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.
Non-Canadian investors interested in these types of investments will find Canada to be a congenial environment, but they still need to be aware of a few important and distinctive features of Canadian law, regulation and market practice. The first post in this series looked at the distinction between primary and secondary transactions and reviewed some key Canadian taxation issues. In this second installment, we consider three more factors that can affect the structuring of growth equity investments into Canada:
- Regulatory review thresholds
- Canadian corporate considerations
- Key transaction documents
4. Regulatory Review Thresholds
Growth equity investments (typically minority investments) often fall below the thresholds for foreign investment reviews under the Investment Canada Act ("ICA") and below the notification thresholds for antitrust review under the Competition Act (see our Competition Law Overview for more information on current threshold levels).
Foreign investment review under the ICA is only triggered on an acquisition of control. An acquisition of control is "deemed" if an investor acquires majority voting control but only "presumed" if an investor acquires more than one-third (but less than a majority) of a Canadian company's voting shares. As a consequence, for growth equity investments falling between one-third and majority voting control post-investment, the parties must consider whether de facto control is being acquired for the purposes of determining ICA filing requirements. This concept of "control in fact" is not clearly defined, but is often understood as the ability to determine the strategic direction of the business, or to manage its day-to-day operations, including through the exercise of special voting rights, the ability to appoint directors or veto decisions, etc. In practice, a minority investment has been found to constitute control in fact where no larger voting interest is held by another person or group.
If control is being acquired and if the transaction meets certain financial thresholds, it may be subject to economic review, which would require the investor to demonstrate to the government, based on factors such as the nature of the acquired business and the identity of the investor, that the transaction is of "net benefit to Canada."
Investments by non-Canadians are also potentially subject to national security review under the ICA. Under this process, growth investments could potentially be reviewed even where they do not meet the control or financial thresholds for economic review. The national security process is initiated relatively rarely, with only 24 transactions receiving a notice of potential review or of immediate review in the 2020-21 year. Full reviews are rarer still, but when they do occur they take an average of 225 days to complete and – where a proposed investment is found to be injurious to Canadian national security – can result in the prohibition, abandonment or unwinding of a transaction, or in the imposition of conditions to its completion. However, reviews are becoming more common, with the number of national security reviews in the most recent year approximately equal to the number in the previous four years combined.
Transactions are particularly likely to receive close scrutiny under the national security framework where they involve specific sensitive technologies, sensitive personal data or critical minerals. Investors that are under state ownership or influence, or (more generally) whose countries of origin may be viewed as potentially hostile to Canadian interests, are also likely to be considered carefully.
Canada's Competition Act requires mandatory pre-merger notification if certain financial thresholds are met, but in the case of growth investments, these only need to be considered in respect of acquisitions of 35% or more of the voting shares of a private company or 20% or more of the voting shares of a public company.
5. Canadian Corporate Considerations
There have been recent initiatives in certain provinces, including Alberta and Ontario, to modernize their corporate statutes in the hopes of encouraging investment. Certain of these amendments, such as reduced thresholds for written shareholder approvals in Alberta and Ontario, and increased protections and flexibility for directors in Alberta, may make these jurisdictions more attractive for investors. Furthermore, most provinces, including Alberta, British Columbia, Ontario and Québec, have now eliminated resident director requirements, although such requirements continue to apply for corporations incorporated under Canada's federal corporate statute.
U.S. investors should also be aware that Canada does not have an equivalent to U.S. limited liability companies. For those accustomed to the flexibility offered by LLCs, for example, the ability with an LLC structure to create certain kinds of investment waterfalls at the portfolio company level, creativity may be required to achieve similar objectives with other structuring options in Canada.
6. Key Transaction Documents
While the model documents published by the Canadian Venture Capital & Private Equity Association ("CVCA"), which are based on the U.S. National Venture Capital Association models, have become ubiquitous on venture capital transactions in Canada, there is generally more variety in the style of documentation used in growth equity financing of later stage companies.
A key document in any financing of a private Canadian company is a unanimous shareholders' agreement. In most Canadian corporate jurisdictions, a shareholders' agreement signed by all shareholders is an effective way to set out how the company will be governed, as well as any agreements amongst the investors regarding the transfer and ownership of their shares, amongst other things. The core documents in a transaction generally include:
- the unanimous shareholders' agreement (often broken into 3 separate agreements if the CVCA's model is being followed);
- the preferred share terms;
- depending on whether a transaction is primary or secondary,
- the subscription, investment or share purchase agreement (primary transaction), or
- a master transaction or similar agreement, under which the target company agrees to the transaction steps and often provides representations and warranties in respect of itself and its business operations, together with any secondary share purchase agreements. (secondary transaction)
The final installment in this three-part series will look at:
- Shareholder approval considerations
- Employment considerations
- Corporate transparency
- The company's perspective
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.