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Welcome to Part 4 of our series, Legal Fundamentals for Canadian Technology Startups. Our aim is to provide a practical legal roadmap for launching your Canadian tech startup. Don't miss out on Part 1 Exploring Business Structures for Canadian Tech Startups: Sole Proprietorship and Partnership, Part 2 Exploring Business Structures for Canadian Tech Startups: The Corporation, and Part 3 Seed Financing 101: Understanding SAFEs and Convertible Notes for Tech Startups
Our series has so far explored financial instruments crucial for startup growth phases, including SAFEs and Convertible Notes. These instruments are essential in early stages where a startup’s valuation is yet to be established. We now shift our focus to a cornerstone of later-stage financing: priced rounds and preferred shares.
Understanding the Startup Financing Ecosystem: Trends and Insights
A deep dive into priced rounds and preferred share financing necessitates an understanding of the broader Canadian tech startup ecosystem. Despite a 34% decrease in venture capital investment to $6.9 billion across 660 deals in 2023, data from the Canadian Venture Capital and Private Equity Association (CVCA) shows that investment levels remain higher than those recorded in 2019 and 2020. This trend indicates a cautious but significant commitment within the VC sector, suggesting a gradual realignment with pre-pandemic investment patterns.
Kim Furlong, CEO of CVCA, anticipates a continued focus on AI and cleantech sectors, along with a careful approach to VC investing in 2024. The emphasis on profitability over mere growth indicates a mature, discerning investment landscape.
AI investments, in particular, are highlighted as a strategic priority. For entrepreneurs exploring fertile financing avenues, YC Combinator's Request for Startups identifies 20 sought-after concepts, with AI in Robotics taking the lead. This is exemplified by Figure, a robotics company, securing $675 million at a $2.6 billion valuation. For more insights into VC trends, consider following my LinkedIn for daily updates.
Now, let’s delve into Startup law 101: priced rounds and preferred share financing.
Startup Law 101: Priced Rounds Explained
Priced rounds represent a crucial milestone in a startup's funding lifecycle, typically occurring when investments exceed $2M. These rounds involve significant changes in terms and financing structures:
Series A is initiated once a startup demonstrates measurable traction, evidenced through revenue generation and customer base expansion.
Series B financing is typically sought when a startup has successfully established product-market fit.
Series C often represents the final financing stage before a startup contemplates an Initial Public Offering (IPO) or acquisition.
Series D may be pursued to enhance valuation pre-IPO or to capitalize on emerging opportunities requiring additional funding.
At these stages, a startup undergoes "pricing," where it negotiates and establishes a valuation on its company. This valuation in turn activates any preceding SAFEs or convertible notes from pre-seed or seed financing rounds. Unlike earlier rounds, however, preferred shares are the legal instruments used for priced rounds. Venture Capitalists (VCs), who generally lead these later rounds, insist on these preferred shares because of the enhanced protections that they afford in terms of equity ownership. Preferred shares are expensive because they need to be closely negotiated and entail significant legal documentation.
Startup Law 101: Delving into Preferred Shares
Preferred shares differ from common stock or shares because they offer some preferential treatment to the investor. These “preferences” can be manifested in different ways and include a variety of different rights. While this list is not meant to be exhaustive, some of the more common rights are as follows:
Liquidation Preferences: Investors often negotiate liquidation preferences to ensure they recoup their investment before other shareholders in the event of a sale or liquidation. The current market tends to set the liquidation preference at "1x, non-participating," which means that investors get back their investment amount but do not participate in further distributions.
Anti-dilution Protections: To protect against dilution in future funding rounds, investors will negotiate anti-dilution clauses. These provisions adjust the conversion price of preferred shares if new shares are issued at a lower price, ensuring investors maintain their ownership percentage
Conversion Rights: Preferred shares are often convertible into common shares at the investor's discretion, potentially upon specific triggers such as an IPO or by mutual agreement. Optional conversion rights are generally non-negotiable and allow an investor to convert their share of preferred stock into common stock on a one-to-one-basis.
Dividend Rights: While not always a focus in startup financing, preferred shares may have provisions for dividends, which are usually non-cumulative and paid only if declared by the board
Voting Rights: These rights modify the voting rights of the preferred shareholder relative to common shareholders and contingent upon agreement and negotiation. As for what's market, VCs often negotiate for terms where all shares vote together as a single class on an "as-converted basis." As-converted basis means they do not require separate approval from preferred stockholders to approve changes like an increase in authorized common shares.
Protective Provisions: These provisions typically require that a certain percentage (often a majority, but sometimes a supermajority) of the preferred stockholders vote to approve certain actions. Some actions that are typically included are dissolving the company, taking on debt, and changing the size of the board.
Drag-along Rights: These rights enable majority shareholders to force minority shareholders to join in the sale of a company, ensuring all can benefit from a collective sale.
The Term Sheet
These preferential terms and conditions are included in a term sheet, which is the most important document that is negotiated during a priced round. The details of how to properly negotiate a term sheet is significant. The blog Strictly Business put out a comprehensive 20 part series on this matter.
On the other hand, if you are a visual learner and would like to see a typical model document of a term sheet, the Canadian Venture Capital & Private Equity Association provides a free model term sheet, updated to November 2020.
Pro forma cap table
When negotiating a term sheet, you should also be developing a pro forma cap table for the entire round. The pro forma cap table is designed to show you what your equity looks like post-financing. It’s advisable to built it up at the term sheet stage because, as negotiations evolve, you can see the impact of the adjustments on your equity interest post-closing.
A pro forma cap table will normally include the shareholder, their title, the amount of stock owned, the type of stock owned, the equivalent of the preferred stock in common stock, the full diluted percentage owned, and stock options and warrants.
Conclusion
Navigating the intricate landscape of venture capital financing, particularly when it comes to the nuanced world of preferred shares and priced rounds, requires a strategic blend of legal insight, market understanding, and negotiation acumen.
For Canadian technology startups poised at the brink of significant growth phases, comprehending the mechanics of these financial instruments is not just beneficial—it's imperative for forging successful paths forward.
By equipping yourself with this knowledge and partnering with seasoned legal advisors like Andrew Roy Legal, you're setting the stage for informed decision-making that aligns with your startup's vision and financial realities. As the Canadian tech ecosystem continues to evolve, staying informed and agile will be key to navigating the venture capital landscape, maximizing growth opportunities, and steering your startup towards a prosperous future.
Reach out today for a free consultation and see how we can help you.
This article is intended for informational purposes only and should not be considered as legal advice and does not establish an attorney-client relationship. Consulting with a qualified legal professional is recommended for specific legal concerns and requirements related to your business.
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