When a tech worker joins a startup, the two sides usually strike
a bargain in which the employee accepts a reduced salary in
exchange for an interest in the company's equity. This bargain
is vital to the success of venture capital-backed companies. The
company preserves precious cash to fuel growth, and the employee
gets rewarded upon an exit (an IPO or sale of the business) —
typically by exercising previously granted options that enable them
to purchase shares at a fraction of their then current value and,
thereby, participate in the exit event as a shareholder.
However, exits can be a long time coming. The significant growth of
private capital as an alternative to seeking funding in the public
markets means that, on average, companies are staying private
longer. On average, they're staying private over twice as long
as in 2000. This creates a situation in which founders and
employees hold a valuable but illiquid, and possibly volatile,
asset. Reasonably, at some point while the company remains
privately held, these individuals may want to realize some of the
value of the company's success and diversify their investment
portfolio.
Secondary Sales
Company-sponsored secondary sales (we will simply refer to them
as secondary sales) offer a potential solution to this liquidity
problem. In a secondary sale, an existing shareholder, typically a
founder, employee or early-stage investor, sells their shares
directly to the investors. This is in contrast to a standard
financing round, also known as a treasury or primary issuance, in
which the company issues new shares (usually of a new series or
class) to investors. Of significance to all parties, including the
company, in a secondary sale, the company does not receive payment
for the shares purchased by investors — that flows to the
selling shareholders.
It is difficult to do a secondary sale outside of a
company-sponsored transaction for a range of reasons, including
rights of first refusal and the requirement for company approval of
any share transfer. However, even when the company is supportive of
a secondary sale, there are challenges to its implementation.
For one, founders and employees typically hold common shares, while
investors want to acquire preferred shares. In some instances,
particularly if a company is approaching an exit, an investor
purchasing preferred shares from the company may be willing to also
purchase some common shares from founders and employees, but this
is not common.
In the United States, secondary sales are more easily accomplished
than in Canada due to differences in the tax treatment of share
repurchases. In our experience, U.S.-style secondary sales often
consist of investors first subscribing for the desired preferred
shares. The company then uses the subscription proceeds to redeem
or repurchase (often by way of "tender offer") the shares
of the selling shareholders.
The Canadian tax regime often makes U.S.-style secondary sales an
inefficient transaction structure. In Canada, a selling shareholder
can often receive the amount of the redemption or repurchase price
equal to the "paid-up capital" (or PUC, as described
below) of the repurchased shares without being subject to taxation.
However, to the extent that the redemption or repurchase price
exceeds the PUC of the repurchased shares, the excess is deemed to
be a dividend paid by the company to the selling shareholder. This
deemed dividend is taxed as the shareholder's dividend income
and, for non-Canadian shareholders, is subject to Canadian
withholding tax. Depending on the circumstances, there can also be
adverse tax consequences to the redeeming company. This makes the
idea of a company redemption or repurchase in the form of a tender
offer a tax-inefficient transaction.
In contrast, where shares are instead sold to a third party (not
the company), the excess of the sale proceeds over the
shareholder's "cost" is generally taxed in Canada as
a capital gain. If the seller is Canadian, only half of a capital
gain is taxable and may actually be non-taxable to the seller to
the extent the seller is an individual able to utilize the
"lifetime capital gains exemption." Canadian resident
individuals are generally entitled to net gains realized on the
disposition of certain properties that can include shares of
"Canadian-controlled private corporations" subject to
certain criteria being satisfied. For 2023, this exemption is equal
to C$971,190 and is indexed to inflation.
Thus, a sale to a third party is often more appealing and, to avoid
the adverse tax treatment associated with a share repurchase or
redemption, a company may, depending on the circumstances,
facilitate a means by which common shares can be purchased by a
third party (providing the desired tax treatment to the seller) and
subsequently be exchanged by the purchaser for newly issued
preferred shares.
Paid-Up Capital
This alternative transaction structure is, however, sometimes
not without trade-offs due to the rules regarding PUC. PUC is a
Canadian tax attribute that is based on the corporate law concept
of "stated capital." Generally speaking, PUC is an
account of the amounts that a company has received on the issuance
of shares, determined on a class-by-class basis. Further, PUC for a
class of shares is averaged across all of the shares of that class.
Effectively, while a company is able to return the amount invested
free of tax, the amount available per share is determined based on
the total PUC for the class, divided by the number of shares of the
class. Consequently, a later purchaser of the shares at a higher
price will not receive the full tax benefit of the amount they
invested (if they receive returns of capital or the company
liquidates), as the PUC available to them will be determined by
both the amount they invested and the lower amounts invested by
earlier investors.
Further, on a subsequent exchange of purchased common shares for
preferred shares, only the historical PUC for the purchased shares
(generally much lower than the amount then being paid for the
purchased shares) is transferred to the PUC of the preferred
shares. This means the third-party purchaser gives up the benefit
of the full amount of the PUC to which would otherwise be created
in a direct purchase from the company.
Many investors (particularly non-Canadian investors, including
funds with non-Canadian partners) will want to discuss alternative
tax structuring to indirectly obtain shares through a secondary
transaction that would have PUC equal to the amount they paid in
the secondary. In some circumstances such tax structuring can be
accommodated. Canadian legal and tax advice should be sought to
determine if such structuring is appropriate in any particular
circumstance.
In addition to tax and legal consideration, there are other
practical considerations for the company, such as which
shareholders are entitled to participate in the liquidity event and
to what extent.
Other Considerations
A corollary to companies taking longer to go public is the significant growth in the number of large, privately held companies. Heightened investor interest, coupled with the increased seller desire for liquidity, has created a widely recognized opportunity to provide a more institutionalized solution than company sponsored secondary sales and complex restructuring transaction. In the U.S., some third parties are finding ways to create trading markets for the securities of large private companies or otherwise enabling shareholder liquidity through loan structures. These options are less well developed in Canada and are not a common solution at this time. There are, however, efforts being made to change this, including by some large, global financial services companies. For now, company-sponsored secondary transactions remain the path to shareholder liquidity prior to an IPO or acquisition of the company.
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