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Written by: Paul J. Leedham, CPA, CGA
As the saying goes, cash is king. For early stage technology companies still seeking to establish their business and build a market presence, entrepreneurs are primarily dependent on obtaining cash inflows through means other than revenue generation, such as through traditional financing avenues and government incentive programs. Beyond having raised funds from seed capital (likely from friends and family), the question arises of which particular financing alternatives are best to pursue – there are pros and cons to each alternative, with trade-offs often being made in order for entrepreneurs to achieve the desired result and maximize value.
Raising capital in the form of debt or equity can provide cash resources to companies relatively quickly, but there are potential drawbacks and risks that entrepreneurs must assess in order to ensure the best interests of their stakeholders and the business are being preserved. Debt financing, for example, has the benefit of preserving existing shareholder ownership interests within a company but must ultimately be repaid at a later date and usually with periodic interest payments that can strain available cash resources. Debt facilities which contain overly-strict operating covenants may impose financial and non-financial restrictions so adverse that it detracts from a company’s ability to operate as the entrepreneur had originally envisioned. Equity financing, on the other hand, does not have to be repaid and usually doesn’t contain restrictive operating covenants. However, depending on the form of equity financing (usually with preferred shares) there may be provisions which result in certain shareholders receiving a disproportionately high return on their equity investment upon eventual sale or change in control of the company in comparison to the founding entrepreneur.
There may also be periodic dividends payable to preferred shareholders. Finding the optimum trade-off between the particular benefits of raising capital via debt or equity in relation to the attributes that might present concerns in enabling entrepreneurs to achieve their original vision for the business can be challenging. These are only some of the merits and drawbacks that entrepreneurs must weigh when contemplating whether a debt or equity financing makes the most sense under the circumstances. In some cases, a mix of debt and equity financing might be viable and allow entrepreneurs the ability to raise the capital they need to grow their business while mitigating exposure to the drawbacks of each alternative which otherwise might have been experienced in isolation.
Entrepreneurs also need to consider the several government incentive programs available to technology companies which can be accessed in order to assist with financing operations, with a significant benefit being that such financing is generally non-dilutive to existing shareholders. Two of the more notable financing mechanisms in this area are obtained in the form of grants and tax credits. The National Research Council’s Industrial Research Assistance Program (“IRAP”) is one of the most often accessed resources by what are considered small and medium-sized enterprises (“SMEs”) to obtain Canadian grants, where many of these SMEs are emerging technology companies. Subject to meeting specified eligibility criteria for obtaining IRAP funding, qualifying technology companies have the opportunity to access non-repayable grants for either small or large scale technologically innovative projects. Examples of commonly accessed tax credit incentives include the Scientific Research and Experimental Development (“SR&ED”) program, which provides companies with an opportunity to claim either refundable or non-refundable tax credits depending on specific factors.
In addition, eligible companies that develop interactive digital media products in British Columbia may qualify for claiming the Interactive Digital Media tax credit which is fully refundable, subject to first being applied against any corporate income taxes payable. Technology companies can significantly benefit from these tax credit incentives through either conserving cash resources by reducing taxes payable in the case of non-refundable tax credits, or through receiving cash for refundable tax credits which can assist with working capital and other needs.
It is important for entrepreneurs to consult with their professional advisors when evaluating the different types of financing mechanisms available to their early stage technology companies, and to help achieve maximum value with the chosen route. Although a particular alternative may seem attractive on the surface, it may only meet short-term goals and be detrimental to sustained growth over the long-term and ultimately result in entrepreneurs not achieving their business objectives.
If you require additional information on this topic, please feel welcome to contact Manning Elliott Partner Paul J. Leedham for assistance at 604-714-3685.
The above content is believed to be accurate as of the date of posting. Tax laws are complex and are subject to frequent changes. Professional advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.