Raising capital is the lifeblood of any startup, because it takes money to turn an idea into an actual product, and even more money to turn that product into a fully-operational business that can begin scaling. Capital raising is one of the core components of any start-up’s strategic planning, and it is thus important for a business to conduct that process with a clear idea of the goals it wants to accomplish and the trade-offs between the different methods of capital raising.
Equity and Debt
Broadly, capital raising can be divided into equity and debt financing.
Equity financing refers to issuing shares in exchange for money from investors, whereas debt financing refers to loans that borrow funds from financial institutions or individuals that must be paid back at a pre-determined deadline and with a set rate of interest.
Within these categories, there are many different types of arrangements that can be pursued, such as different classes of shares or debt that is secured against physical assets, known as collateral.
For Québec start-ups, it is important to pay attention to the rules that apply to your corporation, because different legal requirements are imposed on the business depending on whether it is incorporated provincially under the Québec Business Corporations Act (QBCA) or federally under the Canada Business Corporations Act (CBCA).
For instance, federally incorporated companies can operate in any province and can likewise choose any province to establish their head office, though they will have to register an address in which they conduct business. Québec incorporated companies must maintain a head office in Québec.
Additionally, there are different naming requirements associated with incorporating federally or in Québec. The federal pathway uses the National Business Name Search (“NUANS”) system to track business names and prevent overlap, while Québec’s Enterprise Register is a distinct database. Further, Québec requires business names to be in French. Note that federally incorporated businesses operating in Québec still have to register with the Enterprise Registrar and conform to Québec’s naming and language requirements.
Finally, federally incorporated companies must have Canadian residents for at least 25% of their directors, while Québec imposes no residency requirements on directors for corporations incorporated provincially.
Comparing Debt and Equity
Raising money through the issuance of equity creates a legal relationship with the corporation because the investor becomes a shareholder and can exercise certain rights within the corporation, such as the right to vote on certain decisions, including the appointment of board directors, and the right to receive a share of the profits. Issuing equity can dilute the control of the founders over the company and give others control, depending on the proportion of their holdings.
Equity investors are exposed to higher risk, as the entirety of their investment could disappear if the business fails and is wound-up. Equityholders have rights to the remainder of assets once a company is wound-up or liquidated, but their repayment rights are subordinate to the rights of creditors.
The benefit of equity is that there is no limit to the potential upside. Individual shares, especially if traded on the public market, can fluctuate dramatically in value, leading to large returns.
In contrast, issuing debt creates a contractual relationship where the lender is classified as a creditor. There are no rights regarding the operation of the corporation that are attached to loan agreements, and the terms of the contract will dictate the rights and obligations of both the corporation and the lender.
Debt offers investors lower risk, as creditors have priority over equity holders. In the event of a bankruptcy or the winding up of a corporation, secured debt, which is attached to a specific asset, comes first, followed by unsecured creditors, who are each entitled to a share of the remaining assets of the corporation.
This limited risk is offset by capped returns. Since debt is negotiated at a certain rate, investors are aware of exactly how much they will earn from lending and when they will be repaid.
Raising Capital After Provincial and Federal Incorporation
While there are small distinctions in the powers corporations have to issue equity under the QBCA or CBCA, particularly relating to partially paid shares, there is quite a bit of common ground. For instance, shares give shareholders basic rights that must be included:
- The right to vote at shareholder meetings;
- The right to receive dividends;
- The right to receive the residual amount left after dissolution, once creditors and other claims are paid.
Issuing Shares and Securities Legislation
Under both acts, the board authorizes the issuance of shares by resolution.
Under the CBCA, the shares must be issued for “consideration,” which means that something must be given in exchange for the shares (CBCA s. 25(1)). This can include money, property, or past services, so long as non-monetary consideration is of fair equivalent value. Importantly, shares must be paid in full (CBCA s. 25(3)).
The QBCA mirrors this rule, but allows for partly paid shares (QBCA s. 53). This could provide more flexibility for start-ups to structure their equity to maintain founder control of the corporation even if those founders are unable to invest money immediately. Importantly, the board of directors can call on the shareholder to pay all or part of the unpaid amount and failing to pay the owed amount can result in the shares being confiscated (QBCA ss. 75-80).
Securities Legislation
Corporations that do business in Québec are required to issue a prospectus, which is a detailed snapshot of the company’s financial statements, senior leadership, strategy and projections for the near term, as well as information about the classes of shares being offered, to potential investors when issuing shares as financial securities under the Québec Securities Act. However, private issuers (that is, companies with fewer than 50 shareholders) shares that are issued to family members, friends and business associates are exempt from this requirement under s. 2.5 of the Règlement 45-106 sur les dispenses de prospectus, giving start-ups some flexibility in raising money from the immediate networks of their founders.
However, issuing shares is a technically complex process, and careful documentation of exceptions is necessary to avoid significant penalties for non-compliance. Start-ups that are considering issuing shares should speak to both legal and accounting professionals to ensure good record-keeping and that proper protocols are followed.
SAFEs
A simple agreement for future equity (SAFE) is a type of contractual agreement with an investor that is well-suited for start-ups that are at a pre-valuation stage. A SAFE will generally outline the terms of the upfront investment and set a milestone, such as receiving a patent or getting a product to market, and will specify how many shares the investor will receive once that milestone is met.
This gives start-ups access to capital immediately without having to value their corporation, while still allowing investors to make longer-term investments in early-stage companies that have clear growth potential.
Debt Financing
Unsecured Debt
Debt that is unsecured is not registered against a specific asset. These commonly include loans or lines of credit, and carry higher interest rates because there is no right to take possession of an asset if the corporation defaults on the loan.
Secured Debt
As explained above, secured debt is a type of debt that holds an asset as collateral. This means that, if a corporation fails to pay back the debt, the lender can take possession of the collateral and sell it to pay the balance of the loan.
In Québec, secured debt is governed through the registration of hypothecs, which the lender must publish in the Registre des droits personnels et réels mobiliers (RDPRM).
A hypothec is the right of the creditor to take the property upon default of the debtor (art. 2660 CCQ). Since there is a right being conferred to the creditor to seize assets in case of default, the interest rates associated with a secured loan tend to be lower.
Convertible Debt
Convertible debt, similar to a SAFE, is a flexible type of debt arrangement that begins as a regular loan. However, as part of the loan agreement, the corporation and the lender agree that the debt can be converted into shares at a later date at a specified price.
Convertible debt agreements can be negotiated to include any number of conditions, such as the ability of a corporation to unilaterally force the lender to convert the debt to equity if the share price is higher than the convertible price in the agreement for a specified amount of time.
Convertible debt instruments are generally considered securities and are thus governed by additional requirements, including filing obligations and stringent eligibility criteria, under the Québec Securities Act.
Conclusion
Raising capital is one of the most consequential legal and strategic processes a business will undertake. Whether through equity or debt, and whether incorporated under the QBCA or CBCA, each choice carries distinct consequences for control, compliance, and complexity. With sound legal planning and the right corporate structure, founders can raise money confidently while preserving flexibility and control.
Incorporation needs will vary from business to business. Answers to specific questions should be determined with the advice and assistance of a lawyer.
Useful Resources:
- Book a Consultation – Compass Legal Clinic
- Canada Business Corporations Act
- Loi sur les sociétés par actions (Québec Business Corporations Act)
- Convertible Debentures and SAFEs: Advantages and Disadvantages for Startup Financing – McMillan LLP
- Businesses and Non-Profits – Éducaloi
- Entrepreneurship Programs – McGill Dobson Centre for Innovation
- Vous voulez solliciter des investisseurs pour faire croître votre entreprise? – Autorité des marchés financiers
This blog post is authored by students of McGill University’s Faculty of Law. The content of this blog post is provided for general informational purposes only and does not constitute legal advice. The authors are students and are not acting as lawyers or legal professionals. Reading this blog post, or contacting its authors, does not create a solicitor-client relationship. Laws and regulations vary by jurisdiction and may change over time, and the information provided in this blog post may not be current or applicable to your particular circumstances. You should not act or refrain from acting based on this content without seeking advice from a qualified legal professional regarding your specific situation.