Equity Share Structures in BC VCCs – Improving Investor’s Chances of an Exit

British Columbia’s Small Business Venture Capital Act (“the Act”) provides for a 30% tax credit to investors (refundable in cash) who buy eligible investments through a provincially-registered venture capital corporation (“VCC”). The small business must meet eligibility requirements –

What are the 6 qualifying activities?

the following types of business are NOT eligible:

• primary resource exploration or extraction,
• financial services, such as providing loans, selling insurance or real estate, or trading in securities,
• property management or the rental or leasing of land or improvements,
• the development of or improvement of land,
• traditional agricultural activities,
• retail and commercial services (other than services that are (i) exported outside British Columbia or replace imported services, or (ii) provided by a business which derives more than 50% of its revenues from the provision of services to tourists, or (iii) provided by a regional business and promote community diversification within the region.)
• restaurant or food services,
• the sale or lease of tangible or intangible personal property for a person’s personal consumption or use

The legislation was enacted to help small business attract equity by offering investors 30% of their investment back in cash, to compensate them for risk and a lack of liquidity. Of course it’s one thing to invest in small private companies – but quite another to get your money out again. Angels are invariably concerned that too much of their capital gets stranded in under-performing companies. Angel investors – unless the gods are smiling on them – can only expect to be successful between 10% and 20% of the time. They need a couple of high-performing investments to make it all worthwhile.

For the most part share structures tend to be quite simple and straightforward. There is some concern that complex corporate structures will frighten off venture capital in later rounds, if a company is poised to grow. In addition the Act does not allow shares to

“carry prescribed rights and restrictions. This requirement recognizes that VCCs or EBC investors (herein referred to as “investors”) may invest in voting preferred, as well as common, shares or in unit offerings of a small business. However, some limitations are necessary to ensure that the investors hold a true equity investment that is at risk both as to return of capital and return on capital.”

In other words the Act requires that companies can’t structure the features of a class of shares with things like retraction rights or excessive, cumulative dividends on preferred shares. If they could, shares could look more like debt than equity – defeating the policy objectives of the program. In spite of this the BC Government has published a policy document that seems to allow a fair amount of flexibility.

“Retraction Rights and Puts
A retraction right or put which is exercised at the option of the investors may, depending on wording of the right or put, impair the ability of a small business to carry on an ongoing business with a reasonable expectation of profit or entitle the investors to reduce the impact of any loss in holding the shares in violation of section 3(1) of the regulations.

As a result, retraction rights or puts will be permitted only where the price paid to the investors under the retraction right or put does not exceed the fair market value of the shares. If the parties are unable to agree as to the fair market value of the shares at the time the retraction right or put is exercised, the parties may agree to appoint an independent third person (e.g. a chartered business valuator) to determine fair market value.

A retraction right or put at a fixed price in excess of fair market value will not be permitted because the fixed price downsizes the risk to the investors of holding the small business shares.

The terms of any retraction right or put must provide that the retraction or put can only be exercised where its operation would not threaten the existence of the small business. Generally, this means that retraction rights or puts which would create a working capital deficiency, or cause a small business to be in default of an arms’ length loan will not be allowed.

The terms of any retraction right or put must also provide that the retraction or put is not exercisable until at least five years have passed since the issuance of the equity shares. This five-year period is required to comply with regulation section 8(2) which would otherwise deem the value of the investment to be zero.”

In private companies where founders remain in control, founders can effectively strip all of the value by paying uneconomic wages and investors will have little recourse. – at least if they don’t have retraction rights or other protections built in.

Prospective investors might be in a position to request retraction rights – or potentially cumulative preferred shares with fairly high dividend rates. That might make it more difficult for founder shareholders to ignore the  concerns of preferred shareholders. For shareholders looking to “exit early and often” – this might provide a little downside insurance for investments that turn out to be “lifestyle” businesses.

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As a last resort shareholders can refuse to waive the audit requirement…and at least make their presence felt by management.