What You Need to Know Before You Start Raising Capital for Your Startup
Every startup begins with an idea. To transform this idea into a sustainable business, at some point you’ll likely be asking yourself, “How do I raise capital for my startup?”
While you know how valuable your business is, the key to raising capital is communicating this value to those who have the money to get your idea off the ground. Having proper documentation when you approach investors is a huge part of this; it shows you are serious about your business and prepared for any issues that may arise.
To help you achieve this for your startup, we invited Prentice Durbin, Partner at Harper Grey LLP, and Viridiana Perez, Co-Founder of NANOSentinel to SFU VentureLab’s “Raising Capital” webinar to answer the most important questions that arise for entrepreneurs raising money.
What are the three sources of capital?
As complicated as legal documents can be, understanding your options for raising money is simple: you either borrow it, sell shares, or it gets given to you through grants and gifts.
- Taking out a loan is considered debt financing, which can come with some risk. Some loan agreements require the borrower to grant security, meaning the lender can take control of all your startup’s assets upon default. Prentice explains that “We’re not telling you to never do it, but it’s important to understand what [applying for a loan] means and, above all, knowing you have to repay it eventually.” In addition, many startups would have difficulty getting a loan for the amount required.
- Equity financing, or selling shares, can be an attractive option for startups because it doesn’t have to be repaid. Alternatively, A Shareholders Agreement for Future Equity grants the holder the right to purchase shares in the future. According to Prentice, these are meant to be temporary as “[A SAFE] is a bridge to the next financing that should last no longer than a few months long.”
- Grants are another excellent option as they are non-dilutive and widely available for small businesses. Checking your eligibility for funding programs specific to startups in Canada like SR&ED, CMF, and IRAP is a good starting point. Many additional resources for startups have also emerged to help entrepreneurs respond to COVID-19.
How should I prepare my startup to successfully approach investors?
Before approaching investors, every entrepreneur should connect with a lawyer specializing in startups in Canada to prepare their foundational legal documents. Not only will investors expect you to have these ready, but internally, it sets expectations should any conflicts arise. Making documentation mistakes, especially with IP and other sales and licensing agreements, can lead to expensive clean-up costs that take away from your capital raising successes.
“Most of us come from a science background so the legal language was really new for us. I would definitely recommend you go to a lawyer and get some help. [Our lawyer] was really great at explaining terms to us, which definitely helped, especially with the shareholders agreement which becomes very useful if a co-founder leaves.”
Viridiana Perez, Co-Founder of NANOSentinel
There is such a thing as too much investment and you may be wondering how to raise capital without losing control of your startup. Tracking all equity entitlements in a share capitalization table allows you to see each shareholder’s ownership percentage at any point in time, ensuring you understand what happens to your control at every financing stage.
What does the process for raising equity capital look like in a typical startup?
The steps below show what funding rounds often look like for startups raising capital in Canada; however, the exact process will vary from startup to startup. For example, the capital requirements of Viridiana’s company are so large they are planning to forgo the family and friends round and go straight to angel investors. Use this guide as a starting point, then, assess your startup’s needs to determine your optimal financial roadmap.
Step 1: Issue shares to founders
In the first issue, each founder receives many shares for a very low price per share. Ensure this comes with share issuance guidelines, especially with respect to the number of shares; issuing too few shares will inflate your value and create more dilution as you move forward.
Step 2: Issue shares to family and friends
According to Prentice, “At this stage, valuation is just coming up with a number. Once you get into professional investors, it becomes a negotiation.” To value the shares you sell to friends and family, you can look to anything from industry standards to your total investment thus far.
In the share capitalization table below, we input sample numbers for the number and price of shares issued to founders, family, and friends. The remaining fields are calculated based on these values.
Step 3: Plan for stock options in your share capitalization table (optional)
If you plan on partially compensating your employees through stock options, write this into your share capitalization table early on as it appears in the example below. When you are pitching to professional investors, they will want to see what ownership percentages they get in a fully-diluted scenario.
Step 4: Approach angel investors
Your legal preparation will pay off here as angel investors must look at and sign onto a term sheet and shareholders agreement. At this stage, the term sheet will be simple, specifying the price per share, type of share, and amount of shares to be issued.
Step 5: Approach venture capital firms (Series A and B)
Along with the documents required at the previous stage, raising venture capital requires a detailed investment agreement that contains representations and warranties about the company and covenants that specify the investor’s needs. You’ll often have to also re-write the shareholders agreement and articles to meet the venture capitalist’s demands; “If you want their money, you are going to change it to be their way,” Prentice explains.
In the final share capitalization table, you can see the founder’s ownership has decreased by over 50%. However, dilution isn’t inherently negative; you own less of a company that has much more value which can make giving up some control worthwhile.
Understanding what documents you need to raise capital for your startup is a key step to succeeding in the difficult but necessary task of raising money and scaling up your sales. SFU VentureLabs is a science and technology growth accelerator in Vancouver that aims to provide entrepreneurs with programs, mentorship, and support through these difficult moments that all startups face. To find ways we can support your startup, check out our programs or subscribe to our newsletter to stay up to date on future news, events, and more informational content.
SFU VentureLabs does not provide legal advice. Please ensure you talk to a lawyer on these issues.