FINANCING GROWING TECHNOLOGY COMPANIES
Reference Handout1
Queen’s University Entrepreneurial Summit March 12, 2004
Peter B.B. Tobias
Viner, Kennedy, Frederick Allan & Tobias LLP Barristers & Solictors 27 Place d’Armes, Box 116 Kingston, Ontario (613) 542-8190 ptobias@vkfat.on.ca
Nothing in this document should be taken to be or relied on as legal advice. Readers are urged to seek professional legal advice on the particular issues which concern them. Members of our firm would be pleased to assist readers with specific legal issues.
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© Peter B. B. Tobias 2003-2004, all rights reserved.
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Today’s Objectives ' Identify typical stages of growth company financing $ $ $ $ $ $ $ ' founder funding and contribution of value friends, family and existing business contacts third party angel or seed investors broad exempt offerings by offering memorandum institutional investors and venture capital capital pool companies or reverse take-overs fully marketed initial public offering
Address typical legal and business issues that arise at each stage $ $ $ $ $ access to capital and securities exemptions dilution of control, value and earnings and methods of expression of these changes practical and legal investment minimums listing requirements on junior exchange ongoing reporting requirements to support secondary trading
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Identify the combinations of financing alternatives available and related costs and benefits $ $ $ important to match method with amount sought and proposed use increasing numbers of shareholders increases benefits but also costs the correct time to use a public company structure
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Founders funding and contribution of value - people acting as joint contributors, risk takers or ‘promoters’ of the business opportunity $ $ $ $ $ $ $ $ $ business plan development market research product development intellectual property computer and operating equipment money motivations are personal and economic investment horizon varies, but is longer than most investors trade of shares or securities to the founders and promoters are exempt from the requirements for a prospectus and registration costs depend on the complexity of the arrangements between the founders and any regulatory compliance in the market area of activity - and the extent of intellectual property protection, patent and trademark requirements generally, costs are contained at this stage
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Friends, family and close business contacts - people who trust the founders or to whom the founders would be morally bound to make full disclosure of the business risks and rewards and are not part of the ‘public’ $ $ $ $ early stage or pre-seed funds invested on the basis of belief in and connection with the founders in a majority of cases this kind of investment is made before making any commercial sale often made without a clear understanding of the current or potential value of the business regularly the investors do not demand a significant shareholding, voting control position or significant representation on the board usually invest in common shares or the same class of equity held by the founders often there is no formal shareholders’ agreement investment horizon is indefinite or tied to the founders’ needs - generally not concerned about liquidity trade of shares or securities to friends, family and close business associates must be made on an exempt basis often under the ‘accredited investor’ or ‘closely held’ exemptions it would not be unusual to incur legal advisory costs, accounting and tax advisory costs and filing fee costs in the range of $10,000 to $20,000 at this stage, again depending on the complexity of the business, the negotiating demands of the participants and the amount of tax structuring required
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Angel investors and seed capital investors - investors without a close relationship with the founders, who are prepared to invest in early stage companies, and are members of the ‘public’ $ have the skills and inclination to review the status of the business and its managers by reviewing the business records, contracts, financial statements and interviewing management, suppliers and potential customers have the ability to come to some judgement regarding the current and future value of the business without an offering document believe in the founders, managers and business potential often will invest at the time commercial sales become possible, but have not yet materialized are economically motivated, so negotiate for a proportion of the business which reflects the existing value of the business, but leaves enough to motivate the founders and management often expect and demand some voice in the making of significant decisions, representation on the board and a formal shareholders’ agreement expect a risk adjusted rate of return and liquidity at some point varying based on the industry and the investors trade of shares or securities to the seed capital investors must be made on an exempt basis - often under the ‘accredited investor’ or ‘closely held’ exemptions it would not be unusual to incur legal advisory, accounting and tax advisory and filing fee costs in the range of $10,000 to $50,000 at this stage of financing to prepare and negotiate value, a subscription agreement, intellectual property protection, a shareholders agreement and agreed ‘moving forward’ business plan
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Broad Exempt Offerings Using Offering Memoranda $ investors who want to invest in emerging companies, but who don’t have the time, skills or inclination to undertake the work seed or angel investors have management and founders prepare an offering document describing the business, its capital, management, market, competition, resources, risks and potential, which generally includes some historic and possibly future oriented financial information believe in and choose investments on the combination of skill of management and its match with the potential for investment gain will generally invest only if commercial sales have commenced to sell the offering, securities with an offered rate of return, protective or priority provisions, and voting or consent rights on certain matters are generally offered whether representation on the board or more extensive control provisions are given depend on negotiations with the ‘lead investor or investors’ post offering equity proportions must leave enough equity to founders and management to motivate them - option plans may be introduced at this stage trade of shares or securities to the seed capital investors must be made on an exempt basis - often under the ‘accredited investor’ or ‘closely held’ exemptions it would not be unusual to incur legal advisory costs, accounting and tax advisory costs and filing fee costs in the range of $35,000 to $125,000 at this stage, again depending on the complexity of the business, the negotiating demands of the participants and the amount of tax structuring required
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Institutional and Venture Capital Investors
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professional investors who review many business plans per week, are generally familiar with the market opportunities in specialized market areas want to invest in emerging companies, with a high rate of growth, broad markets and strong management screen business plans to decide which ones justify the expenditure of their time and commitment to consider, and ultimately, their investment generally do not require an offering document but conduct extensive examination of the business, its capital, management, market, competition, resources, risks and potential examine and demand the development of a detailed business plan and annual operating plans which form the foundation of negotiations on investment valuation believe in and choose investments on the combination of skill of management and its match with the potential for investment gain will generally invest only if commercial sales have commenced use shareholders agreements, employment agreements and incentive structures like bonuses and option plans to drive the required high rate of return, and to impose significant participation and control rights and rights to one or more board members generally do not invest in the same class of securities invested in by the founders or earlier investors generally have some kind of security providing capital preference or protection, enhanced and perhaps multiple base recovery of capital, and a means of high rate of return on equity if the business succeeds
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investment horizon is generally as short as 3 years and as long as 6 or 7 years the agreements allow for a forced liquidation if there has not been a voluntary liquidation event before the negotiated liquidation date, either by purchase of the investor’s position, sale of the business or public offering trade of shares or securities to the institutional or venture capital investors must be made on an exempt basis - often under the ‘accredited investor’ or ‘closely held’ exemptions it would not be unusual to incur legal advisory costs, accounting and tax advisory costs and filing fee costs in the range of $40,000 to $100,000 at this stage, again depending on the complexity of the business, the negotiating demands of the participants and the amount of tax structuring required
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# Capital Pool Companies - now available in Ontario - historically used in Alberta and B.C. instead of or to supplement venture capital $ formalized and regulated start up capital structure - two step process ' STEP ONE $ a company is incorporated by the promoters of the financing and seed capital of not less than $100,000 and not more than $500,000 is invested by the promoters at a minimum price of $0.075 per common share or 50% of the ultimate public offering price per common share each director must invest at least $5,000 and only after the first $100,000 is raised, can any additional seed capital shares be sold, up to the $500,000 limit to persons other than officers and directors the company is purposely created before a specific business prospect, plan or technology is identified the promoters prepare and clear a prospectus with disclosure of the intentions of the promoters and intended investment area, and raise money from the public, and must raise not less than $200,000 and not more than $1,900,000 (including any amount raised by sale of seed capital shares) approval of the prospectus requires the regulators to be satisfied with the public company experience and reputation of the promoters and proposed early directors since money is to be raised from the public markets absent a specific business or business plan, relying on the skills of these promoters and directors common shares sold under the prospectus must be sold for not less than $0.15 per share and for not more than $0.30 per share the CPC’s offering must be sponsored by and carried out by an agent which is registered to offer the securities generally a brokerage firm
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following the completion of the public offering, the CPC must have raised not more than $2,000,000, must have at least 1,000,000 common shares outstanding and held by persons who are not related to or part of the promoter group (that is in the ‘public float’) and have at least 200 shareholders holding not less than 1,000 common shares each, excluding the promoter group and investors related to them a single investor must not purchase more than 2%, but may be up to 4% including associates and affiliates it would not be unusual to incur legal advisory costs, accounting and tax advisory costs and filing fee costs in the range of $60,000 to $100,000 at this stage, again depending on the complexity of the business, the negotiating demands of the participants and the amount of tax structuring required - brokerage fees can range up to 10% of gross proceeds, plus broker warrants in the 5-10% range ' STEP TWO
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the promoters and management identify a business or company to purchase as a ‘qualifying transaction’ and enter into an agreement to make such a purchase the exchange will halt the trading of the shares of the CPC until disclosure filings are made relating to the sponsoring broker agents, the directors of the CPC, the exchange has conducted background checks on the promoters and directors involved, and the issuance of a detailed press release regarding the transaction the CPC then, generally, prepares an information circular which is reviewed and must be approved by the exchange, to be provided to shareholders at a meeting at which the transaction is to be approved upon the exchange reviewing the information circular and supporting report of a sponsoring broker it will generally grant conditional approval of the listing and permit the fixing of a meeting date and the mailing of the information circular to shareholders
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generally, the approval of a majority of disinterested shareholders will be required to approve the transaction which excludes from voting those shareholders who are members of the promoter group if given the appropriate shareholder approval, generally the exchange will grant final approval and issue an exchange bulletin allowing for trading to resume resulting company is listed and traded, but likely needs to complete a number of additional rounds of financing it would not be unusual to incur legal advisory costs, accounting and tax advisory costs and filing fee costs in the range of $60,000 to $100,000 at this stage, again depending on the complexity of the business, the negotiating demands of the participants and the amount of tax structuring required - sponsorship fees paid to a sponsoring broker will be in addition to the above
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Initial Public Offering $ $ $ a more conventional ‘going public’ method generally, the company has completed two or three rounds of financing after the founder’s investment for new technology companies the brokers will act only on a ‘best efforts’ agency basis to distribute and market shares broker must be used - an extensive agency agreement providing for broker commissions, an over-subscription or ‘green shoe’ option and broker warrants is typical a prospectus must be prepared, cleared and filed in each provincial jurisdiction in which securities are to be offered this requires a document which meets strict disclosure requirements, and the requirement that all business and financial information relevant to the investor to make a fully informed, reasoned investment decision be provided the disclosure must be ‘full, true and plain’ the costs associated with an initial public offering vary with the size of the offering, the complexity of the underlying business and the number of jurisdictions in which the offering is to be made costs for legal and filing fees can range from $50,000 to $200,000 for typical junior technology company offerings with an additional $40,000 to $100,000 of accounting and securities financial presentation advice broker fees range between 4% to 10% of the offering proceeds, plus broker warrants entitling the brokers to purchase additional offered securities at a discount to the offering price, for an agreed period of time, often in the range of 6 months to 2 years
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ongoing disclosure maintenance, legal compliance, accounting and audit services and investor relations costs, generally range from $75,000 per year on the low end, to a typical cost of $150,000 to $250,000 for a fairly junior company - this is, in effect the built in cost of generally lower cost public capital
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Prospectus and Registration Requirements $ $ $ securities legislation really is consumer protection legislation at the initial offering stage, it uses two principal methods of protecting the public which purchases securities ‘the prospectus requirement’ - full, true and plain disclosure of the business and investment opportunities, risks and rewards must be made in a prospectus, provided to the investor before an investment decision is made - this information is posted and available to the public on SEDAR (the System Electronic Document Analysis and Retrieval) of public securities documents (www.sedar.com) (US equivalent www.edgar.com) ‘the registration requirement’ - the people serving the public capital markets as advisors, brokers, traders and market makers must be registered and comply with capital and performance requirements - this is known as the ‘registration requirement’
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Exemptions to the Prospectus and Registration Requirements $ the exemptions to the prospectus and registration requirements used by small companies for many years have now been completely overhauled the concept of ‘private company’ is now no longer used in Ontario the commonly used ‘private company exemption’ (permitting the exempt sale of securities by private companies to persons who are not members of the public), the ‘seed capital exemption’ (permitting the offering to 50 possible subscribers and the exempt sale to 25 actual subscribers without an investment minimum) and the ‘private placement exemption’ (permitting the exempt sale to investors investing at least $150,000 in fair value) have all been abolished these have been replaced with a number of exemptions, but which for our purposes fall into two key categories ‘closely held issuer’ - in effect the replacement for a ‘private company’ which is permitted to issue its securities to up to 35 persons who are not employees or former employees - not counting ‘accredited investors’ who are discussed below a warning statement in a standard form must be provided to the investor before investment, warning them that investing in small companies is risky, that they might loose all of their money, and that the investment is illiquid
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Requirements: $ $ following the trade the issuer must still be a closely held issuer following the trade the aggregate proceeds received by the issuer and any issuer engaged in common enterprise, in reliance on the exemption, will not exceed $3,000,000
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no promoter has acted as a promoter of any other issuer which has relied on this exemption for a period of 12 months preceding the trade (a promoter is, in general terms, a founder, or central business person involved in building up the business) no selling or promotional expenses are incurred in connection with a trade, unless they are paid to a registered securities dealer or broker
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Accredited Investors $ there are 27 categories of ‘accredited investors’ including banks, trust companies, registered charities and other companies the ‘the $5M test’ - companies or partnerships which have net assets as shown on their most recent financial statements individual ‘accredited investors’ will generally fall into five categories ‘the asset test’ - investors who own on their own or with their spouse, either through a company or directly, cash, securities or insurance (but specifically excluding any home) with a realizable value exceeding $1,000,000 (generally including RRSP holdings) ‘the income test’ - investors who have net income before taxes of more than $200,000 or has net income before taxes when combined with a spouse of more than $300,000 ‘the promoter test’ - an investor who is a promoter and is therefore deemed to be knowledgeable about the risks and rewards of the business ‘the connection test’ - a spouse, parent, or child of an officer, director or promoter of the issuer (note that siblings, cousins, nephews and nieces are not included)
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‘the control block test’ - a person or company who in relation to the issuer holds a control block of securities generally deemed to be a control holder if the person holds more than 20% of the issued and outstanding voting shares note that officers, directors and employees are not treated as accredited investors, but are provided exemptions under a separate rule in the proper circumstances
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