How Venture Capital Deals In Canada And America Differ

Thursday, July 12, 2007

Fredric Tannenbaum and David Chaiton, Practical Lawyer, http://

Abstracted from: Venture Capital Financing In The United States And Canada (Parts 1 and 2)
By: Fredric Tannenbaum and David Chaiton
Gould & Ratner, Chicago, IL (FT); Chaitons, Toronto, ON (DC)
Practical Lawyer - Vol. 53, No. 1, Pgs. 53-62 (Part 1); Vol. 53, No. 2, Pgs. 25-30 (Part 2)

Liquidation preferences.
The venture capital industries in the United States and Canada have each grown tremendously. American attorney Fredric Tannenbaum, an expert in private equity capital, and Canadian attorney David Chaiton, who specializes in corporate finance, demonstrate the similarities and particularly the differences in each country's system of VC financing.

US transactions tend to be larger than Canadian deals (averaging $10 million and $3 million respectively). Canadian investors, unlike their American counterparts, target early-stage companies, which results in lower returns. Almost all US venture transactions provide for liquidation preferences, sometimes in a multiple of the investment. The amount of the preference will differ if the investment participates in or is convertible directly into common stock. In contrast, investors in Canada usually hold convertible debt. Canadians most commonly provide mezzanine financing in the form of subordinated debt with an equity kicker in warrants. Canadian investors favor convertible preferred shares because of the liquidation preference, voting rights, and flexibility those shares offer investors. However, unlike in the United States, the parties to a Canadian transaction must also be mindful of Criminal Code Section 347, the federal usury law. In rare cases, courts have found that the overall rate of return on convertible debt violates this statute.

Dilution protection.
Venture capital investors in the United States generally want protection from dilution by investors in later rounds. Investors may negotiate for preemptive rights, entitling them to purchase a pro rata share of future offerings. US parties bargain over whether the rights will continue if the investor chooses not to participate in a later financing round. Antidilution protection can also include an adjustment in the conversion ratio if a later round is sold at a lower price. The full-ratchet method would reduce the conversion price of the earlier venture shares to the lower price of a subsequent financing. The authors advise founders to negotiate against full ratcheting, which may drastically dilute their shares and the shares of other stockholders not covered by antidilution protection. A fairer provision uses a weighted average price to reduce the conversion price in any later financing at a lower price. In Canada, the antidilution provisions often distinguish between dilution in value and dilution in ownership. Canadian venture capital arrangements also use the weighted average method to make the investor whole if there are down rounds of financing.

Differences in governance.
Venture capital investors often wish to control the board, the authors note, while founders and other earlier investors resist this. The venture investors usually are permitted to appoint at least one board member, and major corporate decisions such as a sale or merger may require the investor's approval. Venture investors may insist that their directors serve on the important board committees. If the venture investor is not represented on the board, it will want to have an observer attend board meetings and receive advance copies of board packages. Canadian boards generally have two investor directors, two management directors, and a director with industry experience, and several directors must be Canadian. US venture investors prefer to act in their capacity as stockholders rather than directors because there is no restriction on making self-interested decisions as a stockholder, as there is when a director makes a decision. Under Canadian law, shareholders might have the fiduciary duties of directors. Those who serve as observers and can speak at meetings may be held to be directors. Investors and founders generally negotiate the extent to which investors can be involved in other projects outside of the company. Founders argue that they should be able to pursue other ventures as long as doing so does not compete with the company and the founders are spending sufficient time to implement the business plan. Investors counter by negotiating for the right to participate in the founders' other ventures.

Exit strategies and investors' needs.
Venture investors are always concerned with how and when they will be able to dispose of their investment. Some investors negotiate the right to sell to a third party (with or without rights of first refusal by other owners), to cause the company to be sold, or to put their shares to the company. The put can be triggered by the passage of time or an event of default. On the other side of the table, companies negotiate a call for the venture shares, sometimes at a premium and with a shorter repayment period than the put generally has. Investors in Canada sometimes negotiate a discounted call in the event of insolvency, even though, the authors indicate, this generally would not survive a public-policy challenge in court.

Abstracted from Practical Lawyer
published by ALI-ABA Committee on Continuing Professional Education 4025 Chestnut Street
Philadelphia PA 19104-3099.

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