For most early stage startups, capital is essential to reach key milestones and grow rapidly. If you’re new to the world of startup funding, read on to learn the basics on potential funding opportunities as your company scales.
Key Points:
- Startup funding in Canada can be broken down into two basic categories: dilutive and non-dilutive. Dilutive financing means capital is raised in exchange for a portion (equity) of ownership in the company, while non-dilutive funds are acquired without loss of ownership.
- SAFEs and convertible notes are ideal funding options for startup founders seeking capital after they reach their bootstrapping limits, but before they’re ready to pitch VCs in a formal equity raise. These two instruments enable an investor to provide capital that can be converted to equity at a later date.
- Venture capital is provided by investors into private companies and, in exchange, they receive an ownership stake in the business along with other provisions.
- Government grants require the startup to pre-qualify to receive the investment, while tax credits occur after the dollars have been spent by the startup. The most well-known program of this kind in Canada is SR&ED (Scientific Research and Experimental Development.)
- Venture debt is loaned to startups to extend runway before the next financing round. A startup should have recently completed an equity round and have an existing cash runway of more than 12 months before exploring this funding option.
The early days of building a tech startup from the ground up are anything but easy. First-time founders must quickly learn to navigate an unfamiliar ecosystem and a slew of startup terms and practices. Among the many competing priorities a founder faces, acquiring capital to help fund the company’s vision is one of the most challenging. Thankfully, there are many funding sources available for high potential tech startups.
But how does a startup acquire seed funding and where does one look? This article offers a breakdown of startup funding basics for first-time founders, along with insights on when and how to pursue them.
Why raise money for your startup?
Unlike a conventional company, tech startups launch with the intent to disrupt the market and scale quickly. Because of their accelerated pace of growth, startups are typically cash burning and unprofitable as they scale. That’s why very few startups can succeed without substantial seed funding beyond their own wallets. While personally financing a startup (also called bootstrapping) may be sufficient at pre-seed, and sometimes even seed, most founders soon realize they need to raise capital to maintain or accelerate momentum.
“There is no right or wrong when it comes to financing your startup, but you need to be strategic about it because the impact is long lasting. Choices you make today are going to impact tomorrow.”
How does a startup get funding?
There are no steadfast rules on when a founder should start seeking outside funding. While some startups can thrive without outside capital for a long time, others may need to acquire funding within the first year of operations.
“As your company ramps up and becomes more complex as it scales, different funders will come into your life cycle,” says Laith Shukri, Director of Early Stage Banking at RBCx. “There is no right or wrong when it comes to financing your startup, but you need to be strategic about it because the impact is long lasting. Choices you make today are going to impact tomorrow.”
Founders looking beyond their own finances for funding will need to communicate compelling reasons for lenders and investors to allocate their dollars to them. The level of expectations to get to ‘yes’ will depend on the source, whether it’s a family friend, government grant, an accelerator, or a venture capitalist. If a startup can’t establish a persuasive case, perhaps it’s not yet time to pursue funding from that particular source.
Founders should also be on the lookout for new opportunities that can arise at any time. The government may suddenly launch a new funding program with a narrow application window, or a VC may announce a new fund that allocates pre-seed or seed investments into startups. Keeping an eye on the startup ecosystem and talking to peers can help determine when is the ideal time to seek funding.
What are the main sources of funding for an early stage startup?
At its most basic level, startup funding falls into two categories: dilutive and non-dilutive. Dilutive financing means startup capital is raised in exchange for ownership (equity) in the company. This is typically done by issuing shares that decrease the ownership of existing shareholders (also referred to as dilution). Dilutive funding often comes with additional changes to the company, such as the need to meet investors’ expectations and providing them board representation. Founders who are resistant to reducing their ownership may instead lean toward non-dilutive financing. Types of dilutive financing include venture capital (VC) and angel investors.
Non-dilutive financing means capital is acquired without any loss of ownership of the company, but may come with fees and interest. Additionally, non-dilutive funding, like loans, may need to be repaid over a set period of time. Types of non-dilutive financing includes loans, grants, and tax incentives.
Personal investing
Startup founders typically rely on their own personal funds to start growing their initial idea into a viable business. While this can be financially challenging as for a cash burning startup, it also ensures the founder has complete autonomy over the business decisions. Bootstrapping also enables founders to concentrate exclusively on business growth, as acquiring capital is often time consuming and effortful.
Family and friends
Some founders may choose to receive funding through family or friends in the early stages of growth. This could require giving up equity in exchange for their capital or flexible repayment terms based on when the company becomes profitable.
Angel investors
Angel investors invest their own money into an early stage startup. These are usually wealthy individuals that provide seed money to promising companies in exchange for ownership, sometimes via SAFEs (Simple Agreement for Future Equity) or convertible notes. These are investment vehicles that require less paperwork than formal rounds and offer more flexibility to both the investor and startup.
SAFEs and convertible notes
SAFEs and convertible notes are ideal funding options for startup founders seeking capital after they’ve hit their bootstrapping limits, but before they’re ready to pitch VCs in a formal equity raise. These two instruments enable an investor to provide capital that can be converted to equity at a later date.
A SAFE is considered an equity instrument because the investor receives an ownership stake after the company completes a priced round. Whereas a convertible note is a debt instrument because it has an interest-bearing loan and a maturity date by which the note must convert to equity or be repaid. “These are basically like little IOUs where you kind of kick the pricing down the line up until the next institutional round,” says Laith.
Accelerators and incubators
Accelerators and incubators are organizations and programs that provide guidance and mentorship to help set up early stage startups for long-term success. They also offer a valuable network of investors and experts that can be a key asset as the company scales and seeks funding. Startup founders must apply for the programs, many of which have a set duration, and should expect to invest significant time to engage fully in the program. Some of these programs also provide seed funding.
Venture capital
Venture capital (VC) is a form of dilutive financing investors provide to private companies that demonstrate strong potential for growth and generating strong returns. In exchange for their capital, VC investors receive an ownership stake in the business along with other provisions, such as board representation.
For many startups, the first formal VC financing round is Series A, however, some VC funds invest in seed stage startups. To acquire venture capital, founders must first pitch to investors. If a VC signals interest in investing, it carries out due diligence on the company, and determines the valuation (the amount of money the company is worth). The valuation of the startup is outlined in the VC term sheet, along with all the financing details. Once the startup and investor agree on the term sheet, legal documentation will follow to finalize the investment. When the deal closes, the VC has equity in the company, is a shareholder, and may have a seat on the board, in addition to other provisions.
Government grants and tax incentives
The federal government of Canada and provincial governments give out billions of dollars each year to Canadian businesses ranging from grants to tax incentives to interest free loans. A substantial portion of that funding is for tech-based companies. Startups that pursue these opportunities stand to gain much needed capital to finance their scaling ambitions.
Canadian government grants
Grants can come from federal, provincial or territorial, and even municipal governments. They require the startup to pre-qualify to receive the investment. That means, to be eligible, startups cannot begin to incur any costs related to the funding request until the application is approved and awarded.
The application process for grants can be arduous and is often very competitive. Still, early stage startups that monitor the various grant opportunities, and invest the time to apply, stand to gain helpful financial assistance. An example of federal funding is the NRC-IRAP (National Research Council of Canada Industrial Research Assistance Program), which provides funding to support research and development projects by small- to medium-size businesses at various stages of the innovation cycle. Successful applicants receive a financial contribution to share the costs of the R&D project activities.
Canadian tax credits
Unlike grants, funds from tax credits are received after the dollars have been spent by the startup. The most well-known program in Canada is SR&ED (Scientific Research and Experimental Development), which offers tax incentives to encourage businesses to conduct research and development in Canada.
Over the previous three years, more than 20,000 SR&ED claims have been filed each year resulting in over $4 billion doled out annually via tax credits.
“Sometimes you have programs that have specific intake, so you might get an announcement a couple of weeks before, ‘we’re opening up an intake for this specific area, this specific eligibility criteria’ and you have six to eight weeks to apply for that.”
Eligibility and applying for government programs
Determining eligibility for the various government programs can be a huge task. “I encourage you to work with a service provider. I’ve seen companies decide they want to save money, so they do it themselves. It’s not as simple as you think, and the way you complete your short application does determine what the outcome is,” says Jigna Shah, Partner in Deloitte’s Global Investment and Innovation Incentives (Gi3) practice. After determining eligibility, the application process can be onerous. To complicate things even further, the incentives landscape constantly evolves.
“Sometimes you have programs that have specific intake, so you might get an announcement a couple of weeks before, ‘we’re opening up an intake for this specific area, this specific eligibility criteria’ and you have six to eight weeks to apply for that,” says Jigna. “So there’s that narrow window of opportunity that if everything checks off, then you can apply and hopefully have a good chance of getting some funding. And then there are those [programs] that are on a rolling basis.”
Business loans
As a cash-burning business in the early stages of growth, it can be challenging to access conventional bank loans. However, there are a number of programs that enable startups to acquire low-interest or no-interest loans. Programs may be limited to specific industries, geography, or other parameters. BDC, for example, offers non-dilutive financing to all varieties of businesses, with funds specifically tailored to tech startups.
Venture Debt
Venture debt is a loan that provides a capital injection to startups to extend runway in order to reach more milestones before the next financing round. A startup should have recently completed an equity round and have an existing cash runway of more than 12 months to be considered for venture debt.
Venture debt charges interest only on the money the company draws upon. While most loans are considered non-dilutive, venture debt can have a dilutive impact because it often comes with a nominal warrant. This gives the investor the right to buy company shares in the future at a pre-established price.
The value of venture debt is, “if you’re a fast growing company, then you’re able to raise at an even better valuation later,” says Laith, however he cautions it’s not right for every company. “Are you growing enough that you know you need this?”
Considerations to help maximize startup funding
There are multiple paths to funding for startups, from pre-seed to pre-IPO. Here are a few tips to help founders take advantage of all the potential sources of funding available to startups in Canada.
Maximize your non-dilutive funding options
Founders should maximize all the non-dilutive funding options their startup is eligible for, such as grants, tax incentives, and low-interest loans before seeking investments or loans through a VC or bank. Lenders and investors will likely ask if all the sources of non-dilutive financing have been tapped into. “Are you maximizing from this perspective before you go into dilutive? It shows up really well for a company looking to do a raise that you’ve done your due diligence and taken advantage of a number of these programs,” says Jigna.
Consider using a service provider with expertise in startup grants
The landscape of grants and tax incentives for startups is constantly evolving, and the process to determine eligibility and apply is challenging and time-intensive. You should use a service provider with expertise in your particular industry. “I’ve seen companies decide they want to save money, and do the work themselves. It’s not as simple as you think, and the way you complete your short application does determine what the outcome is,” Jigna says.
Look at the vintage of the VC fund
When the time comes to seek venture capital, look at the vintage (or age) of their fund because ”that should give you an idea of who has room to invest,” says Laith. Funds that are four years in probably don’t have much, if any, dry powder, remaining. “Dry powder is then reserved for later stage investments to beef up the IRR (internal rate of return).” Also, watch for announcements on new funds, because that could translate to an opportunity for an early stage startup.
Fundraising can take a significant portion of a startup’s time, but the results can be tremendously beneficial. While the effort to acquire funding is a necessary part of leading a successful venture, it’s also important to remain focused on the north star guiding the business. Ultimately, investors and lenders want to know the companies they invest in can stay the course, meet important milestones, and be relentless in their pursuit toward profitability.
RBCx offers support to startups in all stages of growth, backing some of Canada’s most daring tech companies and idea generators. We turn our experience, networks, and capital into your competitive advantage to help you scale and make a meaningful impact on the world. Speak with an RBCx Advisor to learn more about how we can help your business grow.
