Entrepreneurs need to be ready for due diligence, so it’s essential to involve legal advisors and accountants early in the process

Any entrepreneur raising significant funds from investors should be prepared for extensive investor due diligence, which will require (among other things) the preparation of a business plan, compiling financial statements and providing extensive legal information. It’s often essential to involve legal advisors and accountants early in the process to ensure that appropriate measures are being taken to prepare for negotiations, to help produce and/or review legal documents that will be required in the due diligence process and the financing and to lend credibility to the financing. With this in mind, here’s a run-down of financing structures available in Atlantic Canada.

Most entrepreneurs operate what is considered small and medium-size enterprises (SMEs, generally defined as businesses with fewer than 500 employees) and are a core component of the Canadian economy. In 2008, SMEs with fewer than 50 employees comprised 97.8 per cent of all businesses in Canada, and employed more than half of working Canadians.

This sector is diverse, spanning many industries and markets. The five-year survival rate for SMEs in 2006 ranged from 58 per cent for businesses with 50 to 249 employees, and up to 70 per cent for businesses with four or fewer employees.

Because of the financial pressures on SMEs during start-up and development, securing financing is often critical to their survival. Financing is an essential part of an entrepreneur’s business plan; it provides funds for buying assets (such as equipment and inventory), R&D and daily operating expenses. Depending on the stage of the company, the risk to the financier varies. For example, a start-up in the development stage with no income is a high risk; therefore, a high rate of return to the financier will likely be required.

Three main types of financing can be used to help grow a business: equity, debt, and convertible debt. A summary of each follows.

Equity
Equity investors provide funds in return for an ownership interest in the business. To receive equity investments, the business is typically set up as a corporation, a legal entity separate from the entrepreneur. Shares of the corporation may then be sold to investors, designated as common or preferred shares. Common shareholders generally have the right to vote on business decisions in proportion with their share of ownership. On the other hand, preferred shareholders may have limited voting rights but generally enjoy regular dividend payments in priority to the common shareholders. Another common characteristic of preferred shares is priority over common shares in the return of investment in the event of the corporation’s liquidation.

The particular mix of rights and benefits that attach to each type of share is determined by the corporation, and often the subject of intense negotiation with investors and shareholders. These rights are often set forth in a shareholders’ agreement or a management agreement.

Equity investing is considered riskier than debt, and common shares riskier than preferred. As a result, a higher required rate of return is required. Exemptions from prospectus and registration requirements of securities laws must be considered carefully. Some of these exemptions are mentioned in the discussion under sources of financing, and legal advice is necessary to determine if they’re available.

Debt
Debt financing comprises different types of loans, including demand loans, term loans, operating lines of credit, and bridge financing. A lender will make funds available to the business to be repaid according to the terms of the loan, plus interest. This is major component of financing for SMEs; about $148 billion in debt financing was authorized to SMEs in 2008.

The debt is typically secured against assets of the business. If the business stops making required payments or is otherwise not in compliance with the terms of the loan, the lender can generally choose from a number of remedies, including appointing receivers or seizing the assets to satisfy the debt. Similarly, the lender will often require the entrepreneur to give a personal guarantee for the loan, especially if the business has few assets and no cash flow. Many lenders are reluctant to lend if adequate security or guarantees are not available.

Convertible debt
Convertible debt is a middle ground between equity and debt. While the financing is initially in the form of a loan, which may or may not be secured, the lender will have the option to convert the debt, in whole or part, into equity. This type of financing may appeal to investors who want to minimize risk but would like the opportunity to participate in future profits and growth, or to traditional lenders who need the added potential return in order to accept the increased risk associated with the SME. An alternative structure often used to achieve the same result is a debt financing together with warrants issued to the lender providing an option to purchase equity.

John Roberts is lawyer with McInnes Cooper’s entrepreneurial services team, who advises start-ups, entrepreneurs, and mature businesses on business and corporate finance matters. This is part of an ongoing series authored by McInnes Cooper corporate specialists. The second part of this article on Investor Readiness will focus on the Atlantic Canadian program landscape. 

This column has been prepared for information and is not intended to be either a complete description of any issue or the opinion of our firm. McInnes Cooper should be consulted regarding any situation to which any topic discussed herein might apply.