S M L Reset to Default

Investor readiness - Part two

Regardless of the source of financing, an established independent board of directors or advisory board can help attract investors

by John Roberts

As outlined in the first part of this article, an entrepreneur raising significant funds from investors should be prepared for extensive investor due diligence, which will require (among other things) the preparation of a business plan, compiling financial statements and providing extensive legal information.

Involving legal advisors and accountants early in the process will ensure that appropriate measures are taken to prepare for negotiations, that legal documents required in the due diligence process and the financing are prepared and ready, and will lend credibility to the financing.

In this article, five categories of financing sources are discussed as well as applicable government programs available in Atlantic Canada.


 Personal savings, family, friends, employees, and directors
This is often the first source of financing and may be the least difficult to obtain, but it can lead to problems down the road. If an entrepreneur receives financing from friends or family, it can take the form of debt or equity (usually common shares). The due diligence, negotiation and documentation for this form of investment is often less onerous than the categories described below. This can cause tension in personal relationships down the road due to the risks and uncertainties associated with investing in early stage companies. This tension can be reduced by ensuring that all parties receive appropriate independent legal advice and the investment is properly documented.

Equity investments in entrepreneurial businesses incorporated in Atlantic Canada may be eligible for certain tax incentive programs. To increase the value of these types of investments, provincial equity tax credits (ETCs) are available to individual investors in qualifying businesses. These credits can be significant; in Nova Scotia, a maximum annual credit of $17,500 on a maximum investment of $50,000 during the taxation year is allowed.

Under securities laws, a company that distributes securities is required to file a prospectus with securities regulators. However, this requirement can be avoided in certain circumstances if an exemption is available. National Instrument 45-106–Prospectus and Registration Exemptions (the “Instrument”), as well as provincial securities legislation, contain available exemptions. Under the “Family, Friend, and Business Associates” exemption found in the Instrument, a prospectus isn’t required if the shares are issued to a director, executive officer, or founder of the company, or to family members (spouses, immediate relatives, grandparents, grandchildren), close friends, or close business associates of the director, executive officer, or founder.

A prospectus also isn’t required if the company is a “private issuer,” which is defined as a company that isn’t a reporting issuer or an investment fund; has restrictions on the transfer of its shares in its “constating documents” (shareholder agreements); whose shares are beneficially owned by no more than 50 people listed, not including employees; and has issued its securities to certain type of people to the Instrument.

Entrepreneurs should also be aware of the requirement under securities laws to be registered to trade in securities if they or their advisors are in the business of trading in securities or hold themselves out as being in the business of trading in securities. Generally, an entrepreneur with an active non-securities business does not have to register as a dealer if they:

  • do not hold themselves out as being in the business of trading in securities;
  •  trade in securities infrequently;
  • are not, or do not expect to be, compensated for trading in securities;
  • do not act as intermediaries’ and
  • do not produce, or intend to produce, a profit from trading in securities.

 
Angel investors and accredited investors
Angel investors are high net worth individuals who provide financing to entrepreneurs; many are entrepreneurs themselves, who use their expertise and industry knowledge to mentor those in which they invest. There are formal networks of angel investors, such as the First Angel Network, as well as informal networks. In addition, if the investors live in Nova Scotia, they may also qualify for the ETCs mentioned above.

Angel investors generally qualify for the “accredited investor” exemption form the prospectus requirement under the Instrument. Accredited investors include: an individual whose net income before taxes exceeded $200,000 in each of the 2 most recent calendar years or whose net income before taxes combined with that of a spouse exceeded $300,000 in each of the 2 most recent calendar years and who, in either case, reasonably expects to exceed that net income level in the current calendar year; and an individual who, either alone or with a spouse, has net assets of at least $5,000,000. Filings may be required under securities laws if an entrepreneur is relying on the accredited investor exemption.


Venture capital Funds
Venture capital funds provide financing for high-risk early stage businesses, frequently in high-tech industries such as biotechnology, IT or cleantech sectors. These professionally managed funds provide financing in exchange for an equity interest in high growth early stage businesses with a greater than average expected rate of return. Venture capital funds often have stringent investment requirements that many early stage growth companies fail to meet. In addition, venture funds will typically require a more active involvement in the business and impose more onerous restrictions on the business, to help ensure the success of their investment. Many entrepreneurs have difficulty ceding this level of control. This makes it extremely important to find the “right fit” with VC funds.

At the end of 2009, the estimated total of private equity and venture capital resources in Canada was $76 billion, with VC resources alone amounting to $14.9 billion. However, VC funds with operations in Atlantic Canada are relatively scarce. Some examples are GrowthWorks in the private sector and InNOVAcorp, NSBI Venture Capital, and the New Brunswick Innovation Fund in the public sector. Canadian Labour Sponsored Venture Capital Corporations (LSVCCs) such as GrowthWorks, which are sponsored by labour union investors also provide venture capital to entrepreneurs. In contrast to private venture capital funds, these retail LSVCCs offer generous federal and provincial tax credits to attract potential investors.


Government
There are numerous government programs that provide financing, often in the form of loans, to entrepreneurial businesses in Atlantic Canada. For example, the Atlantic Canada Opportunities Agency (ACOA) is a major lender to SMEs in all industries. Other government organizations and departments, such as the NRC Industrial Research Assistance Program (IRAP), will provide funds to SMEs in certain types of businesses, specifically those related to technology.

The Canadian government provides additional financial assistance to SMEs through tax incentives for R&D, such as the Scientific Research and Experimental Development (SR&ED) Tax Incentive Program, and awards supply contracts to SMEs under the Canadian Innovation Commercialization Program (CICP). Below is a brief overview of these programs.

  • ACOA: manages several different programs to aid businesses in Atlantic Canada. Some of these programs include the Atlantic Innovation Fund, which offers financing to projects in technical fields, and the Business Development Program, which provides interest-free loans to SMEs in most sectors. Other programs are targeted to certain business owners, such as the Women in Business Initiative and the Young Entrepreneur Development Initiative, or are designed to develop the export capabilities of businesses in Atlantic Canada.
  • IRAP: provides financial assistance to SMEs in Canada that plan to develop and commercialize innovative or technological services, processes, or products in Canada. NRC will look at the management and financial resources of the business and the prospects of the proposal to decide whether or not to provide assistance. In addition, NRC offers advisory services to businesses through IRAP, including technical and business advice.
  • SR&ED: allows Canadian businesses of any size and in any industry to earn tax credits for expenditures on R&D in Canada. To qualify for the credit, the work performed must “advance the understanding of scientific relations or technologies, address scientific or technological uncertainty, and incorporate a systematic investigation by qualified personnel.” If the business is a Canadian-controlled private corporation, or CCPC, it will earn a credit of 35 per cent on the first $3 million in expenditures and 20 per cent on any larger amount. Non-CCPCs can earn a credit of 20 per cent on these expenditures, regardless of the amount.
  • Nova Scotia: Financing used to be available to businesses in Nova Scotia through the Industrial Expansion Fund. This program was recently closed but the government has indicated there will be a replacement. In addition, Nova Scotia Business Inc. has potential funding programs.
  • CICP: Through the CICP, the Canadian government offers businesses with innovative products or services in the pre-commercialization stage a means to develop a supply relationship with federal government representatives. These businesses have the opportunity to reply to calls for proposals with products or services relating to environment, safety and security, health, or enabling technologies, providing a process to test and commercialize innovations outside of the larger marketplace.

The Canadian government also provides assistance to businesses through its Immigrant Investor Program, which allows prospective immigrants to make a non-interest-bearing loan of $800,000, which is managed by Citizenship and Immigration Canada and guaranteed by the provinces.


Banks
Term loans, demand loans and operating lines of credit are common types of loans made to businesses by traditional banks. In many cases, because of the high-risk nature of the business, traditional bank loans may not be available to SMEs or will be prohibitively expensive. To fill this gap, certain lending organizations are focused on providing financing to entrepreneurial businesses, such as Roynat Inc., the Business Development Bank of Canada and Community Business Development Corporations (CBDCs) in Atlantic Canada.

 
Ongoing obligations

After the first round of financing has been secured, an entrepreneur will normally have ongoing obligations under documents related to the financing, such as shareholders’ agreements for equity investments or the loan agreement. It’s important to assess these obligations, as well as the potential costs associated with compliance, with the help of professional advice before entering agreements and again after they have been signed. Entrepreneurs should also consider the effect these obligations have on their ability to obtain future financing to satisfy growth, expansion and ongoing operating requirements. Creating a plan for growing the business and assessing operating needs makes it easier to obtain financing in a timely manner. The involvement of advisors at this stage is key to developing the proper mix of financing.

Seeking financing for a start-up or development-stage SME can be a long arduous process. The success of an SME in obtaining sufficient and manageable financing depends on the SME’s investor readiness. Several organizations provide non-financial assistance to SMEs in the start-up and development stages, some of which are industry specific. Here are just a few examples:

 

John Roberts is a lawyer with McInnes Cooper's entrepreneurial services team, who advises start-ups, entrepreneurs, and mature businesses on business and corporate matters. This is part of an ongoing series authored by McInnes Cooper corporate specialists.
This column is prepared for information only and is not intended to be either a complete description of any issue or the opinion of our firm. McInnes Cooper should be consulted regarding any situation to which any top discussed herein might apply.

 

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