• D. Jeff Larkins, Solicitor

Small Business & Start-ups: Part Two: Financing

Updated: Feb 6


Small Business & Start-ups: Part Two: Financing

There are countless publications and websites available to individuals seeking information and ideas to finance a new start-up or other business venture. Entrepreneurs, business owners and chief financial officers tasked with raising funds will find no shortage of advice and information as to the form financing their respective business may take but it is a long road from start to a successful finish.

In this article the details of specific forms or types of third party financing will be deferred in favour of some more or less practical tips intended to direct new ventures in the right direction and potentially avoid issues that can undermine financing efforts or, eventually, undermine the entire new venture. The concepts below are best contained in a well organized and written business plan, however at any stage these concepts should be well understood by a party seeking financing and should be capable of well-reasoned articulation to anyone who asks.

Start with asking "why" you need financing.

Is it seed financing to get a business idea off the ground? One time acquisition financing to acquire a technology, property or franchise? Venture financing to fund product development, roll-out or research? Operational financing to manage inventories or cash flows? Mezzanine financing to fund growth or expansion? These are important questions for investors, whatever the sophistication or relationship, to ask and how you answer will go a long way to your success in attracting interest. "Working capital" is an answer that usually attracts some disbelief from investors as any significant allocation of requested funds to working capital (a reasonable allocation of a portion of the target amount to working capital is prudent) typically suggests you have no plan and funds invested will not necessarily result in any consequential increase value.

Be able to articulate the milestone you wish to achieve in some detail and be able to demonstrate your ability to achieve that milestone with some certainty should adequate funding be available.

Have a rational idea of "how much" financing you will need to meet your stated objective.

Be reasonable to budget what you need, within a range of variables, with some working capital to continue forward. Investors like businesses that say what they need and then do what they say. Falling short of financing targets can leave existing investors hanging or subject to unanticipated dilution; obviously prejudice any ability to meet promised milestones and diminish valuations; lead to predatory short term financing or, in the worst case, a premature insolvency situation. Excessive financing can lead to waste or new-found (but ill-conceived) ambition; expansion too early in a business cycle; unnecessary dilution if raised by the issuance of equity and unworkable re-payment obligations if raised through debt; and, generally, a set of expectations from investors that may be less than optimal in terms of future growth or in assessing any future exit scenario.

Take the time to prepare a form of budget, research and validate any assumptions you may have in terms of anticipated cost or expense and be realistic of the current value of your business, the next "value milestone" in your path and the anticipated value of your business if successful.

Answer the "what" and the "who" question in tandem.

When considering the "what" there are basically two, in broad terms, forms of third party financing: equity & debt. For the moment financing from cash flow will not be discussed as few start-ups can immediately rely on cash flow. Grants (typically from governments, government agencies or foundations) will not be discussed here since, as good as it sounds, this form of financing is suggested to represent less than 5% of new venture financing (readers interested in this relatively rare form of funding should take the time to browse provincial and federal small business web sites for more information on available programs - albeit future posts will canvass some of the more popular programs).

“Equity” financing refers to the exchange of some sort of ownership interest for value today and according to many publications typically accounts for over 55% of new venture financing. Equity can mean any sort of ownership interest like a share in a company; a partnership interest; a joint venture or co-ownership interest in a specific project or property; or an interest in a revenue stream and/or the proceeds of any sale of a particular business. While advantageous in terms of risk (since the obligations of the business entity and the business principals are typically limited to the loss of the actual investment), the downside is the surrender or some degree of ownership and/or control, accountability and the imposition of some legal formalities in order to administer co-ownership rights and obligations.

“Debt” financing refers to the exchange of a promise to re-pay at some future point in time for value today and according to many publications can account for slightly more than 40% of new venture financing. Debt can mean commercial loan; shareholder loan; personal loan; demand or term loan; bonds, debentures or promissory notes; lines/letters of credit or even credit cards. As anyone who has been in debt can appreciate, there is risk associated with borrowing and for many startups and small businesses that risk will likely go beyond the assets of the corporation or partnership (many entrepreneurs incorporate for the main purpose of separating their personal assets from business assets but, through the use of personal guarantees or indemnities from individual owners and/or management, many lenders will require personal assets be at risk). The advantages of debt financing include: the operators can usually retain ownership and control (with notable exceptions); the relationship with lenders ends when the debt is re-paid; interest is typically tax deductible and expenses related to debt financing are typically easy to forecast since payment obligations do not fluctuate (subject to notable exceptions).

When considering the "who" be realistic, focused and practical - too often entrepreneurs tend to favour seeking “any investor/ investment” over “suitable investors/ investment” or even “likely investors/ investment” and in that regard tend to waste time and money needlessly and/or find themselves with an unanticipated, and sometimes unassailable, legal problems.

A bank or financial institution is not likely to be looking for an equity investment, nor is it likely to lend to a business with no assets, little cash flow and owners with little security to backup guarantees. Business owners typically do not want more than one (if any) lenders, at least early on, and would perhaps prefer to distribute some of the risk of the new venture among a number of equity investors. Whatever the possibilities or probabilities may be to a particular business understand the reporting and control implications of what you are offering or are about to accept; understand the legal and accounting issues related to any security you offer or any investor you propose to engage; and document applicable terms, rights and obligations carefully in consultation with a qualified professional adviser.

Also, from experience, seek out qualified investors that have the same or similar perspective, to some degree, as the business owners. So-called strategic investors can have a different reason or motivation for investing in a particular situation which can complicate if not frustrate future anticipated expansion or orderly exit. Some investors, more familiar with public markets, may see a particular investment as short-term while other investors, experienced in private lending or equity ownership, are more patient and long-term. It is not always prudent advice to accept funds from an investor with a timeline different from what you can offer or expectations you will not be able to meet simply in order to secure funding.

A word of caution is worth raising here as well. The questions of "what" and "who" need to take into consideration, at some point, the question of securities law. Too often entrepreneurs, their advisers or their perhaps inexperienced legal counsel presume that securities laws do not apply to them (under the misguided belief that securities laws only apply to "publicly traded companies") or do not apply to the type of instrument being used (under the misguided belief that securities laws only apply to shares or debt instruments that are convertible into shares). Securities laws apply to any "trading" and/or "distribution" of "securities" (all terms defined exceptionally broadly under Canadian securities laws) notwithstanding the person, entity, type or (for the most part) location. Some decent guidance by the British Columbia Securities Commission can be found here, but always seek advice from an experienced lawyer in your jurisdiction.

The answer to "when" is, typically, always.

In today's challenging investment and lending market the biggest obstacle for new business endeavour, big or small, is without a doubt financing. Many business owners or executives responsible for financing find that they are, or seem to be, in a constant loop of seeking and if successful securing financing for their business.

Anticipate the time and attention, away from the actual business, obtaining financing can take. Stay open to referrals and mindful of other entities that have been successful in obtaining financing in your area or industry.

Beware of those promising access to equity or debt by finding or locating others ("finders") for a fee and, if retaining such persons or firms then document the arrangements carefully and pay only for funds actually sourced by that finder and pay only on an actual successful financing (and anticipate the securities law regulation around persons that are or may be deemed to be in the business or trading or advising in securities).

Do not leave it too late and anticipate that any necessary financing will take longer, much longer, than anticipated. A quick and easy financing is an exception and is not indicative of future success.

Does not constitute legal or other advice and must not be used as a substitute for legal advice from a qualified legal professional in your jurisdiction who has been fully informed of your specific circumstances. Information may not be up-dated subsequent to its initial publication and may therefore be out of date at the time it is read or viewed. Always consult a qualified legal professional in your jurisdiction.

© 2020 by Endeavor Law Corporation.