be obtained through the shareholders (shareholders' loans) or third party sources (VCs, banks, credit unions, etc.). Debt can be secured (e.g., on the assets of the company) or unsecured. No shares are issued in a straight debt transaction, so share ownership is not diluted. Earns interest for the investor. Debt stands in line ahead of equity upon liquidation. 3. Convertible debenture (debt): a debt transaction that converts into shares at agreed-upon triggers, usually at the option of the investor and on certain defined events. The debt earns interest until conversion. This structure postpones the valuation negotiation.
Exchangeable shares: common shares that can be exchanged into a new class of shares on the next round of financing using a conversion ratio (e.g., 1 for 1). Convertible debenture (debt): a funding instrument for investors that converts to common or preferred shares at agreed-upon triggers, usually at the option of the investor. Earns interest, payment of which may be deferred. Usually converts to equity upon the next round of financing at a discount to the valuation of the next round. This debt instrument puts investors ahead of shareholders in case of liquidation and protects investors from down rounds in next round of investment. This is a more typical vehicle for U.S. financings but is increasingly popular in Canada. Convertible preferred shares: most common security for venture capital investments. Holders of this class of shares have “ preference ” over the common shareholders in the event of a liquidation of the company. Preferred shareholders can receive dividends exercise voting privileges and retain the option to convert to common shares. Venture debt is high yield debt that is often coupled with warrant coverage. A warrant gives an investor the right to purchase shares at a specified price for a specified period. Pursuant to the Small Business Venture Capital Act (BC), BC investors are eligible for a 30% tax credit for investments in “ Eligible Business Corporations ” . Register as EBC pro-actively.
Basic rule: you cannot sell shares in your company to anyone unless you issue a prospectus or rely on an applicable securities law exemption. Private issuer exemption is often the exemption of choice in early rounds of investment. No securities filings are necessary. Accredited Investor: an individual who meets one or more of the following: $1 million or more in net worth; income in excess of $200,000 in each of the last 2 years; or a joint income with a spouse exceeding $300,000 in the last 2 years.
Raising capital is a sales process with a long sales cycle. Obtain a scouting report on investors before approaching them. Know their investing track record, typical deal structures and the individual personalities of the investor and firm. Angels and VCs have different agendas and motivations. Financings are subject to negotiation between two or more parties of unequal bargaining strength.
Be prepared for the investor due diligence checklist by having your data room already in place.
Founder vesting: a term imposed on founders of seed and early stage companies in which the founder ownership is subject to a vesting schedule with nothing up front and linear vesting, typically over 3 – 4 years. The first twelve months ownership is often “ cliff ” vested at the first year anniversary with monthly, quarterly or annual vesting thereafter. The shares are held in escrow by the company and can typically be voted by the founder while they are in escrow. For more mature companies, vesting credit can be applied at the time of investment. The purpose of this agreement is to protect investors from an early, unplanned exit by a founder and to provide investors with the equity necessary to attract a new management team. Some investors demand that a certain percentage of a founder ’ s shares only vest upon a successful exit transaction.
Term Sheets are typically used to document the business deal as an expression of the parties ’ intent and are typically not legally binding on the parties other than provisions expressly made binding, such as confidentiality provisions. The financing terms that are “ market ” vary by jurisdiction, stage of financing and current market dynamics. Terms companies could negotiate in the dot-com frenzy of 1999 are markedly different than the terms that companies are forced to swallow in 2011. Fully diluted: total number of shares outstanding, including all securities that could be converted into common shares, such as warrants, stock options, convertible debt and preferred shares. In challenging economic times, deals are often tranched, with future tranches being based on company hitting specified milestones.
Negotiate a cap on transaction expenses. Representations and warranties: recourse against founders is frequently demanded. Negotiate limitations and caps on this recourse. Conditions precedent to closing typically include: Completion of due diligence by investors; Approval of investment committee; Execution of definitive agreements; No material adverse change to the business; All approvals and consents received. No shop: for a specified period of time after signing term sheet, company cannot shop the deal to other investors. Break fee: if deal does not close due to the company ’ s actions, company must pay investor agreed upon fee.
Voting: typically, common shares entitle the holder to 1 vote for each share held. Dividends: are typically declared at the discretion of the board of directors. Dividends are rarely declared in early stage technology companies. Liquidation or sale of company: the common shareholders will participate in the proceeds of any sale or liquidation of the company proportionate to their percentage shareholders (after paying any debt and any liquidation preference on any preferred shares). Redemption right: gives the investor the right to require the company to buy back his/her shares under certain conditions (e.g., a number of years following the initial investment). Common share offerings rarely give the investor this redemption rights. Conversion rights: a plain vanilla common share offering will not give the shareholder the right to convert his/her/its shares into another class of shares, either on the next round of financing or otherwise.
Discount on conversion: convertible notes are typically structured such that the holder receives a discount on the valuation of the next (qualified) round of financing. Frequently, the size of the discount increases with the passage of time. Valuation cap: investors will often seek to negotiate a cap on the valuation on the next round. Interest rate: the interest rate is negotiable. At this stage of the company, a convertible note constitutes a high risk investment and will typically attract a relatively high interest rate to compensate for this risk. Maturity date: the date when the loan must be repaid by the company in the event that the convertible note has not converted to equity beforehand. 1 – 2 year terms are typical. Automatic conversion events: the convertible debt will automatically convert to equity upon certain specified events, such as: (i) qualified initial public offering; (ii) qualified equity financing. Optional conversion events: convertible notes are often convertible at the option of the holder at any time prior to maturity. Security: convertible notes can be secured on the assets of the company by a general security agreement, or can constitute an unsecured debt.
Dividends: proceeds paid by the company as a return on an original investment. Generally, dividends are discretionary with the company and are not paid unless contracted for. Dividends can be paid in cash or in kind (i.e., in shares). Dividends can be cumulative, non-cumulative, participating and non-participating. Liquidation preference: a preference offered to a certain class of shares over other share classes, upon liquidation of the ownership of the company. Participating preferred shares share (participate) with the common shares upon liquidation or sale. Upon liquidation, those shareholders with a liquidation preference will receive their original investment, any dividends owed, and possibly other consideration, before holders of common shares receive any distribution. Some deals cap the liquidation preference (1x, 2x, 3x, etc.) Conversion rights: rights by which preferred shares convert to common shares, which can be mandatory as in the case of an IPO, and voluntary where certain milestones or met or with the passage of time. Anti-dilution provisions: the means by which a shareholder preserves a percentage ownership in the company without making a new investment. Typically, anti-dilution protection is provided in the event of a stock split, stock dividend or similar recapitalization. A “ full ratchet ” provides a complete preservation of percentage ownership in all circumstances, including protection in the event of a subsequent sale or merger. A Modified ratchet does not provide for ratcheting in cases of a new subsequent offering at prices lower than the per share investment price (down round) or employee equity offerings. Pay to play: a term that requires earlier investors to “ pay ” (participate pro rata, or at some dictated percentage in future financings) to continue to “ play ” (not having their shares converted from preferred to common shares, and thereby losing rights). Redemption right: gives the investor the right to require the company to buy back his/her shares under certain conditions (e.g., a number of years following the initial investment).
There is no such thing as an off-the-shelf shareholders agreement. Clark Wilson has a checklist that can be circulated with the factors to take into account in your situation. Corporate governance is becoming increasingly important to companies and investors alike. Board of directors independence and expertise is paramount. Board sizes range from 3 – 7 in typical Angel and VC backed companies. Watch for conflicts of interest within board of directors due to capital structure and investor nominees on Board. Roster of board of advisors and observers to be negotiated. Right of first refusal on share transfers: requires a shareholder to offer his/her shares to existing shareholders before selling them to a third party. A mechanism to control share ownership. Pre-emptive right: each holder of at least x% of the common equity of the company (on an as converted to common basis) shall have the right to provide financing to the company on the same terms offered to third parties in the amount necessary to maintain such holder ’ s pro rata ownership percentage of the company. A mechanism that prevents existing shareholders from having their share ownership percentage diluted without their consent. Drag-Along Right: If a certain majority of shareholders chooses to sell their shares to a third party, then that majority can require the other shareholders to sell their shares to the same purchaser on the same terms. Prevents an obstructionist shareholder from blocking a sale of the company. Tag-Along Right: The reverse right that allows a minority shareholder to join in on (tag along with) a sale of shares by the majority shareholders. Information rights: financial statements; monthly CEO reports, etc. Approval rights include issuance of shares; management compensation changes; borrowing/lending, etc.
Example of private company that ran itself like a public company during successive rounds of venture financing and ultimately, exit transaction with U.S. publicly traded acquisitor. Example of private company whose capital structure boxed itself into a corner, followed by disorganized due diligence process that led to an asset sale at a significantly reduced valuation through a CCAA bankruptcy process. Microsoft M&A guy: there is a higher bar these days to getting deals done. Companies need to be cleaner. Being disorganized frustrates the investor ’ s or buyer ’ s need for information and hurts the credibility of the management team.
Bootup startup financing by Clark Wilson (05-11-2011)
Bootup Startup Legal 101: Startup Financing May 11, 2011 Brock Smith & Mark Longo Clark Wilson LLP
agenda Legal Aspects of Raising Financing 1. Plant the seeds for a financing 2. financing structures 3. due diligence process 4. financing terms 5. financing deal docs 6. case studies 7. information sources 8. q & a
<ul><li>Plant the corporate and legal seeds to facilitate successive rounds of financing. </li></ul><ul><li>Raise each round of financing with your ultimate exit transaction in mind. </li></ul>plant the seeds for a financing Corporate Structure Customer Agreements 1 1
the new financing reality <ul><li>New rule of thumb: </li></ul><ul><li>raise only as much equity as you need , bootstrap yourself, get to revenue and cash flow positive position. </li></ul><ul><li>Exhaust all available funding sources. </li></ul>Old rule of thumb: raise as much capital as you can .
financing structures <ul><li>Common Share offering (private placement) </li></ul><ul><li>New class of Common Shares (e.g., Class B) </li></ul><ul><li>Exchangeable Common Shares </li></ul><ul><li>Preferred Share offering (Series A, Series B, etc.) </li></ul><ul><li>Convertible debt </li></ul><ul><li>Venture debt </li></ul><ul><li>Bank debt </li></ul>
cross border financing structures 2010 Federal budget eliminated Section 116 Income Tax Act reporting / filing burden on non-resident investors. This change enables U.S. VC funds to directly invest in Canadian companies, eliminating need to employ workarounds, such as re-organizing business into U.S. entity or investing indirectly via offshore company. Direct investment structure will often be the recommended deal structure from corporate, tax and cost perspectives.
securities law considerations <ul><li>Comply with applicable securities laws: </li></ul><ul><ul><li>Canada: NI 45-106: exempt distributions from Prospectus / registration </li></ul></ul><ul><ul><li>Need comparable US federal / state exemptions for US investors </li></ul></ul><ul><li>Private placement Prospectus Exemptions: </li></ul><ul><ul><li>Private issuer exemption </li></ul></ul><ul><ul><li>Friends & family </li></ul></ul><ul><ul><li>Accredited investor (Canada and US) </li></ul></ul><ul><ul><li>Employees, officers, directors, consultants </li></ul></ul><ul><li>Resale restrictions apply to exempt share purchases </li></ul>
due diligence process <ul><li>Due dili can make or break a deal </li></ul><ul><li>Proactively create virtual data room </li></ul><ul><li>Deals have a finite time to close </li></ul><ul><li>Don ’ t give investor reason to walk </li></ul>
the business deal <ul><li>Deal size </li></ul><ul><li>Type of security </li></ul><ul><li>Investment Syndicate </li></ul><ul><li>Use of proceeds </li></ul><ul><li>Price: pre/post money cap table (basic / fully diluted) </li></ul><ul><li>Tranches (Call or option) </li></ul>
general Ts & Cs <ul><li>Closing date </li></ul><ul><li>Expenses of transaction </li></ul><ul><li>Representations and warranties </li></ul><ul><li>Conditions to closing </li></ul><ul><li>“ No shop ” clause </li></ul><ul><li>Break-up fee </li></ul><ul><li>Confidentiality </li></ul>
common share financing <ul><li>Common voting shares </li></ul><ul><li>Dividends discretionary </li></ul><ul><li>Share pro rata on sale of company </li></ul><ul><li>No redemption right on shares </li></ul><ul><li>No conversion rights </li></ul>
convertible note financing <ul><li>Discount on conversion </li></ul><ul><li>Valuation cap </li></ul><ul><li>Interest rate </li></ul><ul><li>Maturity date </li></ul><ul><li>Automatic conversion events </li></ul><ul><li>Optional conversion </li></ul><ul><li>Secured or unsecured </li></ul>
preferred share financing <ul><li>Dividends </li></ul><ul><li>Liquidation preferences </li></ul><ul><li>Conversion rights </li></ul><ul><li>Anti-dilution provisions </li></ul><ul><li>Voting rights </li></ul><ul><li>Redemption right </li></ul>
financing deal docs. <ul><li>Subscription / Investment Agreement </li></ul><ul><li>Shareholders Agreement </li></ul><ul><li>Capitalization table </li></ul><ul><li>Share provisions </li></ul><ul><li>Investor Rights Agreement </li></ul><ul><li>Stock Option Plan </li></ul><ul><li>Opinion of counsel </li></ul>
shareholders agreement <ul><li>Unanimous or not </li></ul><ul><li>Board of directors </li></ul><ul><li>Share transfer restrictions </li></ul><ul><li>Right of first refusal </li></ul><ul><li>Pre-emptive right </li></ul><ul><li>Drag along </li></ul><ul><li>Tag along </li></ul><ul><li>Information rights </li></ul><ul><li>Approval rights </li></ul>