This article was originally published on the Accelerate Okanagan blog
From the embryonic stage of a startup software company until it starts to generate revenue (and often even beyond!), all companies and their founders have at least one thing in common: a need to finance development costs.
The right option for your company will depend on a number of considerations with different legal obligations and liabilities for a company's board of directors and management. You need to consult your legal professionals, since the list of possible problems with legal or regulatory matters is almost endless: tax complications stemming from your choice of legal entity or jurisdiction of incorporation, disputes arising from poorly structured financing, or lawsuits from new shareholders alleging misrepresentation are all examples of reasons to seek professional advice.
A key step towards mitigating legal and regulatory risk is to learn enough about the subject so you can fully appreciate the risks. Below are a few financing options you may want to consider:
Bootstrapping occurs when founders fund development costs without external assistance. Doing so provides founders with a great amount of flexibility in terms of running the business and ownership, but also requires them to take on additional financial risk.
Seed financing involves the investment of capital into a company to fund development or the investigation of a market opportunity. Seed financing is often provided by the founders themselves, friends and family, or angel investors. Recently, many Canadian jurisdictions have announced crowd funding rules that can be harnessed to raise seed capital from many investors.
There are different types of seed financing structures:
- Common share financing: Investors receive an ownership stake in the company, in the form of common shares, in exchange for an investment of cash into the company.
- Note financing: Investors receive an interest-bearing promissory note in exchange for their investment, which is repayable upon the terms and conditions set out in the note. A note financing is a common investment structure and can also include an option or requirement that it be converted into equity at a prescribed time in the future.
- Series seed financing: Investors receive preferred shares in exchange for their investment in the company. Investors who hold preferred shares receive certain preferential rights to get their investment back (plus an additional return in some circumstances) before holders of common shares are paid upon a sale or liquidation of the company.
Venture capital financing
A venture capital financing typically results in a larger investment from a venture capital firm in exchange for preferred shares. In addition to receiving a preferred return, like in a series seed financing, venture capital investors also typically receive corporate governance rights such as a seat on the company's board of directors and approval rights on certain transactions. A venture capital financing typically occurs when a company can demonstrate a significant business opportunity to quickly grow the value of the company but requires significant capital to do so.
Each option has its fair share of pros and cons, and there isn't a hard and fast rule for which option is best. It's important to understand that there are intricacies within each financing option that should be considered on a case by case basis, which is why a solid and trusting relationship with a legal professional who knows your business and its background is vital.