For most early stage startups, seed capital is essential to helping them reach key milestones and scale rapidly. So is knowing the various funding opportunities available and how to harness them.
Key Points:
- Funding can be broken down into two basic categories: dilutive and non-dilutive. Dilutive financing means capital is raised in exchange for a portion (equity) or ownership in the company, while non-dilutive funds are acquired without loss of ownership.
- After successfully raising venture capital, startups usually get a valuation that determines what the company is worth, while non-dilutive sources, such as grants and loans, do not. There are other instruments which help founders raise capital without an immediate valuation, such as SAFEs (Simple Agreements for Equity), and Convertible Notes.
- Government grants require the startup to pre-qualify to receive the investment, while 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.)
- Fundraising is an onerous and time-consuming process for early stage startups, however the use of a service provider can be immensely valuable when applying for government grants and tax credits.
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. Among the many competing priorities a founder faces, one of the most significant is acquiring capital to help fund the company’s vision—not an easy feat for cash-burning companies. 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 seed funding basics for first-time founders, along with insights on when and how to pursue them. The content is based on the RBCx Early Stage Banking webinar, Funding 101: Where to Find Capital for Your Startup, featuring Jigna Shah, Partner in Deloitte’s Global Investment and Innovation Incentives (Gi3) practice and Laith Shukri, Director Ecosystem Engagement at RBCx.
Why raise money for your startup?
Unlike a conventional company, tech startups launch with the intention to disrupt the market and scale quickly using innovative technology. Because of their accelerated pace of growth, startups are typically cash burning and unprofitable as they scale during those early stages. That’s why very few startups can succeed without substantial seed funding beyond their own pockets and those of families and friends. While 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.
When does a startup fundraise?
There are no steadfast rules on when a founder should start seeking outside funding. While some startups can thrive by bootstrapping for a long time (even until IPO), others may need to acquire funding in pre-seed.
“As your company ramps up and becomes more complex as it scales, different funders will come into your life cycle,” says Laith. “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.”
When founders look outside their inner circle of family and friends for funding, they’ll need to be able 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 government grant, an accelerator, a venture capitalist, or other source. 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 investments into startups. Keeping an eye on the startup ecosystem and talking to peers can help determine when is the ideal time to seek seed capital.
What are the main sources of funding for an early stage startup?
At its most basic level, startup funding can be broken down into two categories: dilutive and non-dilutive.
What is dilutive financing?
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 lean toward non-dilutive financing, instead.
Types of dilutive financing include: venture capital (VC), angels, and accelerators.
What is non-dilutive financing?
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, awards, and tax incentives.
Dilutive funding
What is venture capital?
Venture capital (VC) is a form of dilutive financing provided by investors into private companies that demonstrate strong growth potential and the ability to generate a strong return. In exchange for their capital, VC investors receive an ownership stake in the business along with other provisions, such as board representation.
“Venture capital is generally understood to be the riskiest asset class, and failure is built into the (VC) model,” says Laith. “For every 10 startups that raise, basically you can expect a sizable number of them to shut down or to be writeoffs within a VC portfolio.”
For many startups, the first formal VC financing round is Series A. However, Laith says there are an increasing number of VC funds investing in seed stage startups across Canada. 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 startup valuation (the amount of money the company is worth). The valuation of the startup is outlined in the VC term sheet, along with all of the financing details. Once the the startup and investor agree upon the term sheet, legal documentation will follow to finalize the investment. Once 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.
“It directly impacts your ownership of the company and your ability to control, manage, and run your company, so these are things that you should actually think about,” says Laith.
What’s a startup accelerator?
Accelerators 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. 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 accelerators also provide seed funding.
What are angel investors?
Unlike VCs, 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. Instead of an exchange of capital for equity in the company, some angels may use SAFEs (Simple Agreement for Future Equity) and convertible debt. These are investment vehicles that require less paperwork than formal rounds, and offer more flexibility to both the investor and startup.
SAFEs and convertible debt
For both SAFEs and convertible debt, a valuation of the business is not required. In the case of a SAFE, valuations are delayed to a future date, usually after the startup has raised capital and increased in value. The investor can then convert their investment to common shares at a cap or discount.
Convertible debt (or convertible notes) is an interest-bearing loan and, similar to a SAFE, also postpones the valuation. Rather than repay the full debt amount (and interest), startups can give the investor the option to convert the loan to equity at a discount if certain conditions are met (usually when the company raises qualified equity financing.)
“So these are basically like little IOUs where you kind of kick the pricing down the line up until the next institutional round,” says Laith.
Download our RBCx Canadian Resource Guide for Startups for a list of useful early stage articles, Canadian government funding programs, incubators, accelerators, and tech communities.
Non-dilutive seed funding
Government grants and tax incentives for startups in Canada
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.
The government invests significantly in the following sectors, from both an R&D perspective and an incentives perspective:
Aerospace
Agriculture
Advanced manufacturing
Clean tech
Automotive
IT
“That doesn’t mean if you don’t fit into one of these six buckets that you’re not eligible for funding,” says Jigna. “But we’re trying to emphasize that if you do have a technology or if your company is developing products that fit into one of these buckets, then you likely have quite a bit of funding available to you from a non-dilutive perspective.”
Sectors that the Canadian government prioritizes for incentives and grants.
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 has been approved and awarded.
The application process for grants can be arduous and is often very competitive. That being said, 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) that offers tax incentives to encourage businesses to conduct research and development in Canada.
“The largest funding source for Canadian companies, over $3 billion is given out to Canadian companies every single year and over 21,000 companies take advantage of this program,” says Jigna. “It’s a really lucrative program for Canadian companies that are doing what is deemed eligible from a research and development perspective.”
Because it’s funded by the CRA (Canada Revenue Agency), claimants must submit their SR&ED claim with their income tax return for the year. This will reduce the claimant’s income tax payable.
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,” Jigna says.
“Keep in mind, as a first time claimant, you’re more than likely to get audited by the CRA. It doesn’t really matter what the size of your claim is… having a good service provider that understands the work that you do and can help you with the backing of your work during a CRA audit is super important.”
After determining eligibility, the application process can be onerous. To complicate things even further, the incentives landscape constantly evolves. “There are a number of different buckets that we would typically look at from an incentives perspective,” says Jinga. “So when we’re having conversations with companies what we’re saying to them is, there are certain triggers that we would normally use to identify whether you’d be eligible for programs.
“Sometimes you have programs that have specific intake, so you might get an announcement a couple of weeks before, hey, 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.”
Zero-interest or low-interest 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 a program 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, says Laith, is “if you’re a fast growing company, then you’re able to raise at an even better valuation later.“ But he cautions it’s not right for every company. “Are you growing enough that you know you need this?”
Multiple funding paths
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 seed funding available to early stage startups.
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, and 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.
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