One of the most common questions we receive is: how do we structure funding, especially in the first stage where you might choose to raise funds from family members and friends.
Let’s explore some of your options.
- Should you issue SAFE agreements?
A simple agreement for future equity (SAFE) is a short financing contract between a company and an investor that can provide the investor with the right to receive equity (shares). This is upon the happening of an event specified in the contract, such as future equity financing (i.e. when a company raises capital (money) through the sale of shares). A SAFE sets out the terms and conditions for such a transaction, including how the invested funds will convert into equity.
The main benefit of a SAFE is that it can be a simpler way for companies to raise money. SAFEs can be tailored to a company and its unique circumstances. A main downside for investors is the high-risk level if the specified events fail to materialize, i.e. no shares are issued in a funding round. Often, there is no obligation on the company to repay the principal to the investor. The SAFE can be drafted to minimize risk for investors by, for example, including contractual payouts in the event of dissolution of the company or liquidity events (when owners realize the value of shares by cashing in investments). Standard SAFEs can be inflexible and can be hard to get out of.
Two main components of SAFEs are the valuation date and the discount. A valuation cap is a limit on how much a SAFE can be converted into equity ownership. A discount is a discount off the price per share paid by other investors in the same funding round.
A SAFE is not a debt instrument nor a convertible note, although there may be similar features. However, a SAFE has no maturity date, meaning SAFEs remain outstanding until the specified event happens. There is also no right to interest on the monies invested – this can be of importance to investors if there is a long period between providing investment funds and the issuance of shares.
- Should you issue shares of the Company?
A common way to provide investors with an equity interest in a company is to issue shares (a type of security). Securities laws in Ontario apply to all issuances of securities, regardless of whether the issuer is a public or private company. A prospectus is a detailed disclosure document that issuers must prepare who want to offer securities to the public in Ontario. A prospectus must be filed with the Ontario Securities Commission every time a person or company distributes a previously unissued security. There are a series of exemptions that companies can use in order to avoid the necessity of having to file a prospectus and associated formalities. The default for Ontario securities laws is that every issuer must be registered. The Company would likely not need to register as, among other factors, it is assumed that Company is not “in the business” of advising on or trading in securities.
With regard to Company, the Private Issuer Exemption (PIE) and Family, Friends and Business Associates Exemption (FFBAE) should be considered. Both would allow the Company to distribute securities to certain persons without having to issue a prospectus. There are other, less onerous, formalities that one would still need to fulfill.
To use the PIE, the company must have less than 50 shareholders and must not have distributed shares to the public. The FFBAE is based on an investor having a close relationship with a principal of the issuer. The onus would be on the Company to establish that a close personal relationship exists with family members and friends. There are no limits on investment by family members and friends.
- Should you provide employee stock options?
Employee stock options are equity compensation given to employees of a company, allowing employees to purchase shares at a predetermined price for a number of years. An employee must usually have been employed for a certain length of time before the option can be exercised.
A stock option pool is composed of shares of a company that are reserved for employees to exercise. The amount of the stock option pool is negotiated by the parties. To note, the stock option pool represents a potential reduction in existing ownership rights and must be carefully set up. Unlike shares, stock options do not carry any ownership rights such as the right to receive dividends. They are a future right to buy shares at a predetermined rate.
What Should You Do?
Every case is dependent on many different factors. We encourage you to speak to a legal counsel to explore those options.
Some startups choose SAFE agreements mostly due to the ease and lower cost associated with such agreements. If there are close relationships and trust between all the parties, a SAFE agreement may be simplest way to receive investment funds. If family and friends want to receive shares at the same time as they provide investment funds, then the issuance of shares pursuant to the PIE and FFBAE exemptions can be considered.
Further, if you decide to issue shares, be mindful that the decision0making powers can change. For example, if family and friends were to be receive these shares, they would have decision-making powers with regard to the Company. Preferred shares should be considered by the Company, which would necessitate changing the share structure.
The contents of this article are not to be construed as legal advice. Contact Emerge Law’s lawyers for legal assistance. Should you require any assistance, please contact info@emergelaw.ca and book an appointment with one of our lawyers today.