Practical Considerations for Raising Capital As A Startup Company
Raising money to get a new business off the ground is one of the most challenging obstacles an entrepreneur must overcome. Generally, initial capital is contributed from an entrepreneur’s own resources or family and friends. However, additional funding is often required to help operate and develop the business. Further, a startup company’s financing needs will inevitably change as its business matures, as will the startup’s ability to secure investors and lenders to fund its business. Thus, a startup company should explore the various financing options and capital raising considerations discussed below at various stages in its life-cycle.
The following is a high-level summary of the material covered in Chapter 3 Capital Raising of a new book Startup Law 101: A Practical Guide edited by lawyer Catherine Lovrics, which was contributed by Wildeboer Dellelce LLPlawyers Rory Cattanach, Al Wiens, Davia Wang and Patricia Good. Startup Law 101: A Practical Guide was published by, and is available for purchaseonline here.
Debt and Equity Financing
Startup companies typically have two main options to raise capital: debt or equity financing.
Debt financing allows startups to borrow money from a variety of lenders, including shareholders and financial institutions. Raising capital through debt financing does not result in the lender retaining any ownership interest in the business. Rather, the business becomes obligated to repay the borrowed funds plus any interest when the loan comes due.
Equity generally refers to an ownership interest in or a financial claim to the capital of a business or asset. Through equity financing, a corporation raises capital by selling shares to investors in exchange for money. The advantage of equity financing is that investors are not entitled to have their investment repaid. Instead, shareholders acquire an ownership interest in the business and may realize a return on their investment upon selling their shares. Shareholders can also profit in the success of the business if management declares and distributes dividends.
A private company may only issue equity by selling its shares to purchasers that meet specific criteria to qualify as a private transaction. However, a company may wish to raise greater amounts of capital by selling its shares more broadly to the public, in which case it will be exposed to disclosure obligations.
Businesses may also utilize hybrid instruments that have both debt and equity financing elements to raise capital. For example, corporations can issue preferred shares offering preferential treatment to their holders. Preferred shareholders often have a priority claim to any dividends and residual assets upon dissolution of the business over holders of common shares. However, similar to debtholders, preferred shareholders typically do not have voting rights. Alternatively, some entrepreneurs seek a middle ground between equity and debt financing through convertible debt. This is a debt obligation that can be turned into equity in the future.
Issuing Equity Securities to the Public
Any trade in securities constituting a distribution requires the issuer to either file a disclosure document (referred to as a prospectus) with its applicable securities regulator or to rely on an exemption from the prospectus requirement. A prospectus is a legal document which discloses extensive information. A prospectus must contain full, true and plain disclosure of all material facts about the issuer, its business and the securities for sale for potential investors to be able to make a reasonably informed investment decision.
An initial public offering (“IPO”) is the process by which a private company offers its securities to the public for the first time resulting in it becoming a public company. Going public can increase a company’s access to capital and provide for improved liquidity as the business becomes increasingly more marketable. However, the going-public process and the reporting obligations and regulatory requirements associated with operating as a public company can be challenging, time-consuming and expensive.
Each time a reporting issuer intends to issue shares to the public, a prospectus must be filed; however, there are certain exemptions from such prospectus requirements. Given that the prospectus regime can be costly and time-consuming for small and mid-size issuers, the prospectus exemptions are especially useful. Among the various exemptions, the private issuer exemption and the family, friends and business associates exemption are particularly attractive to startups and small issuers.
In addition to an IPO, two other types of liquidity events include selling a business or amalgamating with another business, which are discussed in Startup Law 101: A Practical Guide
Read a more robust summary on the practical considerations for raising capital as a startup company on Wildeboer Dellelce’s website.
This update is intended as a summary only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.
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