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 startup 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 startup), in reality, an early stage startup 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, a startup 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 startup 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 startup, if the startup is dissolved, that right is subordinate to the startup'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 startup.
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.