Ten Key Considerations for Growth Equity Investments in Canada: Part 1 | Stikeman Elliott LLP
As growth equity investment strategies gain prominence in global private equity fundraising and institutional capital allocation, we have seen an increase in this type of investment in Canadian companies, particularly by U.S. and other non-Canadian private equity and growth equity funds interested in mid-stage companies in software, technology and other high growth industries.
Growth equity transactions are material minority investments in high growth companies that are somewhere between the start-up and exit-ready stages. These types of investments typically take the form of preferred equity securities.
Non-Canadian investors interested in making these types of investments should be aware of some unique features of the applicable legal regimes and market practices in Canada. This three-part series looks at ten key considerations that can impact decision-making by growth equity investors and the structuring of their investments into Canada. The issues dealt with in this first post are:
- Primary vs. secondary transactions
- Maximizing paid-up capital (PUC)
- CCPC status considerations
1. Primary vs. Secondary Transactions
Growth equity investments can include primary investment transactions (where shares are purchased directly from treasury), secondary transactions (where shares are purchased from some or all of a company’s existing shareholders, sometimes with mechanisms to facilitate optionholder participation), or a combination of the two.
Any growth equity investment that involves a secondary component generally involves more structuring considerations. Nevertheless, including a secondary component can be a useful way for companies to provide liquidity to their existing securityholders, especially in the face of more challenging IPO and M&A markets. Secondary transactions also entail certain commercial considerations, which should be part of the advance planning and negotiations. Often best addressed while negotiating the term sheet, these considerations can include the structuring that may be undertaken to provide the selling securityholders or investor (or both) with a more tax-efficient position (together with the allocation of any risk in connection with such structuring), as well as the allocation of responsibility for the representations in connection with the business to be provided to the investor.
2. Maximizing Paid-up Capital
Paid-up capital (“PUC”) is a tax attribute of shares related to the amount paid to the issuer on subscription. PUC can be returned to investors without incurring Canadian tax – a particularly valuable feature for non-Canadian investors who might otherwise be subject to Canadian withholding taxes on distributions. However, PUC is aggregated across shares of a class (or series), so it is often important for up-round investors in a primary transaction to invest in a new class or series of shares in order to segregate their elevated PUC level.
Secondary transactions can also be structured to permit an investor to obtain elevated PUC, although that generally requires more steps, including the formation of a Canadian acquisition company to purchase the secondary shares and subsequently exchanging the shares of that acquisition company for a new class of shares of the target company (via certain customary transaction structures). Such share-exchange structures also offer a mechanism to give a new investor its bargained-for economic and other rights in the terms of a new class of shares.
3. CCPC Status Considerations
Non-Canadian investors in Canadian businesses should be aware that Canadian tax laws afford advantageous tax treatment to “Canadian-controlled private corporations” (“CCPCs”) and that the retention of CCPC status may significantly impact transaction structuring. Specifically, CCPC status may be lost if investors who are not Canadian residents are collectively considered to be in a position to “control” the private corporation.
The preferential tax treatment enjoyed by CCPCs includes enhanced and refundable R&D tax credits, reduced corporate tax rates, capital gains exemptions for individual Canadian-resident selling shareholders and preferential treatment of employee stock options. Losing CCPC status can therefore have measurable impacts on the cash flow of a business (particularly with respect to a loss of refundable tax credits). The target company may already have non-resident Canadian shareholders with the result that even a relatively modest additional investment from non-Canadian funds could tip the balance so that CCPC status is lost. It is important for non-Canadian investors to mindful of the impacts that different transactions structures can have on CCPC status and, if applicable, take those implications into account when evaluating a Canadian investment opportunity and/or negotiating the governance entitlements that would attach to such an investment.
The second and third posts in this series will look at:
- Regulatory review thresholds
- Canadian corporate considerations
- Key transaction documents
- Shareholder approval considerations
- Employment considerations
- Corporate transparency
- Working with existing shareholders