Author: | Published: 4 Jan 2001
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Canadian private equity and venture capital activity reached record volumes in 2000. While final figures for the year were not available at the time of publication, press releases in November for year-over-year activity showed the number of venture capital deals soaring 40%, and the amount invested in start-up companies during the most recently reported quarter almost doubling from the previous year level. Needless to say, this level of activity saw some interesting developments, new players and new funds, continued strength in the labour-sponsored sector and changes in the legislative and regulatory environment.

The year in review

During the past year, venture capital pools have been closely associated with the high-tech sector centred largely in Toronto, Ottawa ("Silicon Valley North"), Waterloo (perhaps the "Next-Silicon Valley North"), Montréal, Calgary and Vancouver.

Notwithstanding the March/ April public market meltdown in the sector, and perhaps because of it, year 2000 venture capital investment at the time of publication was forecast by the Canadian Venture Capital Association, based on results prepared by Macdonald & Associates, a widely quoted venture capital and private equity database-tracking company, to attain "dramatically higher records", both in amounts invested and number of financing rounds over 1999.

Indicative of the trend of institutional equity funds stepping up to the plate, where scheduled IPOs faltered because of the spring market correction, was the investment by the merchant banking arm of Ontario Municipal Employees Retirement System (OMERS), one of the largest pension funds in Canada, in the publicly announced C$157.5 million private placement in September, of equity shares in ClientLogic Corporation, an international provider of integrated marketing, customer-contact management and fulfilment services focused on e-commerce and technology companies. ClientLogic had filed a registration statement with the SEC and a preliminary prospectus with the OSC in April, but decided to pull its filings after tech stocks fell out of favour in the spring. OMERS, along with other pension funds, Mosaic Venture Partners and various high-net individuals, also participated in the publicly announced C$46 million second-round financing, also in September, by Skulogix, a Toronto-based software developer that handles the logistical and strategic challenges faced by name-brand manufacturers and online retailers.

Venture capital partnerships were quite successful in raising funds from merchant banks and high-net individuals during 2000. Indicative of such success were the closings in Toronto of JL Albright III Venture Fund in May (which raised over C$100 million), and Brightspark Ventures, an incubator fund, in March (which raised $40 million) as well as the successful public offering of common shares and warrants in the spring by itemus, a rapidly expanding hybrid of software developer, service provider, and venture capital investor (or in the jargon of the industry, an internet accelerator). On the flip side, things have never been better for tech company entrepreneurs. For example, in November, Hyperchip of Montréal cobbled together C$100 million in its third-round of financing – a deal believed to be the largest-ever infusion of venture capital for a private Canadian tech company.

New players, new funds

'Capital breeds capital' seems to be the mantra in the venture capital industry. For example, at the same time as companies such as Research in Motion, Open Text and Descartes Systems Group, all in Waterloo, began making a name for themselves, and enlarging the pool of capital available for start-ups, US-based companies such as Cisco Systems and AOL have invested their capital in local companies and enriched company founders who have reinvested in other start-ups. That has bred venture capital partnerships such as Waterloo-based Venture Labour Capital Partners, newly formed to target pre-revenue companies too advanced for angel investors, and too early to access institutional private equity. The same story exists for Ottawa (see Ottawa Capital Network (OCN) which operates an investment matching service that helps emerging advanced technology companies access early-stage financing from local private investors), Vancouver (GrowthWorks Capital, which manages the C$450 million Working Opportunity Fund) and Toronto (the creation in late 2000 of the internet site which allows entrepreneurs to pitch their ideas to investors for a fee).

Successful fund launches in 2000, in addition to JL Albright III Venture Fund and Brightspark Ventures, included Ventures West Management, which raised C$200 million for a new venture capital fund that invests in early-stage technology companies, as well as XDL Capital, which raised C$140 million, McLean Watson Capital, which raised C$116 million and EcomPark, which received C$57 million in financing. These domestic venture capital funds were supplemented by announcements from some of Silicon Valley's most powerful venture capital firms such as Mohr Davidow and Greylock Partners that they plan to invest hundreds of millions of dollars in the Ottawa region. There were also announcements from industry players setting up corporate investment programmes or venture capital arms, such as telecom giant Telus, which announced a minimum C$50 million commitment to invest in emerging technologies. The ever-present Business Development Bank of Canada, an arm of the federal government which offers unconventional financing, venture capital and consulting services to small businesses, announced in October that its BDC Venture Capital Group planned to invest more than C$120 million of venture capital into emerging businesses annually.

Labour-sponsored funds

A unique feature of the Canadian venture capital industry is the existence of the federal government's controversial labour-sponsored venture capital corporation programme, under the Income Tax Act (Canada), and related provincial registration programmes for labour-sponsored investment fund corporations, such as that in Ontario under the Community Small Business Investment Funds Act (Ontario).

Industry experts estimate that labour-sponsored funds account for more than half the venture capital assets under administration in Canada, and some have called for the elimination or phase-out of tax credits (which cost taxpayers about C$130 million a year) as the corporate and private sectors step up to the plate. Others, however, are concerned that the pension funds have not yet sufficiently moved into the venture capital sector to justify the elimination of labour-sponsored funds. For example, according to press reports in November, of the C$2.3 billion of venture capital raised in Canada in 1999, only 1% came from pension funds, compared to the US where pension funds represented 25% of the $45 billion industry in 1999.

In the meantime, the Income Tax Act (Canada) provides that individuals resident in Canada, and annuitants under qualifying trusts which are first purchasers of labour-sponsored fund shares, are eligible for a federal tax credit equal to 15% of the purchase price, to a maximum credit of C$750 per year, based on an investment of C$5,000 per year. Investment in these shares by a Registered Retirement Savings Plan (RRSP) entitles the RRSP to increase its ownership of foreign property by, generally, three times the cost of the investment, to a maximum of 45% in 2000 and thereafter, 50% of the total cost of the RRSP property. In addition, many provinces have corresponding tax credits, such as in Ontario, where the Income Tax Act (Ontario) parallels the Income Tax Act (Canada) in providing a provincial tax credit equal to 15% of the purchase price, up to a maximum credit of C$750 per year based on an investment of C$5,000 per year. There are also both federal and provincial penalty tax provisions applicable to labour-sponsored funds failing to meet minimum and maximum levels of investment in eligible businesses.

Changes in the legislative and regulatory environment

The legislative and regulatory environment for private equity and venture capital continued to be favourable during 2000.


Continuing the relationship between venture capitalists and high-tech companies, there is no legislation in Canada comparable to the State of California's recent Business and Professional Code provisions providing a statutory right to employees to job hop (by limiting the enforceability of non-competition agreements, and by allowing employees to bring residual know-how to new employers) coupled with California's non-subscription to the inevitable disclosure doctrine, which makes employer injunctions difficult. Accordingly, venture capitalists in Canada continue to enjoy a somewhat greater sense of security in the enforceability by investee companies of non-disclosure/ non-competition covenants from high-tech employees.

Changes in taxation of capital gains

Holders of equity securities in Canada receive a capital gain (or capital loss) on the disposition of their interests, to the extent that the proceeds of disposition exceed (or are exceeded by) the adjusted cost base to the holder, and any costs of disposition.

Generally the cost base is equal to the subscription price paid. Three-quarters (reduced to two-thirds in the federal February 28 2000 budget) of any capital gain or capital loss will be the holder's taxable capital gain or allowable capital loss, as the case may be. In a federal mini-budget introduced on October 17 2000, the inclusion rate for capital gains was reduced further to one-half from two-thirds. However, with the dissolution of Parliament on October 22 2000, the tax proposals contained in pending legislation, as well as tax proposals announced but not contained in pending legislation, basically died on the order paper. If reintroduced in the House of Commons after the November 27 2000 federal election (and this is quite likely since the Liberal Party which introduced the changes was re-elected with a large majority), these proposals would have a positive impact on direct equity investments by taxable institutions and individuals, as well as on the continued development of venture capital partnerships.

Changes in taxation of options

As a partial response to criticisms that Canadian high-tech employers were having trouble attracting and retaining qualified employees in the over-heated, worldwide high-tech labour market, the federal government in the February 28 2000 budget recognized the increasing importance of share ownership and stock option plans for recruiting and retaining key employees by proposing to postpone taxation on C$100,000 per year of qualifying employee stock options for publicly listed shares, and instead of taxing the benefit in the year of exercise, taxing it when the shares are sold. Again, if reintroduced and passed in the House of Commons, these changes will improve the climate for venture capital investment in Canadian high-tech and other companies which will be better able to compete with US rivals.

Changes in securities regulation

There were a number of proposed changes to the securities regulatory environment in 2000 which would impact, upon becoming effective, the private equity and venture capital industry, both in terms of private placements of securities by companies seeking investment, as well as on resale and escrow of securities by investors.

Exempt distributions

In September, the OSC published for comment Proposed OSC Rule 45-501 – Exempt Distributions. In its release, the OSC stated that it was "taking significant steps to revamp and streamline its regulations to make it easier for small and medium-sized businesses (SMEs) to do private placements". If implemented, the proposed rule would introduce three exemptions to replace some of the current exemptions, and would help SMEs to raise capital without a prospectus.

  • Closely-Held Issuer Exemption: Issuers would be permitted to raise a total of C$3 million, through any number of financings, from up to 35 investors. There would be no restriction on the number of issuers' employees able to acquire securities under an incentive plan; any closely held issuer with more than five stockholders would be obliged to provide potential investors with a standard information statement which would contain a required list of questions.
  • Family Member Exemption: Issuers would be allowed to issue securities on an exempt basis to spouses, parents, grandparents or children of its officers, directors and promoters.
  • Accredited Investor Exemption: Issuers would be allowed to raise any amount at any time from individuals meeting a financial asset threshold of C$1 million or an annual income threshold of C$200,000. Accredited investors would also include companies, trusts and partnerships with assets of at least C$5 million, and mutual funds whose prospectuses disclosed that the fund may purchase securities under the proposed rule.

The most common existing exemption, the so-called 'sophisticated investor' exemption, requiring a minimum purchase price of C$150,000, would be repealed and replaced with the new exemptions, which are more consistent with the US private placement rules under Regulation D to the Securities Act of 1933.

Resale of securities

Also in September, certain members of the Canadian Securities Administrators (CSA) (including Ontario but not Québec) published for comment Proposed Multilateral Instrument 45-102 – Resale of Securities. The purpose of the proposed instrument, according to the CSA, is "to harmonize certain provincial and territorial resale restrictions imposed on subsequent trades of securities initially acquired under an exemption from the prospectus requirement". The proposed instrument is based on the System for Shorter Hold Periods for Issuers Filing an AIF (SHAIF System) in use in Alberta and British Columbia. The SHAIF System allows a reduced hold period for resale of exempt securities, where the issuer has an AIF and has satisfied other conditions.

The proposed instrument provides for a four-month hold period for securities acquired under a private placement exemption, where the issuer is a qualifying issuer at the time of the initial distribution. A qualifying issuer is a reporting issuer in any one of several listed provinces, who is an electronic filer under SEDAR, who has filed a current AIF, and who either has a class of equity securities listed or quoted on certain specific exchanges, or outstanding securities that have received an approved rating. A 12-month hold period would be imposed for securities acquired under a private placement exemption where the issuer is not a qualifying issuer.

For securities acquired under a seasoning exemption, including the first trade in previously issued securities of an issuer that has ceased to be a private company or private issuer, there is no prospectus requirement for resale where the initial distribution was made by a qualifying issuer which has been a reporting issuer in any one of several listed provinces for at least four months. The seasoning period for securities of a non-qualifying issuer is 12 months.

The proposed instrument also tries to harmonize distributions from control blocks (generally over 20% of the outstanding voting securities of an issuer) and trades in securities of a non-reporting issuer over a foreign exchange or market.


The CSA also published Notice 46-301, announcing its intention to develop for comment a national instrument relating to a proposal for uniform terms of escrow which would apply to IPOs. The proposal would guide securities regulatory staff in exercising their discretion to accept escrow arrangements consistent with the proposal, in lieu of escrow arrangements under existing policies.

The Toronto Stock Exchange (TSE) has stated its support of the proposal, and has discontinued its practice of scrutinizing and, in some cases, disallowing, pre-IPO options granted at a discount to the IPO price. Instead, the TSE will treat options granted before the date of the preliminary prospectus as equity securities, for the purpose of determining the number of securities, if any, to be escrowed.

These developments will be of interest to venture capital investors who are caught as related security holders, because they often hold more than 10% of a class of equity stock. The proposal clarifies which securities are to be escrowed, which principals are captured by the escrow requirements and which issues are subject to escrow. Generally speaking, the proposal also allows shorter escrow periods and faster releases.


At the time of publication, industry specialists were forecasting dramatic increases in both the number of venture capital deals completed, as well as amounts raised per round and in total for the industry. With favourable legislative and regulatory changes proposed in 2000, some of which are likely to take effect, 2001 should easily surpass previous records.

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