Avoiding the Apocalypse: Tax-Planning Basics for Startups

I've spent a ton of time lately on startup organizations, which I suppose is another great sign of the most recent end of the most recent tech apocalypse. In fact, there have been slightly more misplaced "end is nigh" predictions in our business, especially in Canada, than in the raft of recent Mayan calendar-inspired Hollywood offerings (one of which my wife and I endured, and I mean endured, last night - like really, how many active volcanoes can John Cusack leap with a relatively ill-equipped recreational vehicle?).

In any event, all these warm and fuzzy thoughts of recovery have inspired me to cover a few tax-planning thumbnails for founders thinking about finalizing their companies' share capital structures. Here are my thoughts, brief and disclaimer-free enough to send our tax lawyers Dineen Beath and Estelle Duez screaming down the hall this afternoon with two fistfuls each of qualifications (each of Dineen and Estelle are outstanding by the way, and I'd be happy to frighten them in person with my treatment of your startup's issues anytime).

Structure Before Success: Here is the basic guideline all founders need to follow: option grants/share issuances at fair market value = good tax result, and option grants/share issuances at less than fair market value = bad tax result. As a result, you should complete all of your sweat equity structuring before your company gets valued (usually, through a financing). Once you create a defensible value in the company, you create a bunch of tax issues for the founders, employees, directors and consultants getting free or near-free shares in your company.

Get the $750K Clock Ticking: Shareholders of most startups in Canada get the benefit of the $750,000 capital gains exemption upon the sale of the shares. One of the conditions to getting the benefit, though, is that the shareholders must have owned the shares for at least 2 years. As a result, get stock in your founder group's hands as soon as possible to give them a fighting chance to get this benefit. This usually means choosing restricted stock (which is issued up front) rather than stock options (the right to purchase shares in the future) as the instrument of choice. Address any vesting requirements with contractual repurchase rights (typically, with any unvested shares repurchased for nominal consideration). If you want to retain control over the shares, get a voting trust or power of attorney from the affected shareholders. Providing you get this done before you've created real value in the company, you won't cause any near term tax obligations to any of the affected shareholders.

You Don't Need a Mini-Van to Have a Family Trust: Holding founder shares through a family trust is a great, legitimate tool for multiplying the number of $750K capital gains exemptions available to protect future exit proceeds from tax. Properly structured, the founders can totally and absolutely control both the voting rights of the shares held by the trust, as well as decide where the proceeds go on exit. They are cheap to set up, and hey, just because you have a family trust doesn't mean you have to leave your bachelor/ette lifestyle behind, sell the loft and move to Aurora or Kanata to the house with the white picket fence - they work for everyone.

The TaxMan (Heart) Employees: Last thing, you can't really screw up from a tax perspective in giving shares or options to employees of your startup, even if you blow the basic guideline set forth above. The Canadian taxman won't tax Canadian employees, directors or officers (like a CEO or CFO) until they actually sell the shares that they hold in the startup. This isn't true for consultants. If these guys get free stock after the company has been valued, or if you paying the fees payable under a development or other contract in shares, those guys are going to have to pay tax on benefit right away, even though the shares that they hold may not be sold for many years later.

As you can probably tell, this is the one area of startup law, like the plotline of 2012, that doesn't always add up. But if you do need someone to reach out of a moving airplane to pull you in, or reach over an earthquake-inspired crack in the earth to pull you to solid ground, consult a early stage company-savvy corporate or tax lawyer (like us) and we'll get you on the Ark to safety.

Are You There Blog? It's Me, James.

Has it been almost a month? It starts small and innocent enough, that nagging feeling that you've neglected your blog. It's kind of like not calling your mother. At some point, you're almost embarrassed to do so.

Well, here goes in any event. I've been in each of Montreal, Ottawa, Waterloo and Toronto since the last post, and my colleague Justin Young was in Vancouver, attending and organizing a myriad of events and meetings in each of the cities that suggest that things are basically rocking across the country in the startup space.

Since last post, we've had our startups get huge notice at RIM's DevCon show, as well as salesforce.com's Dreamforce show this past week. We assisted the new Toronto office of Bridgescale Partners close its first investment in Canada (in Bluecat Networks), helped Toronto-based Peraso Technologies close its Series A financing with Celtic House and iNovia, and (for the first time in a long while), helped three public companies complete public financings in the same week (Dynex, Chemaphor and IMRIS).

We attended a great event put on by the Fusion folks in Vancouver, I accepted an award as one of Canada's leading lawyers under 40 (hooray!), we attended terrific programs featuring early stage companies put on by Toronto's Extreme Venture Partners and the Ivey business school, we helped the Rogers Venture Fund with its Ottawa launch this coming December 3rd, and (phew) I met with or chatted by phone with 13 brand spanking new startups looking for some help to get things going and 5 funders/investors checking out the buzz up here (2 from the US).

If my blog neglect is a bellweather, then. let 'er ring and keep the good news brewing. Now, time to call mom.

LW Cleantech Event - Tues October 27th - 4-6:30pm

Best in Venn

Courtesy of Network Hippo's Scott Annan, and in tribute to the social media skeptics stalking the halls of LaBarge Weinstein, this is absolutely the best faux Venn diagram I've seen, presented by Scott with aplomb and to a standing ovation to the Montreal Startup crowd this past Thursday. You've probably seen it before or own the t-shirt, but still post-worthy.

If you're looking for pitch guidance, corral Scott or get a video of his MSup presentation. If his effort is any lesson, it's to throw out all of the self-consciousness inspiring pitch advice from the myriad of resources out there. If you boil your presentation down to something authentic, and you truly care about your product and customers, you'll likely get the kinds of reactions upon which you can build more in-depth engagements. Here's hoping Scott can do just that.

Cloudy with a Chance of Funding

Apologies for suffering a little post-post depression, but I've been steadily catching up on my stack of business cards since last addition, as well as fielding a steady stream of calls about the steady stream of new funds and funding opportunities out there (and sneaking in a trip to NYC over the weekend as well, phew!). The recent additions to our local funding circles have indeed been significant, with Rogers Communications announcing its venture fund in Montreal last night (I was there, and will be there for the Waterloo launch in Tuesday), echoing the increased activity of Google Ventures in our fair nation. I'd previously posted about the OETF and IAF, and there are a couple of complementary developments for southern Ontario startups that are out there for the taking, including a new federal government initiative, as well as a BDC-sponsored fund, each designed to support knowledge-based companies in small, southern Ontario communities that formerly (and still) have mucho manufacturing dependency.

This is all well and good, I suppose, but how do you work up a plan to catch some of this rain? Here is my take on how to sort through the maze:

Get a helping hand: There is great virtual CFO talent around, and many have enough paying gigs that if you bring enough game to the table, they'll help you navigate the forms and build up an incremental plan to get a little, and squeeze three times the dollars out of it.

Get a bird in the hand: If you really need the capital, and especially if you're a young entrepreneur, don't agonize over terms. I truly think building good social networks among advisors and investors has an inherent value separate from the venture you're building. If you leave a little money on the table, all the better to make life-long friends.

Make hay: Make every effort to turn every financing event that you have (SRED financing, gov funding, initial seed capital) into a conversion trigger for interested investors sitting on the fence. Get your audience, keep them updated, and make every effort to turn good news into even better news for your financing strategy.

Bring a little "grid computing" to your strategies: You should parallel process your debt, government, angel and institutional strategies, and start and monitor and measure each of them in parallel. Even mature VC-backed startups have priorities among each, and again a decent virtual CFO can help you work up the to-do list that will be your guide.

Update on the Ontario Emerging Technologies Fund

Over the past summer, my partner Debbie Weinstein has been closely involved in the industry outreach conducted by Ministry of Research and Innovation’s John Marshall relating to the launch of the Ontario Emerging Technologies Fund (OETF), which was originally announced by the McGuinty government in winter 2009. The Fund represents an exciting opportunity for our cash- or syndicate partner-starved clients (startups, venture investors and angels alike) to access government funding in a reasonable and timely way.

If you would like any additional information regarding the OETF, including how to become a “Qualified Investor” or submit an investment for consideration, we would be happy to assist.

What You´ve Likely Heard Already

OETF is a $250 million direct investment fund administered by the Ontario Capital Growth Corporation (OCGC), announced in February 2009. OETF has been designed as a matching fund for investments in Ontario-based companies, providing syndicate support for qualified investors that have sourced, diligenced and led financings. The Fund will invest $50 million per year during the term of the program, and $100 million will be available for funding over the next 18 months.

OETF will piggybacking on the diligence and pricing efforts of “qualified” investors that participate in an fund-sponsored approval process, and lead syndicated venture capital transactions.

OETF can invest in private companies, the majority of whose: (i) payroll is paid to Ontario employees and contractors, (ii) workforce is working in Ontario, and (iii) senior officers maintain their permanent residence in Ontario. Targets must carry on business in one of the OETF’s recognized industry categories, including clean tech, life sciences, digital media or communications.

The minimum initial investment requires target firms to be raising at least $1 million (including the matching money from the Fund), and will be made on the same deal structure terms as those made available to the qualified investor. The Fund will match the largest qualified investor up to $5 million per round. The OETF has adopted some stylized deal structure requirements for financing rounds where the syndicate relationships are more complex, or where the transaction contemplates a material follow-on investment by the qualified investor, and we would be happy to discuss those at your convenience.

OETF can do follow-on financings, which is terrific, provided that the maximum amount invested in any single target cannot exceed $25 million.

What You Need to Know and Do Now

Get Your Investors Qualified: Any investor, regardless of residence or location and whether an institutional venture capital firm or angel, can become a “Qualified Investor”. In order to seek approval, investors are required to submit an application to the Fund and submit to certain background and other diligence checks regarding the investor and its principals. OETF has engaged Toronto’s Northbridge Capital Management Inc. to administer and support granting these approvals. We have been advised that, once OGCG and Northbridge settle upon the set of administrative and diligence procedures to make these determinations, an application to become a qualified investor will take no longer than 15 days to process. Unfortunately, non-institutional investors (angels) are required to reapply for qualified status for each investment that they make.

Get Your Term Sheet Qualified: In order to submit a proposed transaction for approval, qualified investors are required to submit an application to the Fund. OETF has engaged Toronto’s Covington Capital Corporation in order to administer and support the approval and funding of qualified investments. We strongly suggest that interested parties submit applications for investor qualification at the same time as they pursue investment approval. Since accommodating applications this past July, we understand that the Fund has received more than 200 proposals for investment. We also understand that the Fund has every intent of distributing these Funds as soon as possible. It may very well be that the qualified investors who are first to the post will be the first to reap the rewards of their efforts.

Consolidate Your Angels: The most important limitation of the Fund is that it will only match the investment amount of the qualified investor. This is a real challenge for angel syndicates, but Mr. Marshall’s team has indicated a strong appetite and willingness to consider strategies to consolidate angel investments under a corporate, partnership or trust entity. This should streamline the investor approval process for the affected angels, and by consolidating the Funds to be invested will maximize the OETF’s matching investment in the target.

If You Have A Cross-Border Structure, You’re Still Eligible: Please keep in mind that targets do not themselves need to be Ontario or Canadian companies. If your corporate structure includes a Delaware parent or sister, as with many of our clients’ corporate structures, your qualified investors can still try and access the Fund.

If You are in the IAF Pipeline, Be Mindful of OETF Limitations: There are funding limitations where the target has received substantial concurrent Ontario government contributions, including OCE or IAF (Investment Accelerator Fund) funding. Targets should seek advice regarding these restrictions and how they might the affect the target’s status and eligibility for matching funding pursuant to the OETF.

The Fine Print: What You Should Consider Before Engaging the Fund

The intent is that OETF will act as a passive investor, but like any government-sponsored funding program, there are some traps and challenges to engaging the program.

There are some specific minimum deal terms to be reviewed and incorporated into your investment proposals before they are submitted for approval. More important, OETF investments will be subject to call rights in favour of the Fund should the target lose its Ontario footprint after the date of the investment. This should not affect conventional investment exits, which OETF will review and approve in the ordinary course in its capacity as a shareholder. However, if your firm anticipates near-term growth in its workforce and C-class management in the near term, you should get some advice on how those call rights work. It is similarly unclear as to how such rights will mesh with our venture and bridge loan contracting patterns over the last few years.

Overall, our team remains very bullish on the Fund’s potential for stimulating syndicate formation in Ontario, and we would be happy to assist you in engaging the Fund, and working through its eligibility and approval requirements.

VC Fairs, or Vanity Fairs?

On the heels of VC fair week in Canada (Ottawa, Banff), and with the National Angel Organization's annual event upcoming, we've heard a number of founders lamenting the lack of actual investment conversion stemming from these kinds of things. Sometimes that can seem like a fair comment, especially as I looked out among the audience in Banff on Friday mid-morning with institutional investors focused principally on shaking off modest Thursday night hangovers and cradling Blackberrys and iPhones like long-lost friends. Are the investors in it for real, or do they regard VC fair participants with the attention my mini-van driving wife might give to passing, picked over roadkill on the road to our cottage?

My answer is absolutely the former, but with a catch that most of the pros in the business seem to catch and use to their advantage. Basically, selling to investors is no different than selling to customers. Unless you get lucky (and it happens), the sales cycle requires research, a committed and self-conscious campaign and the gentle building of a momentum story over a number of different engagements. You won't nail the deal from the presentation podium. Rather, the quality work will be done before or after the event. As a result, founders should be realistic about expected outcomes before you agree to spend the time and resources to participate: do you just want to start the process with a range of players? is the VC fair a good forum for providing a general update to your story to previously engaged investors? do you have an internal round in hand, and are taking one last kick at the new lead investor can?

Taking the VC fair organizers off the hook, the lack of actual deal flow begs a couple of questions. What can well-meaning organizations like OCRI and Infotech Alberta do better? One thing is to recognize the realistic outcomes, and create a wider and perpetual range of engagements among founders and investors (and perhaps among co-investors) both during and after the event. These organizations have started with this with startup-focused events, and I've also seen folks like Michelle Scarborough do incredible work at the OVTS cocktail party making introductions among founders and investors. I think more of this stuff will contribute to building quality engagements, and I also think that the government, service provider (read accountants and lawyers) and other attendees should be actively encouraged to take their role seriously in supplementing efforts to create actual deal flow from the event.

More importantly for many founders (at least those that have not led a VC-backed company to exit in the last decade), if the VC fairs aren't about term sheets, what then is the secret sauce for quality engagements with the new VC contacts you might run across at such an event? Over the course of the week, I quizzed the guys/girls with the chequebooks (or, given the state of perpetual closing of VC funds, those that know the guys/girls with the chequebooks and may or may not get a cheque from enough of them in order to cut you a cheque...you get the idea...). What elements led them to commit the mental and other resources to moving from prospect to qualified lead for a startup founder? Here's what you need in order to make it happen:

Game: As Spartan Bioscience's Paul Lem and I discussed this past Tuesday evening, it maybe goes without saying that you have to bring "game" to the table. It's a hard thing to describe, the investors suggest, but they seem to know it when they see it. Founders that know their industry cold (especially everything about their competitors), are unabashedly sold as to their company's potential, and have a little mental strut that goes with being a thought leader in business segment - these people get that second look.

Time: Of course, you need time to move investors from interest to diligence. Most everyone in the game seems to advocate the "it's never too early" school of thought as to when to engage the community, whether at a VC fair event or otherwise. Getting a meeting from an angel or institutional investor that leads to some good advice, or an introduction to a helpful contact, is a genuine investment in the business, as well as the founder's career. It's the kind of thing you can build on, and that's all the start you should look for.

A Plan: Every engagement with investors, as with customers, should have a purpose and desired outcome, and put you in a better position to close than prior to the engagement. Creating a "momentum" communications plan implemented over the course of many months seems to be the most effective strategy. Often, investors will provide those milestones for you (call me when you get the carrier deal, or when the product has been tested, or when you have 100,000 UIs per month). Connecting and reconnecting, and connecting again, that seems to be the only to move the hearts (yes, VCs do have hearts...) of this "show-me" community.