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Tax and legal changes affecting private equity

The year 2000 was another record year for Canadian private equity says Smith Lyons LLP. And, with tax and legal changes on the horizon, 2001 looks set to be even better.

Canadian private equity and venture capital activity reached record volumes in 2000. Figures released in March 2001 by the Canadian Venture Capital Association showed that dollars invested reached C$6.3bn - more than double the C$2.7bn recorded in the previous year. Needless to say, this level of activity saw some interesting developments, some new players and new funds, continued strength in the labour-sponsored sector and changes in the legislative and regulatory environment.

THE YEAR IN REVIEW
During the past year, venture capital pools have been closely associated with the high-tech sector centred largely in Toronto, Ottawa (‘Silicon Valley North'), Waterloo (perhaps the ‘Next Silicon Valley North'), Montréal, Calgary and Vancouver.

Notwithstanding the March/April 2000 public market meltdown in the sector, and perhaps because of it, the Canadian Venture Capital Association forecast that - based on results prepared by Macdonald & Associates - year 2000 venture capital investment would attain ‘dramatically higher records' both in amounts invested and number of financing rounds over 1999.

A noticeable trend developed whereby institutional equity funds appeared to step up to the plate when the spring market correction caused scheduled IPOs to falter. Indicative of this was the investment by the merchant banking arm of Ontario Municipal Employees Retirement System (OMERS), one of the largest Canadian pension funds, in the publicly announced C$157.5m private placement in September 2000 of equity shares in ClientLogic Corporation. ClientLogic had filed a registration statement with the SEC and a preliminary prospectus with the OSC in April, but decided to pull its filings after tech stocks fell out of favour in the spring. OMERS, along with other pension funds, Mosaic Venture Partners and various high net worth individuals, also participated in the publicly announced C$46m second round financing, in September 2000, by Skulogix.

Venture capital partnerships were quite successful during 2000 in raising funds from merchant banks and high net worth individuals. Indicative of such success were the closings in Toronto of JL Albright III Venture Fund in May (which raised over C$100m) and Brightspark Ventures, an incubator fund, in March (which raised US $40m). There was also the successful public offering of common shares and warrants in the spring by itemus, a rapidly expanding hybrid of software developer, service provider, and venture capital investor (or in the jargon of the industry, an internet accelerator). On the flip side, things have never been better for tech company entrepreneurs. For example, in November, Hyperchip of Montréal cobbled together $100m in its third round of financing - a deal believed to be the largest-ever infusion of venture capital for a private Canadian tech company.

New players/new funds
‘Capital breeds capital' seems to be the current mantra in the venture capital industry. For example, at the same time as companies such as Research in Motion, Open Text Corp and Descartes Systems Group, all in Waterloo, have begun making a name for themselves, and enlarging the pool of capital available for start-ups, US-based companies, such as Cisco Systems Inc. and AOL have invested their capital in local companies and enriched company founders, who have reinvested in other start-ups. And that has bred venture capital partnerships such as Waterloo-based Venture Labour Capital Partners, formed to target pre-revenue companies too advanced for angel investors and too early to access institutional private equity. It's the same story in Ottawa (witness the existence of the Ottawa Capital Network, which operates an investment matching service, helping emerging advanced technology companies access early-stage financing from local private investors), Vancouver (GrowthWorks Capital, which manages the $450m Working Opportunity Fund) and Toronto (witness the creation in late 2000 of a new internet site www.venturedrive.com, which allows entrepreneurs to pitch their ideas to investors for a fee).

Other successful fund launches in 2000 included Ventures West Management Inc., which raised C$200m for a new venture capital fund that invests in early stage technology companies, XDL Capital Corp which raised C$140m, McLean Watson Capital, which raised C$116m and EcomPark, which received C$57m in financing. These domestic venture capital funds were supplemented by announcements from some of Silicon Valley's most powerful venture capital firms - such as Mohr Davidow and Greylock Partners - that they planned to invest hundreds of millions of dollars in the Ottawa region. This was also in addition to announcements by industry players establishing corporate investment programmes or venture capital arms, such as telecom giant Telus Corp announcing a minimum C$50m commitment to invest in emerging technologies; and the ever present Business Development Bank of Canada, which announced in October 2000 that its BDC Venture Capital Group planned to invest more than C$120m of venture capital into emerging businesses annually.

Labour-sponsored funds
A unique feature of the Canadian venture capital industry has been the existence of the federal government's controversial labour-sponsored venture capital corporation program under the Income Tax Act (Canada) and related provincial registration programs for labour-sponsored investment fund corporations, such as that in Ontario under the Community Small Business Investment Funds Act (Ontario).

Industry experts estimate that labour-sponsored funds account for more than half the venture capital assets under administration in Canada and some have called for the elimination or phase-out of tax credits as the corporate and private sectors step up to the plate. Others however are concerned that the pension funds have not yet sufficiently moved into the venture capital sector to justify the elimination of labour-sponsored funds. For example, according to press reports in November 2000, of the C$2.3bn of venture capital raised in Canada in 1999, only one per cent came from pension funds. Compare this to the US where pension funds represented 25 per cent of the US $45bn industry in 1999.

In the meantime, the Income Tax Act (Canada) provides that individuals resident in Canada and annuitants under qualifying trusts that are first purchasers of labour-sponsored fund shares are eligible for a federal tax credit equal to 15 per cent of the purchase price to a maximum credit of C$750 a year based on an investment of C$5,000 a year. Investment by a Registered Retirement Savings Plan (RRSP) in such shares entitles the RRSP to increase its ownership of ‘foreign property' held in the RRSP by, generally, three times the cost of the investment to a maximum of 45 per cent in 2000 and thereafter, 50 per cent of the total cost of the RRSP property. In addition, many provinces have corresponding tax credits, such as in Ontario, where the Income Tax Act (Ontario) parallels the Income Tax Act (Canada) in providing a provincial tax credit equal to 15 per cent of the purchase price to a maximum credit of C$750 a year based on an investment of C$5,000 a year. In addition there are both federal and provincial penalty tax provisions applicable to labour-sponsored funds failing to meet minimum and maximum levels of investment in eligible businesses.

CHANGES IN THE LEGISLATIVE/REGULATORY ENVIRONMENT
The legislative and regulatory environment for private equity and venture capital continued to be favourable during year.

General
There is no legislation in Canada comparable to the state of California's recent Business and Professional Code provisions, providing a statutory right to ‘job hop' by employees (by limiting the enforceability of non-competition agreements and by permitting employees to bring residual know-how to new employers) coupled with California's non-subscription to the ‘inevitable disclosure doctrine', which makes employer injunctions difficult. Accordingly, venture capitalists in Canada continue to enjoy a greater sense of security in the enforceability by investee companies of non-disclosure/non-competition covenants from high-tech employees.
Changes in taxation of capital gains

Holders of equity securities in Canada receive a capital gain (or capital loss) on the disposition of their interests to the extent that the proceeds of disposition exceed (or are exceeded by) the adjusted cost base to the holder and any costs of disposition.

Generally the cost base is equal to the subscription price paid. Three-quarters (reduced to two-thirds in the federal February 2000 budget) of any capital gain or capital loss will be the holder's taxable capital gain or allowable capital loss, as the case may be. In a federal mini-budget introduced in October 2000, the inclusion rate for capital gains was further reduced to a half from two-thirds. However, with the dissolution of Parliament in late October, the tax proposals contained in pending legislation, as well as the activity to advance the tax proposals announced but not contained in pending legislation, basically died on the order paper. These proposals are likely to be re-introduced in the House of Commons since the party introducing the changes was re-elected with a majority. These proposals will have a positive impact on direct equity investments by taxable institutions and individuals as well as on the continued development of venture capital partnerships.

Changes in taxation of options
As a partial response to criticisms that Canadian high-tech employers were having trouble attracting and retaining qualified employees in the over-heated worldwide labour market for such employees, in the February 2000 budget the federal government recognised the increasing importance of share ownership and stock option plans for recruiting and retaining key employees. It proposed postponing taxation on C$100,000 a year of qualifying employee stock options for publicly-listed shares. Instead of taxing the benefit in the year of exercise, the benefit will be taxed when the shares are sold. Again, when reintroduced and passed in the House of Commons, these changes will improve the climate for venture capital investment in Canadian high-tech and other companies better able to compete with US rivals.

Changes in securities regulation
There were a number of proposed changes to the securities regulatory environment in 2000 that would affect the private equity and venture capital industry, both in terms of private placements of securities by companies seeking investment as well as on resale and escrow of securities by investors.

Exempt Distributions
In September, the OSC published for comment Proposed OSC Rule 45-501 - Exempt Distributions. In its release, the OSC stated that it was ‘taking significant steps to revamp and streamline its regulations to make it easier for small and medium-sized businesses to do private placements'. If implemented, the proposed rule would introduce three new exemptions to replace some of the current exemptions and would facilitate smaller companies raising capital without a prospectus:

• Closely held issuer exemption: issuers would be permitted to raise a total of C$3m, by way of any number of financings, from up to 35 investors, and there would be no restriction on the number of issuers' employees who would be able to acquire securities under an incentive plan. Any closely held issuer with more than five stockholders would be obliged to provide potential investors with a standard information statement containing a required list of questions.
  
  
• Family member exemption: issuers would be permitted to issue securities on an exempt basis to spouses, parents, grandparents or children of its officers, directors and promoters.
  
  
• Accredited investor exemption: issuers would be permitted to raise any amount at any time from individuals meeting financial asset (C$1m) or annual income (C$200,000) thresholds. ‘Accredited investors' would also include companies, trusts and partnerships with assets of at least C$5m and mutual funds whose prospectuses disclosed that the fund might purchase securities under the proposed rule.

The most common existing exemption, the so-called ‘sophisticated investor' exemption, requiring a minimum purchase price of C$150,000, would be repealed and replaced with the new exemptions, which would be more consistent with the US private placement rules under Regulation D to the Securities Act of 1933.

Resale of Securities
Also in September, certain members of the Canadian Securities Administrators (CSA) (including Ontario but not Québec) published for comment Proposed Multilateral Instrument 45-102 - Resale of Securities. The purpose of the proposed instrument, according to the CSA, is ‘to harmonise certain provincial and territorial resale restrictions imposed on subsequent trades of securities initially acquired under an exemption from the prospectus requirement.' The proposed instrument is based on the ‘System for shorter hold periods for issuers filing an AIF' (the SHAIF System) in use in Alberta and British Columbia. The SHAIF System permits a reduced hold period for resale of exempt securities where the issuer has a current AIF and has satisfied other conditions.

The proposed instrument provides for a four-month hold period for securities acquired under a private placement exemption where the issuer is a qualifying issuer at the time of the initial distribution. A ‘qualifying issuer' is a reporting issuer in any one of several listed provinces, who is an electronic filer under SEDAR, who has filed a current AIF, and who either has a class of equity securities listed or quoted on certain specific exchanges or outstanding securities that have received an approved rating. A 12-month hold period would be imposed for securities acquired under a private placement exemption where the issuer is not a qualifying issuer.

For securities acquired under a seasoning exemption, including the first trade in previously issued securities of an issuer that has ceased to be a private company or private issuer, there is no prospectus requirement for resale where the initial distribution was made by a qualifying issuer that has been a reporting issuer in any one of several listed provinces for at least four months. The seasoning period for securities of an issuer that is not a qualifying issuer is 12 months.

The proposed instrument also attempts to harmonise distributions from control blocks (generally over 20 per cent of the outstanding voting securities of an issuer) and trades in securities of a non-reporting issuer over a foreign exchange or market.

Escrows
The CSA also published Notice 46-301 announcing its intention to develop for comment a national instrument relating to a proposal for uniform terms of escrow that would apply to IPOs. Securities regulatory staff will be guided by the proposal in exercising their discretion to accept escrow arrangements consistent with the proposal in lieu of escrow arrangements under existing policies.

The Toronto Stock Exchange (TSE) has expressed its support for the proposal and has stopped scrutinising and, in some cases, disallowing, pre-IPO options granted at a discount to the IPO price. Instead, the TSE will treat options granted prior to the date of the preliminary prospectus as equity securities for the purpose of determining the number of securities, if any, to be escrowed.

These developments will be of interest to venture capital investors who are caught as ‘related security holders' because they often hold more than ten per cent of a class of equity stock. The proposal clarifies which securities are to be escrowed, which principals are captured by the escrow requirements and which issues are subject to escrow. Generally speaking, the proposal also allows shorter escrow periods and faster releases.

Conclusion
Industry experts at the time of publication were forecasting dramatic increases in both the number of venture capital deals completed as well as amounts raised per round and in total for the industry. With favourable legislative and regulatory changes proposed in 2000, many of which are likely to take effect, 2001 should easily surpass previous records.

Reprinted with the kind consent of the author, Nicholas Dietrich, of Smith Lyons LLP, Toronto, Canada, and the International Financial Law Review www.iflr.com

Smith Lyons private equity practice group covers merchant banking, venture capital and institutional equity funds. Smith Lyons represents early-stage companies, the institutional equity funds and merchant banks that foster their development and the investment banks that act as agents in private placements, IPOs and M&A transactions. Representative clients on the investment side include two of three largest pension funds in Canada, the merchant banking divisions of three of the ‘big five' Schedule I Banks and two of the largest life insurance companies in Canada. Contact: Nicholas EJ Dietrich; phone: 001 416 369 7288; e-mail: nejdietrich@smithlyons.ca

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