Common Equity Financing

The 101 on raising money for your startup using a Common Equity Financing as your investment instrument.

1. What is a Common Equity Financing?
2. Pricing and Scope
3. What is the Process?
4. Advantages of a Common Equity Financing
5. Frequently Asked Questions
6. Book a Common Equity Financing

 

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What is a Common Equity Financing?

A Common Equity Financing is an investment instrument for early-stage founders to raise pre-seed or seed capital from friends and family, business associates, employees, and accredited investors by selling common shares in their corporation. This is the ideal investment instrument for early-stage startups so long as a valuation for your company can be agreed upon.

Common shares are by far the simplest form of equity investment and come with several advantages. They align founders and investors with the same class of shares giving them both the same rights, preferences, or privileges, and simplifies the legal work required when compared to the sale of preferred shares. Additionally, due to their simplicity, common shares in priced equity rounds may be used at any stage of fundraising before a venture capital Series A investment.

Sometimes the concept of a “priced” round can seem difficult to achieve for early-stage companies that might not have the metrics or traction to confidently price their shares. Although the valuation step might seem confusing or difficult to justify, it is worth the effort for the added simplicity of the associated legal negotiations compared to SAFEs or Convertible Notes, especially when fundraising from friends, family, and colleagues. Further, many believe that SAFEs or Convertible Notes effectively by-pass the valuation issue until a later round of financing or an agreed milestone, however, when setting the valuation cap for Convertible Notes and SAFEs, the company has to complete a valuation analysis anyway.

 

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Pricing and Scope

Financing rounds can vary drastically depending on a variety of factors. We've outlined what a Common Equity Financing looks like on Goodlawyer to give founders more transparency and insight into the legal side of the fundraising process.

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What is the Process?

1. Book a call: Pick a time to discuss your Common Equity Financing with a Good Lawyer. They'll help you determine if it’s the right investment solution for you.
2. Design your round: Work with your Good Lawyer to design a Common Equity Financing that meets your business’ and investors’ needs. You might need to negotiate with your investors on the deal, especially if they are exercising their right to seek independent legal advice. One round of minor revisions following your negotiations is included in a Goodlawyer Common Equity Financing.
3. Secure the bag: Once you and your investors agree on the deal, you will receive a final copy of your investor materials, ready for use. It’s up to you to collect signatures and get that money!
4. Close the deal: After you’ve collected all the required signatures and investment funds, your lawyer will update your capitalization records and issue share certificates (or digital equivalent) to your new shareholders. Congratulations! You're funded!

 

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Advantages of a Common Equity Financing

Simplicity.

Common shares are by far the simplest of the early-stage investment instruments. They typically do not include any special rights, preferences, or privileges, and are a direct buy-in to equity so you don’t need to worry about loan interest or preferred terms like in a SAFE or Convertible Note.

Equality.

Some founders and investors like that they receive the exact same security. Their rationale is that this closely aligns the incentives between the founders and their earliest investors because they are all on the same playing field.

Cost.

The documents that the founders used to acquire their common shares at the company's incorporation (such as a Shareholder Agreement) can often be easily retooled for use with investors who are willing to purchase common shares, creating savings on legal fees. In addition, if there are sufficient common shares available for the investors, there is typically no need to amend and restate the company's articles or governing corporate documents, creating efficiencies and savings on legal fees.

 

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Frequently Asked Questions

How does the Goodlawyer Service Fee work?

Because we believe in transparent pricing, we make our best effort to be upfront about additional fees and how they are calculated.

Visit the Goodlawyer Service Fees page for a detailed explanation.

What is an Investment Readiness Assessment?

An Investment Readiness Assessment ensures your company is clean, your record-keeping is up-to-date and you are ready to efficiently close your investment round. Your Good Lawyer’s goal is to identify legal or procedural barriers to completing your investment round by checking things like articles of incorporation, shareholder agreements, share capitalization table (the “cap table” or list of who owns stock) and other documents. 

The information discovered by your Good Lawyer during the Investment Readiness Assessment helps to:

• Draft a high-quality subscription document
• Ensure compliance with applicable securities laws, governing organizational documents and other contractual restrictions

The principal topics of review covered by your Good Lawyer in an Investment Readiness Assessment are:

• Corporate structure — organizational documents, including certificates or articles of incorporation, amalgamation or continuance, by-laws and other organizational documents relating to your company. 
• Corporate governance — minutes of your company's board of directors relating to equity issuances, as well as any documents or contracts relating to shareholders, equity issuances or pre-emptive rights.
• Share capitalization — records relating to all holders of the issued and outstanding classes and series of shares in the capital of your company, including the date of grant, purchase, or transfer. All shareholder or similar agreements to which your company is a party.
• Convertible securities — records relating to all holders of warrants, stock options or any other securities convertible, exchangeable or otherwise exercisable for any class or series of shares in the capital of your company, including date of grant, exercise price, number and type of securities, expiration date, vesting terms, and any other significant term in relation to such rights or interests.
• Promised but unissued securities — records authorizing or granting shares, options, warrants, stock options (including all stock option plans and other equity incentive plans and any shareholder rights plans) or other rights or interests in your company.
• Shareholder voting and governance arrangements — records relating to outstanding proxies, voting rights agreements and voting trusts or other assignment of rights attaching to any securities of your company.

Are there any disadvantages to Common Equity Financings?

Some of the pros of a Common Equity Financing with common shares can also be cons depending on what your goals are. Equality and simplicity might actually be a drawback for some more sophisticated investors looking for preferred shares or privileges in future financing rounds. 

What is the difference between common shares and preferred shares?

Common shares are the most common form of ownership interest in a corporation. Common shares give their holders voting rights, the right to receive dividends when declared, and the right to a distribution of the corporation's assets on a liquidation or dissolution. Common shares do not have any special priority over your corporation’s assets. 

Preferred shares, on the other hand, give investors rights that the other shareholders in a company (like the founders and previous investors) don’t get. Primarily, they include a preference at the next round of fundraising or liquidity event like an acquisition or wind down. Other common preferred rights include things like special control rights, but there are many more rights that your investors might ask for. Talk to your Good Lawyer about including any preferred shares in your Common Equity Financing.

What is the difference between Pre-Money and Post-Money Valuation?

The value of your company before you take on external investment is called the pre-money value. The share price in a Common Equity Financing is the pre-money value divided by the number of new shares to be issued. 

Before an investor puts money into your company, that investor owns 0% of the pre-money shares. After accepting external investment, your new investors own a percentage of the post-money shares. For example, if your company’s pre-money valuation is $2 million and you accept a $1 million investment, your investor purchased 1/3, or 33%, of your company, not 1/2! If the pre-money value of your company is $3 million, a $1 million investment buys 1/4, or 25%, of your company.

Post-money value = Pre-money value + Money invested

% investor owns = Money invested / Post-money value

What are some common valuation methods for early-stage investment rounds?

Traditional valuation methods for established companies with stable cash flows (e.g. discounted cash flow, projections of future profits, asset value, book value) are totally inappropriate for valuing your company at an early-stage investment round. 

Valuations for startups at early-stage investment rounds must instead emphasize the value of a company's human capital, intellectual property, key reference accounts and solid strategic partners.

Here are some common methods by which experienced founders and angel investors determine and negotiate pre-money valuation ranges for early-stage investments in startup companies. 

1. Revenue multiple method

If your company has any revenues, you can establish a minimum valuation as a multiple of your revenue. 2–3X revenue is commonly accepted by angel investors for early-stage investment rounds. 

This method is commonly pushed by angel investors when evaluating an early-stage startup investment because it is easy to calculate and favourable to the investor. As a founder, however, you should be wary of this method since it assumes very low growth rates for your company and ascribes no value to the quality of your management team. Consider applying this method to determine the very bottom of your pre-money valuation range.

2. Market value method / Scorecard and risk factor summation methods 

Many angel investors argue that all interesting startups have essentially the same valuation at the very early growth stages (seed and pre-seed); typically, between $2.5 – 6 million. 

In many angel investors' eyes, your startup falls somewhere on this typical early-stage valuation spectrum depending on factors such as: 

• Strength of your business idea 
• Size of your market opportunity 
• Your prototype or MVP (Minimum Viable Product)
• Quality of your management team 
• Sales traction
• Strategic relationships 
• Value of your company’s Intellectual Property 
• Other investors on your capitalization table
• Other factors that might be unique to your startup

3. Discount to exit value (rate of return or venture capital method) 

This valuation method was originally created by Venture Capitalists and merchant bankers that provided bridge funding for a known exit. This valuation method is, generally, difficult to apply at an early-stage investment round because reliable exit prospects are rare for early-stage startups. Again, having a reliable line of sight on an exit with a relatively predictable valuation is critical for this pricing method.

If you expect to sell your company for $30 million within a reasonably predictable period of time, and your angel investor insists on a 5X return on their investment (ROI), we know your company’s maximum post-money valuation is $6 million.

Post-money valuation = Exit value [$30 million] / Minimum ROI [5]

If your company needs $2 million to hit the milestones required to achieve your anticipated exit, then your investor purchases 1/3 of your company.

% investor owns = Money invested $2 million/ Post-money value $6 million

How should I think about dilution and future investment rounds?

Your company may require multiple rounds of financing before it grows sustainably. Each additional round of financing will reduce, or dilute, the ownership positions of founders and prior investors.

Here’s a simplified investment scenario to illustrate: 

Your angel investors purchase $500,000 of equity at a pre-money valuation of $1.5 million for 25% of your company ($2 million post-money). You successfully grow the company, validating your business model and generating revenue to justify a new pre-money value of $8 million. 

Your company is now seeking an additional round of investment to further accelerate growth. Let’s assume VC-A invests $2 million for 20% of the company. If the Founders do not co-invest, they will be diluted down from their original 75% to 60%. Here’s the math: 

Original Ownership Stake % (75%) x (1 – Stake of New Investors (0.20)) = Diluted Ownership Stake % (60%)].

When the company grows 3X to $30 million, it becomes eligible for a Series B financing. Again, the numbers work well if VC-B puts in $15 million for 33% of the company. This will dilute the founders down from 60% to ~40% [60% x (1 – 0.333) = ~40%]. 

See a summarized breakdown of this scenario in the table below.

	Seed	Series A	Series B
Pre-Money Valuation	$1.5 million	$8.0 million	$30.0 million
Angel Investment	$500,000	—	—
VC-A Investment	—	$2.0 million	—
VC-B Investment	—	—	$15.0 million
Post-Money Valuation	$2.0 million	$10.0 million	$45.0 million
Founder Ownership	75%	60%	~40%
Angel Ownership	25%	20%	~13%
VC-A Ownership	—	20%	~13%
VC-B Ownership	—	—	~33%

Why am I limited in who I can take investment from for Common Equity Financings?

In Canada, securities laws state that any corporation, even a private issuer, must file and deliver a prospectus any time there is an issuance of securities (in this case, a round of financing). However, private issuers are exempt from the prospectus filing requirements so long as they issue securities to certain categories of investors: 

1. Employees, officers, directors or consultants
   Exempt from the prospectus requirement so long as participation in the distribution in each case is voluntary and they have not been coerced into investing
2. Family and friends
   Friends and family are individuals who know the director, executive officer, founder or control person well enough and have known them for a sufficient period of time to be in a position to assess their capabilities and trustworthiness 
   1. The relationship between the individual and the director, executive officer, founder or control person must be direct. For example, the exemption is not available to a close personal friend of a close personal friend
   2. An individual does not qualify simply because the individual is a relative, a member of the same organization, association or religious group, or a client, customer, former client or former customer of the issuer
3. Close business associates
   Close business associates are individuals who have had sufficient prior business dealings with a director, executive officer, founder or control person of the issuer to be in a position to assess their capabilities and trustworthiness 
   1. The relationship between the individual and the director, executive officer, founder or control person must be direct. For example, the exemption is not available for a close business associate of a close business associate 
   2. An individual does not qualify simply because the individual is a client, customer, former client or former customer of the issuer
4. Accredited investors
   An accredited investor is an individual, entity, or financial institution that reaches certain financial thresholds that enable them to invest in certain opportunities that are not legally available to ordinary investors. If the investor does not fit the criteria of 1, 2, or 3 listed above, then they must be “accredited” by meeting 1 or more of the following criteria
   1. An individual who, alone or with a spouse, owns financial assets that exceed $1,000,000. Financial assets include cash and securities, but do not include a personal residence
   2. An individual who owns financial assets that exceed $5,000,000
   3. An individual whose net income before taxes exceeded $200,000 in each of the last two most recent calendar years or whose net income before taxes combined with that of a spouse exceeded $300,000 in each of the two most recent calendar years and who, in either case, reasonably expects to exceed that net income level in the current calendar year
   4. An individual who, alone or with a spouse, has net assets of at least $5,000,000. Personal residences are included
   5. A person, other than an individual or investment fund, that has net assets of at least $5,000,000 as shown on its most recently prepared financial statements, where a "person" is defined as a corporation, trust, etc.
5. Persons, other than individuals, for an investment amount that is at least $150,000, where a “person” is defined as a corporation, trust, etc. and the investment is paid in cash at the time of trade

What materials should I have ready for Investors in my Common Equity Financing?

It really depends on the sophistication of your investors and how far along you are, but here is a list of some materials that we suggest founders prepare when seeking investment:

1. Investor materials 
   1. Business Plan or Executive Business Summary
   2. Slide deck — see FAQ note below
2. Organized minute book, specifically
   1. Incorporation documents
   2. Share Register
   3. Capitalization Table
   4. Shareholder Agreement
3. Intellectual Property (IP)
   1. Documentation relating to your corporation’s critical copyrights, trademarks, patents or other intellectual property
   2. IP Assignment Agreements
   3. IP Licensing Agreements
4. Financials
   1. Historical financial statements, if any
   2. Budgets and forward-looking projections
   3. Any recent tax filings 
   4. Tax and payroll numbers from the Canada Revenue Agency
   5. Any grant related documentation
5. Team information
   1. Founder & employee contracts
   2. Team biographies and resumes
6. Business development
   1. Sales pipeline (AKA deals in progress)
   2. Sales deck and any other marketing collateral (i.e. case studies)
   3. Copies of any commercial contracts in place
7. Media
   1. Press clippings
   2. Links to online coverage and reports from third parties
8. Other: any other relevant information

Does the information that we share with investors create any legal risk or consequences for my company or leadership team?

Under Canadian securities laws, corporations that market and sell their securities with the assistance of slide decks, investor presentations and/or marketing materials may be liable for statutory penalties and direct damages payable to the purchasers of their securities where such materials contain a misrepresentation. This risk of liability is known under Canadian securities laws as the “Offering Memorandum” risk. 

In order to avoid the Offering Memorandum risk when sharing company documentation and/or marketing materials with prospective investors, some corporations carefully limit the information they deliver to prospective purchasers and choose to present or share investor presentations rather than leaving them with a prospective purchaser. 

If you are using slide decks, investor presentations, and/or marketing materials to help market your business to prospective purchasers, take extra care of the following:

• Ensure your materials do not contain false or misleading statements that could be expected to have a significant effect on the price or value of your company’s securities

• Limit use of and/or reliance on future-oriented financial information, unless you have a  reasonable basis for presenting such information
• Update previously disclosed forward-looking information that is no longer accurate
• Limit exaggerated reports and potentially misleading promotional commentary

Finally, corporations should always include a representation from the investor in the subscription agreement that they did not receive an Offering Memorandum or other offering document.

Nextblock Global Limited (Nextblock) and their executive team learned about the Offering Memorandum risk the hard way, in 2019. In a settlement with the Ontario Securities Commission over misleading statements in materials provided to potential investors, Nextblock and their CEO agreed to pay administrative penalties of more than $1 million, including $300,000 personally from the CEO. Nextblock’s investor deck wrongly stated that four people in the blockchain industry had agreed to be advisors to the company. 

The Nextblock case is a clear warning to founders that false statements in your slide deck can result in liability for both your company and your executive team and that the associated penalties may be severe.

Will my Good Lawyer negotiate with investors on my behalf?

No. Your lawyer will draft the required documents based on the information provided about the business and the structure and economics of your Common Equity Financing. Your Good Lawyer will NOT represent the company in negotiations with any particular shareholder, founder, or investor. If requested, your lawyer will be happy to expand the scope of work relating to your investment round to manage investor negotiations, investment mechanics and closing matters.

Are Shareholder Agreements legally required?

Your company is not legally required to have a Shareholder Agreement in place. When raising early-stage investment capital with Goodlawyer, however, we recommend your corporation use a Shareholder Agreement to manage control matters among your new minority investors. Critically, your Shareholder Agreement should accommodate future minority investment and investors, while protecting the founders’ interests to efficiently manage the corporation’s operations. 

Learn more about Shareholder Agreements.

 

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