Slicing the pie: Offering security in a startup

Joseph A. Gill

Overall, 2021 has been a big year for Saskatchewan tech. In August, the Canadian Venture Capital & Private Equity Association (CVCA) reported Saskatchewan venture capital investment reaching a record-breaking level of $171 million for the first half of 2021.1 In November, the CVCA reported an additional $28 million of private equity investment over 13 deals in the province.2

As founders make plans to raise and access that capital, set out below is a quick primer on types of security they can offer.

  • Common Equity – This means standard common, voting shares in the capital of a startup. They will typically be of the same class of shares as the ones held by the founders.
  • Simple Agreement for Future Equity (SAFE) – This is a right to acquire shares of the startup in future once a raise round of a certain amount has occurred. At that time, the principal amount of the SAFE (i.e. the amount the investor invested) will convert into shares of the startup at a certain conversion amount. Key concepts within a SAFE include:
    • Discount Rate – This is the discount to the future raise round price that the investor will enjoy when the raise round occurs.
    • Cap – This is the maximum valuation of the startup at which the SAFE will convert into shares. This is meant to protect the investor against a runaway valuation in future.
    • Qualified Financing – This is the trigger for a conversion of the SAFE into shares of the startup.
  • Convertible Note – This is a debt instrument that sees the investor lending the startup a certain amount of money, with the investor keeping a right to potentially convert that amount into shares of the startup at a future time. A convertible note has essentially the same key concepts as a SAFE (i.e. Discount, Cap, Qualified Financing). The key difference, however, is that the note is debt to the startup, which gives rise to three key points:
    • Financial Statements – The note will be treated as debt of the startup for purposes of financial statements. This could have a negative impact when looking at securing external financing.
    • Maturity Date Repayment – If the startup does not have a “Qualified Financing” before a certain period of time, the note (like any other debt) may be repayable by the startup. Note, however, that many notes simply convert into shares of the startup on maturity (so they don’t become debt).
    • Interest – The note will bear an interest rate on it. That interest is not repayable until the maturity date of the note. Additionally, if the note converts into shares of the startup, the interest is simply converted into shares as well.
  • Preferred Shares – There is also the concept of Preferred Shares, which we’ve intentionally dealt with separately. These most often rear their head as part of later funding rounds and are a preferred investment vehicle for venture capital money. Preferred shares usually have several features, including the right to be redeemed at full price if the startup is sold and the right to convert preferred shares to common. Additionally,
    private preferred shares may come with special voting rights.
  • ESOP – An Employee Stock Ownership Plan (ESOP) is an employee benefit plan that turns your business team into business owners by issuing stock. Shares in the business can be granted as a bonus, they can be distributed as an incentive, or employees can purchase shares directly from the company. As a means to raise capital, an ESOP in which employees purchase stock, can offer numerous benefits—immediate benefits that lower monthly expenses and long-term benefits that keep a startup’s employee roster stable.

Annie Quangtakoune

At McKercher, we have groups of lawyers focused on startups and entrepreneurs in the Saskatchewan tech ecosystem. We have assisted tech startups with everything from initial incorporation through seed round and series financing and finally to exit transactions. We are also proud to offer fixed-fee solutions to help keep costs in check during the critical startup phase of a business.

For more on SAFEs, check out our previous article in the Industry West’s Winter 2020 edition.

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McKercher LLP
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Regina, SK
(306) 565-6500

1“Saskatchewan Tech Companies are Shining in 2021”, online: https://www.saskatchewan.ca/government/news-and-media/2021/october/06/saskatchewan-tech-companies-are-shining-in-2021
2“Q3 2021 Canadian Private Equity Market Overview”, online: https://www.cvca.ca/research-insight/market-reports/q3-2021-canadian-vc-pe-market-overview

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