In response to current market conditions, angel investors are looking for ways to minimize risk while contributing to the development of new ventures. Clustering or investing in groups has been identified as one means for angel investors to reduce transaction costs while increasing opportunities and returns.
By pooling assets, angel investors can share the risks and leverage the expertise of partners. They can also participate in offerings with high-quality private growth companies, which may not be available to the individual angel investor. This approach also gives investors more negotiating power with respect to the terms of the financing and the direction of the business. And by pooling their money, angel investors can present an attractive value proposition to growth companies that readily competes with formal venture capital dollars.
While there is no “ideal” angel structure, this paper will address two specific types of structures that facilitate group investing: limited partnerships and the Capital Pool CompanyTM (CPCTM)program of TSX Venture ExchangeTM. It also outlines two other structures, which are currently unavailable, but are worth considering for the future.
Angels have used limited partnerships for many years as a way to bring together capital and expertise for specific investments. Syndication allows for greater leverage of funds than individual investors can achieve on their own.
HOW LIMITED PARTNERSHIPS WORK
In Canada, a limited partnership is formed between a general partner, who is liable to all creditors of the business, and limited partners, whose liability is limited to the capital contributed to the partnership. Limited partners are not allowed to participate in the management or operations of the business or they risk losing their limited liability status.
In Canada, limited partnerships are regulated under provincial legislation.
According to the Ontario Limited Partnerships Act:
13. (1) Limited partner in control of business. – A limited partner is not liable as a general partner unless, in addition to exercising rights and powers as a limited partner, the limited partner takes part in the control of the business.
(Source: Consolidated Ontario Business Corporations Act, Related Statutes and Regulations, 25th Ed., 2002)
A key issue is determining when a limited partner’s activities amount to participation in the management or operations of the company. This issue is further complicated if the limited partner is itself a corporation. If a limited partnership is to be used, qualified legal advice should be obtained.
WHY ANGELS SHOULD CARE
Limited partnerships offer angels several advantages. They allow angels to syndicate on bigger deals than they might otherwise have access to. They distribute the transaction costs, which in turn facilitates comprehensive due diligence and the negotiation of more favourable investment terms. The liability of the limited partner is limited to the size of its investment. And limited partnerships can be structured to allow for investments in single or
multiple targets over time. For example, the limited partnership could make calls for additional funds from limited partners for subsequent investments.
There are also disadvantages with limited partnerships, however, and angels should be aware of them. In particular, limited partners cannot be active in the management or operations of the limited partnership or the target company. This will be a negative feature for many angels who like to be actively involved in the businesses in which they invest. As well, establishing the limited partnership can add complication and expense.
CAPITAL POOL COMPANYTM (CPCTM) PROGRAM
The Capital Pool Company (CPC) is a product of TSX Venture Exchange and originated with the Junior Capital Pool (JCP) program on the Alberta Stock Exchange in the 1980s. The CPC is an alternative route to the traditional initial public offering (IPO) or reverse take-over (RTO) for taking a company public.
The CPC program is currently available to residents of British Columbia, Alberta, Saskatchewan, Manitoba, Ontario, and Quebec. This means that residents of these jurisdictions can participate in the initial public offering of the CPC.
HOW THE CPC PROGRAM WORKS
The CPC program introduces investors with financial market experience to entrepreneurs with development-stage companies requiring capital and public company management expertise. Unlike a traditional IPO, the CPC program enables seasoned directors to form a Capital Pool Company with
no commercial operations and no assets other than cash, and then list it on the TSX Venture Exchange and raise a pool of capital through the CPC prospectus. The CPC management team then uses the funds to seek out an investment opportunity in a growing business. Once the CPC has completed its “qualifying transaction” and acquired an operating company which meets Exchange listing requirements, its shares continue trading as a regular listing on the Exchange.
There are two phases in establishing a Capital Pool Company.
Phase I: The Capital Pool Company
Creating the CPC
- Three to six individuals with an appropriate combination of business and public company experience put up a total of between $100,000 and $500,000 in seed capital.
- These founders incorporate a shell company – the CPC – and issue shares priced between $0.075 and $0.15 in exchange for seed capital.
- The CPC and its advisors prepare a prospectus that outlines management’s intention to raise between $200,000 and $1,900,000 by selling CPC shares at up to prices between $0.15 and $0.30 and at least twice the issuance price of the seed shares, and to use the proceeds to identify and evaluate potential acquisitions.
Selling the Shares
- The CPC files the prospectus with the appropriate securities commission(s), and applies for listing on TSX Venture Exchange.
- The sponsoring broker sells additional CPC shares to at least 200 arm’s length shareholders, each of whom buys at least 1000 shares. No one individual can purchase more than two per cent of the offering, and no one individual together with his or her associates or affiliates, can purchase more than four per cent of the offering.
- Once the distribution has been completed and closed, the CPC is listed for trading on TSX Venture.
Phase II: The Qualifying Transaction
Announcing the Transaction
- Within 18 months, the CPC identifies an appropriate business as its “qualifying transaction” and issues a news release to announce that it has entered an agreement in principle to acquire the business.
- The CPC prepares a draft filing statement or for non-arm’s length transactions, an information circular providing prospectus level disclosure on the business that is to be acquired.
- TSX Venture reviews the information and evaluates the business to ensure that it meets minimum listing requirements.
Preparing for the Vote
- For acquisitions with a non-arm’s length component, the approved information circular is mailed to the CPC’s shareholders, who vote at a shareholders’ meeting on whether to approve the qualifying transaction.
- Following shareholder approval, the qualifying transaction closes and the business is acquired.
- Shortly thereafter, the “resulting issuer” – no longer a CPC – begins trading as a regular listing on TSX Venture Exchange.
Maximum Cash Pre-Deal
|Seed Financing Range||$100,000||$500,000|
|Prospectus Financing Range||$200,000||$1,900,000|
|Pre-Listing Gross Cash Maximum||
Additional financing usually occurs at the time of the qualifying transection through a private placement. There is no limit on the amount of money that can be raised in this “side car” financing.
THINGS TO CONSIDER
There are three sets of criteria to consider when examining the feasibility of the capital pool structure. These are the needs and wants of the private company, the current market conditions and the critical success factors. Understanding and satisfying all three is critical in achieving a successful CPC.
- Private Company
The private company should want or require the following:
- Alternative access to capital
- To be a public company and understand the benefits and consequences
- Greater flexibility in the going public process than is possible with an IPO.
- Reduced risk and greater certainty than with an IPO.
- To maintain greater control of company. (In a CPC, only 20 per cent of the float needs to be held by the public).
- A simple and clean way to go public versus an RTO.
- Prefer the less restricted terms sometimes offered by venture capitalists.
- Market Conditions
The following market conditions are likely to be present:
- Company is at too early a stage or doesn’t have the financial history for a broadly distributed IPO.
- A weak IPO market.
- VC financing is not viable or management prefers not to use it.
- Critical Success Factors
Factors critical to success include:
- The company has progressed beyond the start-up phase.
- A strong management team with public company and sector experience.
- Long-term strategy to grow as a public company (i.e., management recognizes that this is just one step in growing a business.)
- The company has a reasonable valuation, which in turn results in a viable share structure.
- Long-term investor support.
- The presence of advisors (lawyer, broker, investment banker) experienced in public venture capital.
- Management recognizes and accepts the responsibilities of being a public company, including the additional costs, disclosure requirements and the limited liquidity inherent in small-cap stocks.
WHY ANGELS SHOULD CARE
The CPC is simply a mechanism to grow a company. Accordingly, an investor still requires a good deal to be successful. The CPC is not for every company, but in the right instance, it is an excellent growth vehicle, as it allows the company to multi-tier finance and create a structure similar to an IPO with a strong investor base. It may also enable investors to attract money they would not have access to as a private company.
It is also important not to emphasize short-term liquidity, but to concentrate on building a company. The key is to create a like-minded approach with the other angel investors, the broker, counsel, management and the board of directors, focused on creating share holder value. Having a core group of long-term angel investors will definitely give the CPC an advantage.
Here is a summary of some of the “pros” and “cons” of a Capital Pool Company:
- It allows the entrepreneur and seed investors to leverage private dollars with public dollars.
- Angels are able to maintain greater control of the company for longer term, especially in structuring and financing.
- Angels face fewer operational restrictions than working with VCs.
- The CPC does not have the complexities of VC term sheets and structures.
- It allows participants to partner with “patient capital” from institutions.
- It provides access to capital, especially for businesses not considered by VCs.
- It creates a recognized market valuation for the company.
- The public shares can be used as currency for M&A activity.
- The shares can be used to attract talented management.
- The company can create stock option and share purchase programs as an incentive for employees.
- Can raise up to $2 million, a significant amount for growth capital.
However, the CPC is not for every company.
- Being a public company is onerous on management and financial resources and requires a good board of directors, management team and professional advisors.
- The cost of listing and maintaining the public company are not insignificant.
- Public companies are open to public scrutiny.
- Creating a CPC is not a liquidity event for founders or seed investors.
- CPCs must deal with the liquidity challenges inherent in the small-cap marketplace and will have to work to obtain a following from the financial community in the early years.
Limited Liability Company (LLC)
Limited Liability Companies (LLCs) are similar to limited partnerships from a taxation perspective. However, unlike a limited partnership, LLCs allow the members to participate in the management of the business without losing their limited liability status. As is the case with a limited partnership, investor liability is capped at the amount of the investment.
LLCs are currently available only in the United States. However, the LLC is an investment vehicle that would likely be attractive to Canadian angels who want to consolidate their investment activities. Consideration should be given to lobbying for LLCs to be available under Canadian income tax legislation.
Community Small Business Investment Fund (CSBIF)
The CSBIF is not particularly relevant to angels in its current form, but may be a model to consider adapting for angel investments. It’s worth noting that in early 2003, Ontario’s provincial budget proposed changes making angel-driven CSBIFs possible. However, at time of publication, these proposals were yet to be approved.
CSBIFs are currently available in Ontario and are often established by labour sponsored funds (LSFs) to assist them in meeting their investment pacing requirements. If an LSF invests in a CSBIF, it receives two credits (i.e. one dollar invested in a CSBIF equals one credit and the second credit is issued to the LSF when the CSBIF invests that dollar in a company).
CSBIFs require sponsorship by a local non-profit organization. Typically, one LSF and one sponsor invest together in a local venture.
There are restrictions on what the CSBIF can invest in. Investments are usually made only in small start-ups. The maximum CSBIF investment in a single business is $1 million.
Investors other than LSFs are entitled to receive a modest 7.5 per cent tax credit for investing up to $500,000 in a CSBIF, resulting in a maximum tax credit of $37,500.
When selecting the right structure, it is important to consider the specific deal and circumstances. Realize that each of these mechanisms is just one step in building a successful business. A long-term strategy should be developed to take advantage of opportunities in the present and the future.