For US venture funds investing in Canadian businesses, the ?exchangeable share? deal structure has become almost routine. At its core, the exchangeable share structure is aimed at ?Americanizing? the Canadian company by inserting a US company as a holding company for the Canadian operating company. This positions the business to better exploit the large US sales markets, tees up the company for a possible IPO in the US and generally makes it easier to attract additional venture financing from US-based funds that are constrained from making cross-border investments or want to avoid some of the more problematic Canadian tax laws such as the infamous ?LLC trap? – sometimes called ?the 1940 Act bear trap.?
Few things in life are more painful than a tax recognition event.
Unfortunately, the Americanization of a Canadian company is not as simple as making the Canadian company into a whollyowned subsidiary of a US company, with everyone swapping his or her Canadian company shares for US company shares. The reason? Doing so would create at least one – and potentially two – substantial Canadian tax problems. The first problem is that, regardless of how the stock swap is structured, Canadian tax law makes the swap a taxable transaction to Canadian stockholders. For management teams and investors alike, few things in life are more painful than a tax recognition event without a contemporaneous liquidity event giving the stockholder the cash to pay the taxes. The second problem is that Canada's tax laws provide enhanced R&D tax incentives to emerging companies that are ?Canadian controlled? private corporations (?CCPC?). In general, to qualify as a CCPC, the Canadian company may not be controlled by non-residents or public corporations or any combination thereof. Making the Canadian company into a subsidiary controlled by a US company would almost certainly cause the Canadian company to lose its status as a CCPC and the opportunity to utilize such enhanced tax incentives.
The exchangeable share structure was developed to address these Canadian tax issues while still ?Americanizing? the business. In this structure, the stockholders of the Canadian company do not swap their Canadian shares for US shares. Rather, they keep their Canadian company shares and are granted the right to exchange at a later time their Canadian shares for economically identical shares in the US company. This exchange is designed to take place upon an IPO, a sale or other liquidity event that provides the exchanging holder with the liquidity to pay the taxes resulting from such exchange.
In this structure, the US-based venture fund makes its investment in the US company, and the US company immediately reinvests the funds in the Canadian operating company. Stockholder agreements and/or charter provisions set forth the governance of the dual companies, which can vary significantly from transaction to transaction. Typically, however, the respective companies are designed to ?mirror? each other, the US investor acquires effective veto rights over corporate actions and minority board representation and Canadian stockholders maintain control over a majority of the board of the Canadian company, which preserves enhanced R&D tax incentives.
This is all well and good, except for one important – and potentially fatal – fly in the ointment. Curiously, this problem is frequently overlooked, even by seasoned venture practitioners. The problem is that the US company may be an ?investment company? under the Investment Company Act of 1940, as amended (the ?1940 Act?), and, therefore, required to register with the SEC. For a venture-backed company, having to register with the SEC as an investment company is untenable. Registering under the 1940 Act is not only expensive and time-consuming, but the 1940 Act puts such severe regulatory handcuffs on the company that normal financings and operations become almost impossible. On the other hand, if a company is required to so register but neglects to do so, the effect can be even worse. Among other things, contracts made in violation of the 1940 Act are unenforceable and it may be difficult for an unregistered investment company to enforce any contractual obligations against anyone, be they investors, licensees, landlords or employees. Being an unregistered investment company can also pose a significant stumbling block to the US company undertaking a material corporate transaction, such as a merger, borrowing or security offering. The US company may not be able to make the standard representation that it is not an investment company under the 1940 Act, and it may also be difficult for its law firm to produce a legal opinion to this effect. As you can see, once contracted, the disease of being an unregistered investment company can be fatal.
Clearly, the only solution to this 1940 Act problem is to structure the deal in such a way that the US company is not an ?investment company. What might make the U.S. company an investment company in the first place? Simply the fact that the US company's assets are comprised primarily of securities of a Canadian company which is not a majority-owned subsidiary.
The definition of an investment company under the 1940 Act includes a company that holds 40 percent or more of its assets in investment securities (the ?40 percent test?). The term ?investment securities? is defined broadly and basically includes all securities other than government securities and securities of majority-owned subsidiaries that are not themselves investment companies. ?Majority-owned? in this context means ownership over at least 50 percent of the outstanding voting securities of the issuer. ?Voting security? means entitling the holder to vote for the election of directors. In an exchangeable share structure, if the US company does not have the power to elect at least half of the members of the Canadian company's Board of Directors, the Canadian company may not be a majority-owned subsidiary of the US company (within the 1940 Act definition) and securities of the Canadian company held by the US company may therefore be investment securities. Presumably, the US company would have few assets other than securities of the Canadian company, with the result that such Canadian company securities would normally constitute more than 40 percent of its assets.
There are some potential solutions to the 1940 Act problem. First, if the US company has 100 or fewer beneficial owners, it will not be an investment company whether or not the securities of the Canadian company are investment securities or securities of a majority-owned subsidiary. Such closely held companies are excluded from the definition of investment company under the 1940 Act. In practice, however, this exception may be of little utility as it can be expected that the US company would exceed 100 beneficial owners. For this test, each holder of the US company's outstanding securities other than short-term paper – whether stock, options or otherwise – would be counted. The exchangeable share structure requires that each shareholder of the Canadian company be issued shares in the US company. As a result, Canadian companies with broad-based employee ownership could normally be expected to exceed 100 owners. In addition, the US company may also need to count the limited partners of its venture fund investors. The attribution rules of Section 3(c)(1) of the 1940 Act require that any holder of 10 percent or more of the US company's voting securities that is itself a private fund be ?looked through? for purposes of counting beneficial owners. Since most venture funds in these deals can be expected to each own 10 percent or more of the US company, their limited partners would be included in determining the 100 owner limit.
Since the 100 owner exception would most likely be unavailable, perhaps the best practical solution to the 1940 Act problem is to make the Canadian company the US company's majority-owned subsidiary squarely within the 1940 Act definition. This can be accomplished by providing the US company with the power to elect at least half of the Canadian company's board. Thus, simply issuing 50 percent of the Canadian company's voting securities to the US company, with a resulting 50-50 split between the US company and the original Canadian company shareholders to elect directors, will suffice. So long as there are no other non-Canadian or public corporation shareholders of the Canadian company holding voting securities, this structure should also preserve the Canadian company's status as a CCPC. CCPC status merely requires the absence of control by non-Canadians or public corporations, which standard will be met if Canadians control the power to elect at least 50 percent of the directors.
For a number of reasons, it may be difficult to structure a transaction so that voting securities are split evenly between Canadian shareholders and the US company. For example, if the actual investment by the US company in the Canadian business is greater or less than 50 percent of the Canadian company. Alternatively, an otherwise equal split may be upset if the Canadian company issues securities in the future to employees or others. However, the 1940 Act analysis does not necessarily require that the US company hold 50 percent of outstanding voting securities. What is important is that the US company has the power to determine half of the Canadian company's board. The staff of the Securities Exchange Commission construes the definition of voting security broadly for this purpose. The staff has stated, among other things, that the definition includes the de facto power based on facts and circumstances to determine, or influence the composition of, an issuer's board. Thus, the Canadian company should generally be considered a majority-owned subsidiary of the US company (for purposes of the 1940 Act) if the US company has the power, by contract or otherwise, to determine 50 percent of the Canadian company's board whether or not it actually holds 50 percent of the Canadian company's outstanding voting securities. In this analysis, generally only the power to elect directors is important and other voting rights (e.g., to approve a merger) are disregarded.
Of course, in most exchangeable share transactions the power to determine the board is unlikely to match the actual economic investment by the venture fund in the Canadian business as a result of the competing 1940 Act and CCPC issues. In cases where the venture fund is acquiring a majority of the economics of the Canadian business, the exchangeable share structure results in a diminution of voting power as compared to the actual economic investment that is a significant departure from the typical venture deal. In the typical deal, the venture fund has control of the board commensurate with its economic investment. An exchangeable share deal requires that a venture fund be satisfied with control over only half of the board. Thus, it is critical in such deals that the agreements relating to the conduct of the Canadian business clearly provide the venture fund with contractual rights sufficient to protect its investment. Practitioners should be aware, however, that overly favorable rights provided to the venture fund directly or through the US company can put a Canadian company's status as a CCPC at risk. As a rule of thumb, significant veto rights can be provided to the US venture fund. However, to the extent that the venture fund or US company has significant power to act unilaterally with respect to the Canadian company, it may result in the Canadian company being controlled by non-Canadians with a resulting loss of CCPC status.
For venture funds and companies contemplating an exchangeable share deal structure, one thing is clear. It is important to involve an experienced 1940 Act lawyer in the process as early as possible, certainly before any documents are drafted and develop a life of their own. With some careful thought at the design phase, it is much simpler to craft a deal structure that works and that minimizes any 1940 Act risk.
Stephen O. Meredith is a partner in the Private Equity and Venture Capital practice group of Edwards Angell Palmer & Dodge, a law firm with a special industry-based focus in the financial services, insurance and reinsurance, life sciences, education, airport, technology and private equity/venture capital sectors. He may be reached at: firstname.lastname@example.org. John C. Molloy, Jr. is a partner with Edwards Angell Palmer & Dodge and head of the firm's investment management practice group. He may be reached at: email@example.com.
The co-authors wish to thank Sharon A. Bennett with Gowling Lafleur Henderson LLP for contributing to this.