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Executive Summaries Jan 22, 2019

Venture capital financing instruments: Which way to go?

When seeking financing for their businesses, entrepreneurs generally knock on their financial institution’s door. As business people are quite familiar with traditional loans, which trespass very little on the life of the corporation and, above all, do not give access to the capital stock, this method of financing allows entrepreneurs to keep, with some exceptions, control of their corporations.

At the seed or startup phase, a corporation may, however, have trouble obtaining bank financing given that it is still at the concept or development stage of a product. Accordingly, venture capital in combination with a traditional loan, subordinated or not, is an attractive source of financing for a savvy entrepreneur who is not averse to sharing his capital stock.

A growing market in Quebec

Venture capital is a specialised type of capital investment which makes high-risk or very high-risk investments in corporations at the early seed or startup stage, or at the intermediate or later stages of development. Such financings primarily take place in the high-tech or scientific sectors, which offer strong growth potential. However, venture capitalists or investors diversify their portfolios in so-called traditional sectors, like manufacturing.

Quebec sometimes ranks as high as second among the Canadian provinces in terms of its importance in the venture capital market (both in terms of the number of deals and the amounts invested).

However, the venture capital market is still expanding in this province, most notably due to the number of startups and other corporations in the above-mentioned sectors that have set up their headquarters here.

Financing tools generally utilised

Venture capital is generally provided through two instruments, namely convertible debentures or share subscriptions.

Convertible debenture

A convertible debenture is an instrument by which an investor advances to the corporation a sum of money which will bear interest. The amount (including interest) is repayable at maturity or convertible into shares of a specified or determinable class at a price that is discounted on a predetermined date if there is a default or a liquidity event.

The debenture contains representations and warranties pertaining to every aspect of the business, but is generally not accompanied by a security. However, depending on the corporation’s stage of maturity, the entrepreneur might have to make those representations and warranties solidarily with the corporation. Since this instrument presupposes that the investor will become a shareholder of the corporation, the debenture frequently contains the anticipated terms and conditions of a potential shareholders’ agreement.

Capital stock

A subscription for shares of the capital stock is made by way of a subscription agreement containing representations and warranties pertaining to every aspect of the business which, depending on the corporation’s stage of maturity, may also be made solidarily by the entrepreneur.

Shares can be in two forms: common shares or preferred shares. Common shares carry the right to vote, the right to dividends, and the right to share asset residue in the event of liquidation. Investors favour this type of shares when the target corporation is well established, has a good reputation and solid earnings. In a venture capital context, investors will favour a subscription of preferred shares. The rights and restrictions carried by preferred shares will be negotiated by the parties at the stage of the letter of intent. Generally, they will be voting and will stipulate an annual rate of dividends that will be in line with the risk, payment priority in the event of liquidation, and “anti-dilution” clauses.

Since the investor becomes an owner of the corporation to the extent of the percentage of his shareholding, he will want to make sure that he will benefit from certain rights and that the object of his investment will be well protected. A shareholders’ agreement will therefore have to be put in place for this type of investment. In addition to the usual rights, the agreement will contain:

  • A right of redemption by the corporation or the entrepreneur after a certain period of time (note that this type of capital is patient. In Quebec, depending on the investors, the exit horizon can generally vary between 5 and 10 years); and
  • A right to have the corporation sold if it or the entrepreneur is unable to proceed with the aforesaid redemption.

And afterwards?

Unlike a loan, after the investment, the investor will take part in the corporation’s governance. Without necessarily being involved in the day-to-day decisions, the investor will:

  • Have the right to at least one seat on the board of directors and to appoint members to any committee of the board;
  • Have the right to name an observer on the board of directors and any committee of the board; and
  • Have controlled management rights (or veto rights) under the terms of the shareholders’ agreement or the debenture.

Partnering a corporation with a venture capitalist should be studied in depth by the entrepreneur. In advance of that entire process, the entrepreneur should make certain that the venture capitalist shares his values and his vision of the corporation’s growth.