1. Capital Structure of Corporation
Many startup companies, particularly in technology sector, require capital beyond the means of their founders in order to finance continued growth. Expenses quickly add up, and a business that cannot manage its cash flow will not survive. Because startup companies typically have a limited operating history and are considered to be risky ventures, obtaining even simple financing arrangements can be a difficult task.
Theoretically, while financing alternatives include debt or equity financing (Debt financing is borrowing money with a final obligation to repay the debt; Equity financing is selling to investors an opportunity to own part of the company), in reality, an early stage emerging company is limited to raising money through equity financing. A new company just starting operations will have difficulty obtaining a bank loan without substantial cushion of equity financing. As far as a bank is concerned, a startup has little proven capability to generate sales, profits, and cash to pay off a loan. Even the underlying protection provided by a startup’s assets used as loan collateral may be insufficient to obtain bank loans. Asset values can erode with time, and in the absence of adequate equity capital and good management, they may provide little real loan security to a bank.
Having chosen equity financing, an entrepreneur can sell two types of equity securities in a corporation – common shares and preferred shares. Common shares are a security that gives its holders the right to participate in management control of a company by choosing the directors and by voting on fundamental changes. Also, common shareholders have the right to receive declared dividends and to share in the distribution of net assets if the business is dissolved. Although common shareholders have a claim to the net assets of the business, if the business is dissolved, that right is subordinate to the business's debtors and the preferred shareholders.
Preferred shares are a security that has some characteristics of equity capital and some characteristics of debt. Preference shares are used in situations where the investor wishes to be in a position somewhere between that of a full equity shareholder (common shareholder) and that of a creditor who becomes entitled to repayment of the debt due to him before repayment to any capital of any shareholder of any class. Depending upon the rights attached to the shares, a holder of preferred shares may be in a preferred and safer position than the common shareholder, but not quite as safe as a holder of debt financing. For a startup, preferred shares may be one way to obtain equity capital without diluting the control of the common shareholders or diluting their participation in the growth of the business.
Generally, preferred shares have the right to a preferential dividend entitling the holder of such shares to the payment of a specified dividend before any dividend is paid upon common shares. Preferential shares may provide for a further participation over and above the cash dividend in the earning of the corporation after the specified preferential dividend has been paid. Preferred shares may have cumulative or non-cumulative dividends. Cumulative dividends, if not paid, continue to accumulate and must be paid for all periods in arrears before dividends on common shares. In the case of non-cumulative dividends, the right to receive dividends in each year expires at the end of the corporation’s fiscal year, and if a dividend is not declared, the shareholder forever loses the right to dividends.
Where redemption is included as a right of the holder of preferred shares, the corporation will be entitled to require the shareholder to sell his or her shares to the corporation at a price pre-determined and established in the share conditions. Similarly, the shareholder will be entitled to require the corporation to purchase his shares at a price pre-determined and established in the share conditions. Redemption rights are usually triggered upon the expiration of a five to seven year period following the date of purchase. Preferred shares may be converted into common shares at a predetermined ratio. Preferred shares typically do not have voting rights. However, often a voting right will be granted to holders of preferred shares during a period in which preferred dividends are in arrears.
2. Traditional Methods of Finance
Banks are a major source of both short-term and long-term funding for many conventional companies. Through borrowing, an entrepreneur is able to acquire the funds he needs to operate his business without giving up control of a business. For startups the principal problem with bank borrowing is that, in addition to charging interest, banks require borrowers to adhere to very strict operating standards to keep the loan in a good standing. The pressures of operating in such an environment can outweigh the benefits, particularly for a startup company that may experience difficulty being confined by external restrictions imposed on its changing business models.
Another problem with bank borrowing is that, when making a decision whether to extend a loan to a startup company, banks pay close attention to the company's financial history and projections and to the management of the business. Since most startup companies rarely have more than a business plan and a budget, qualifying for bank loan is often not possible. Also, banks usually will not lend funds without collateral valued at least the principal of the loan. Most startup companies are not able to provide such security. Many startups are not "asset-intensive" businesses, and it is often difficult for even established companies to qualify for a loan, unless they possess highly valued intellectual property protected by patents. Banks typically will also require a personal guarantee of a loan from owners of a startup business, so should the company fail, the bank will seek to collect as much of its loan as possible and the entrepreneur could lose more than he bargained for.
Venture capital (VC) can generally be categorized as high risk, usually equity (or convertible debt) capital provided to startups by high net worth individuals and institutions who take an active interest in a company. The VC industry is highly competitive on the supply side, especially when a promising company is involved. The VC industry is attracting substantial amounts of money, and VC firms compete not only among themselves, but with other investors, including "angels" and corporations, such as Adobe, Intel, Cisco, Informix and Netscape. VCs also compete with other forms of startup financing, including "bootstrapping," commercial lending and public equity markets.
Virtually all VCs focus intensely on the experience and maturity of the management team of a startup company. Their investment policies cover a range of preferences in investment size, maturity, location and industry or a business. Individual partners within a VC firm frequently specialize in a targeted business market, such as biotech or software. One of the keys to raising venture capital is to seek investors who will truly add value to the startup company well beyond the money. While VCs may require seats on the board of directors, they always require significant rights to be informed on a current basis of all material financial and strategic events of a company. Requests for information begin during the VC's due diligence, and such information assists in determining conformity of the target investment with the VC's investment criteria, such as the size of the target's potential market and specific projected growth rates.
Startup companies that can obtain venture lending are able to minimize overall equity dilution, diversify sources of capital and, and most importantly, better manage cash flow. For most would-be entrepreneurs, venture capital financing is notoriously difficult to obtain. Only those startup companies that have already raised some money and are affiliated with institutional VC firms can obtain venture loans. Typically, this is because most venture lenders will still want the startup company to have at least some outside capital to finance the growth of the business and thus help give value to the venture lender's equity stake.
Private placements, another traditional source of financing, consist of the offer and sale of equity or debt securities in an offering exempt from many of the more complex federal and provincial securities laws. Private placements are an attractive source of equity capital for a startup company that for some reason has ruled out possibility of going public. If the goal of a startup company is to raise a specific amount of capital in a short time, this equity source may be the answer. In this transaction, the company offers shares to a few private investors, rather than to the public as in a public offering. In order to qualify for any securities law exemption, most private placements are restricted to institutional investors and wealthy individuals known as accredited investors.
The advantage of such an offering is that the company is able to control its cost of capital and financing timeframe by setting the terms of the sale and selling to those parties willing to buy. In addition, the company is able to avoid the burdensome disclosure and filing requirements required in public offerings. Obtaining a private placement, however, is generally not a viable option for a startup company to pursue. At the early stages of development, a startup company will likely find it difficult to pay the costs to retain a placement agent or investment bank to help draft a private placement memorandum and to market its securities. In most cases, a startup company will likely have to raise their initial capital from some of the other sources discussed below.
3. Seed Capital
Given the difficulties of raising capital through bank and VC lending, an immediate issue any new startup faces is how it will finance its startup operations. This issue is especially important where a business plan is still in its shaping stage. In a new startup company the founders, friends, family and “angels” usually contribute the seed investment. This capital typically funds the development of a prototype, covers startup expenses and protects intellectual property. The timing and terms of this financing depend on the existing resources of the founders, their friends and families. It may also depend on the track records of the founders.
An entrepreneur must understand two things: (i) any potential investor will likely evaluate the entrepreneur as much as the business plan he proposes, and (ii) any eventual negotiated deal will likely include the sale of a significant portion of the company. Investors willing to provide a startup company with its seed capital, generally trust their ability to evaluate people more than their ability to evaluate an untested business plan. Therefore, who the entrepreneur is and how he comes across will play an important role in whether any seed capital will be obtained. In addition, the seed investor will likely demand a significant amount of ownership of the company either in common or preferred shares.
Entrepreneur's Personal Resources
The first place many entrepreneurs get money from is themselves. Entrepreneurs must be personally and financially committed to the business. Many entrepreneurs mortgage their homes, cash RRSP, and use credit cards to finance the initial operations of the business. Access to these sources of capital may be critical to a startup company, but they come at a high emotional and financial cost. After entrepreneurs exhausted their personal financial resources, they usually turn to their friends and family for financing assistance. Institutional investors, however, are hesitant to fund companies owned by a large number of individual investors or companies controlled by family members. If the business fails, and the probability of that is high, the friends and family will lose their money invested. Failure invariably strains relationships. By adding multiple investors, an entrepreneur adds complexity, such as holding management meetings and potentially losing control of the business.
A potential way to avoid the pitfalls of "friends and family" money is for a startup company to secure its seed capital from the government. Both Federal and various provincial government agencies fund organizations which help finance small businesses in a variety of ways, including (i) the issuance of a direct financial award (more typical among provincial organizations), (ii) the extension of a low-rate loan and/or (iii) the guaranty of a commercial bank loan.
When traditional VC firms refuse to lend, a startup turns to individual private equity investors known as "angels". In addition to moneys, angels also bring expertise and experience to a startup and may serve on the board of directors or provide guidance through consulting or mentoring. Angels risk their capital based on their experiences and instincts. They tend to invest together with trusted friends and associates or on the recommendation of service professionals. They are capable of investing quickly (30-60 days to a closing) and their due diligence can be less rigorous than VCs or strategic investors. Angels may buy into concepts of a business and be forgiving on valuation. A single angel's participation in an investment usually ranges from $25,000 to $100,000.This informal investment market tends to be regional – Ottawa, Toronto and Waterloo. Angels are not listed in directories and they are hard to find, thus, raising this type of seed capital involves a costly and time-consuming networking process for entrepreneurs.
Unfortunately, it is precisely the non-institutional nature of angel investing that creates the obstacles that entrepreneurs in search of capital must overcome. First, the angel market is highly fragmented. Angels do not operate as investment companies; they operate as sole proprietorships. The angel usually invests his or her own capital in one or two investments at a time. Second, most angels restrict their investments to industries they are familiar with or have competed in. As a consequence, the more innovative the product or industry, the less chance there will be of finding an angel willing to invest. Third, angels usually like to keep a close personal watch on their investments, and they typically will not invest in a company that operates too far away from their home. This can pose a difficulty for startup companies that are not located in major urban or investment centers such as Ottawa, Toronto and Waterloo.
The Internet has made finding an angel easier. Today, companies such as www.garage.com and www.nvst.com have web sites that enable startups to make contact with angels. These sites allow startups to list themselves on the Internet in the hope of attracting an investor. Investors are screened and approved. Once approved, investors are able to view all private offerings listed on the site.