On July 16 2022, AAIA Board member, lawyer of Ontario, Shui Luo presented legal tool kit series specifically for startups considering foreign investment funds. The webinar introduced four aspects of foreign funds: 1) source of funding; 2) special requirements of foreign investors; 3) cross boarder restructuring; 4) special deal terms. The information delivered in this webinar and this recap shall not be used as legal advice.
1. Source of Funding
The speaker focused on funds from US and China, the two main sources of foreign funds for Canadian startups. According to VC statistics in Canada for Q1 2022 and 2021 from CPE Analytics, 57% VC investment for Canadian startups were from US, 15% were from other foreign countries, while 28% were from Canadian VC firms.
2. Special Requirements of Foreign Investors
- to maximize return of investment, foreign investors may request startup to move to the investor’s country from Canada. This request may come in different forms:
- Require startups to physically move to foreign countries
- Require startups to set up foreign subsidiaries
- Require founders to relocate
- Require setting up joint ventures with foreign entities
- Require licensing deals
There are specific consideration for each of the scenarios:
- Require startups to physically move to foreign countries –
- Benefit for Chinese investors include proximity to Chinese market, VC funds, and other local resources, which may make next round of financing easier and valuation higher
- Reasons for US investors to make this request include
- History reason: before 2010, clearance certificates were required by Canadian tax law when foreign shareholders transfer the shares; this hindered US investment to Canadian companies
- US tax laws used to set restrictions to VC firms who invest in foreign companies; the restrictions were removed later
- Main reason is proximity to market and access local investment
According to the speaker, the willingness of US investors to invest in Canadian startups is getting higher. It is also easier for Canadian companies to pursue investment in US, for example, Shopify went public on NYSE in 2015; Lululemon’s US subsidiary went public in Nasdaq.
The decision of moving company to US depends on needs of R&D; it would be less beneficial to relocate to US if main R&D teams remain in Canada, because the Canadian company would:
1. Loss Canadian Controlled Private Corporation (CCPC) status, and SR&ED tax benefit
2. Loss cost advantage – salaries for Canadian R&D labor force are lower than US
3. Loss connection with Canadian ecosystem
There are also flexible ways to meet relocation requirements, for example, keeping both foreign headquarter and R&D subsidiary as CCPC, which adds complexity to company management.
2. Require startups to set up foreign subsidiaries – this is relatively simple; the company’s headquarter remains in Canada as entity to receive investment, while the subsidiary can take advantage of foreign local market, as well as foreign government financial support.
3. Require founders to relocate to the foreign country — this requirement is normally made by Chinese investors when the Canadian company establishes headquarter in China as entity for receiving investment. If the founder prefers not to move, he/she needs to negotiate arrangement with the investor.
4. Require setting up joint ventures with foreign entities – normally requested by strategic investors; joint ventures offer special advantage and challenges to the startup, especially for young founders, collaboration with partners from foreign culture is not easy. Other challenges come with joint venture model include valuation of intangible assets.
5. Require licensing deals – traditional licensing can provide financial income for the startup, but the income may not come immediately and it is critical to ensure the technology is not easily reverse engineered. For startup, it is better to combine financing and licensing together, which offers immediate cash flow to the startup and connects the strategic investor with company management.
3. Cross Boarder Restructuring
- the Canadian startup which considers foreign investment may need to restructure company, establish foreign entity; overall, there are four major cross-border restructuring options:
- Canada holding company structure
- Foreign holding company structure
- Parallel structure
- Cayman structure
There are special considerations for each restructuring options. The speaker briefly introduced each of them:
- Canada holding company structure – Canadian company remains headquarter and entity for future IPO in US or Canada, and foreign subsidiary manages foreign market development, while all revenue goes to Canada holding company. Canada holding company may have the following concerns when dealing with foreign investment:
- If the investment is RMB fund from China, Chinese government has strict laws on currency management and the fund flow can be very lengthy;
- The company needs to ensure the investor is in compliance with according foreign security regulations;
- Foreign investment on Canadian company may trigger national security review in Canada
- Foreign holding company structure – Recipient of the investment is foreign holding headquarter, while the Canadian company is entity for R&D. The Canadian entity can not maintain CCPC status and SR&ED tax benefit.
If the Canadian company was incorporated before the foreign holding company and its valuation is high, when transferring shares to the foreign holding company, CRA will charge large amount of capital gain tax.
- Parallel Structure – the Canadian company and foreign company have same shareholders and share structures. The Canadian company can still enjoy CCPC status and tax benefit, while foreign company is flexible on financing.
The investor will have same weight on cap table for both Canadian and foreign companies when valuation of company is still low, and restructure Canadian company into the foreign company before valuation increase significantly to avoid capital gain tax problem.
- Cayman Structure – preferred by many Chinese investors. Investor and the founder incorporate a holding company in Cayman, which owns both Canadian company and the foreign company, and is the entity to receive funding/IPO. In this case, Canadian company is not CCPC and may be subject to foreign investment review from Canadian government.
4. Special deal terms for receiving cross-boarder investment
- Liquidation preference – Chinese investors normally request multiple + participation, while US and Canadian investors normally adopt no participation rights
- Dividend entitlement — Chinese investors normally request compounding dividend, which is not concern for US and Canadian investment deals;
- Anti-dilution – Chinese investment agreement normally include Full Ratchet Provision/Full-ratchet anti-dilution protection
- Redeemable – Normally not part of term sheets from US and Canada, but common for TS from Chinese investors.
At last, the speaker suggested to Canadian startups to:
- Take proper understanding and thorough consideration of the particular issues arising from receiving foreign funding
- Seek pragmatic and solid legal advice in both Canada and the according foreign country.