The influence of taxation on capital structure in venture capital investments in Canada and the United States.

• Author: Ollivierre, Scott

Abstract

Broadly speaking, venture capital refers to the pooling of private capital for investment in early-stage companies with a high potential for capital growth. One of the most important choices in venture capital contracting is the method of financing to be used. Evidence has shown that the preferred methods of financing change depending on the country of the investment. In particular, empirical studies show that, in the U.S., convertible preferred shares are used in the vast majority of venture capital investments, while in Canada a wider range of structures are used.

American academics have argued that, by investing via convertible preferred shares, venture capitalists investing in U.S. portfolio companies can reduce the tax burden on employee stock compensation, providing a benefit that can be shared between both parties. Portfolio companies can receive such a tax benefit by valuing the convertible preferred shares at an artificially high level compared to the common shares used as employee compensation. The argument is that lax enforcement by the IRS of these artificial valuations lowers the effective tax burden on employee stock compensation and has resulted in convertible preferred shares being the financing vehicle of choice.

This paper compares the tax regimes of Canada and the U.S. as related to capital structure choices and concludes that taxation may provide an explanation for why venture capitalists investing in Canada choose to invest using a wider range of vehicles. First, in relation to stock-based employee compensation, it concludes that while it is uncertain as to how the CRA or Canadian courts would react to a U.S.-style low valuation of common shares compared to convertible preferred shares, even if such a valuation would be acceptable, the tax incentives to pursue such a strategy in Canada are not as strong. Second, because there are other Canada-specific provisions where tax incentives (or disincentives) may militate against convertible preferred shares, venture capitalists investing in Canada may choose different capital structures to take advantage of those incentives (or avoid the disincentives). The paper closes by laying the groundwork for further research and analysis by questioning whether a tax-neutral legislative regime would be preferable to systems such as the U.S., and to a lesser extent Canada, which provide incentives to choose a particular capital structure.

Resume

Le capital de risque designe la mise en commun de capital prive aux fins d'investissement dans des societes en premier developpement avec un fort potentiel de croissance du capital. La methode de financement s'avere une des decisions les plus importantes s'attachant aux engagements contractuels lies au capital de risque. Les recherches demontrent que les methodes de financement privilegiees different selon le pays ou se font les investissements. Plus specifiquement, les etudes empiriques revelent que les actions privilegiees convertibles sont utilisees dans la grande majorite des investissements de capital risque aux Etats-Unis, alors qu' au Canada une gamme plus etendue de structures est utilisee. Les universitaires americains maintiennent qu'en investissant au moyen d'actions privilegiees convertibles, les societes de portefeuille americaines peuvent reduire le fardeau fiscal impose au regime de remuneration a base d'actions des employes, creant ainsi un profit pouvant se partager entre les deux parties. Les societes de portefeuille recoivent un avantage fiscal en evaluant les actions privilegiees convertibles a un niveau artificiel eleve comparativement aux actions ordinaires de remuneration des employes. L'argument est que le laxisme de l'I.R.S. par rapport aux evaluations artificiellement elevees reduit le fardeau fiscal de la remuneration a base d'actions des employes et contribue au choix des actions privilegiees convertibles comme mecanisme de financement privilegie.

Cet article compare les regimes d'imposition canadien et americain en rapport aux choix de structures financieres et conclut que la fiscalite peut expliquer pourquoi, au Canada, les societes de capital risque privilegient une plus grande variete de structures financieres. D'abord, ence qui concerne la remuneration a base d'actions des employes, l'article conclut que meme si l'on ne peut predire les reactions de I'ARC et des tribunaux canadiens devant a une evaluation peu elevee des actions ordinaires vis-a-vis des actions privilegiees convertibles--meme si une telle valeur etait acceptable--les incitatifs fiscaux pour adopter une telle strategie au Canada ne sont pas aussi considerables. Ensuite, puisqu'il existe d'autres dispositions canadiennes ou les mesures incitatives (ou dissuasives) fiscales desavantagent les actions privilegiees convertibles, les societes de capital risque qui investissent au Canada auront tendance a choisir des structures financieres qui favorisent les mesures incitatives (ou encore evitent les mesures dissuasives). Enfin, en questionnant si un regime legislatif de neutralite fiscale serait preferable au systeme americain, et a un moins degre, au systeme canadien qui offre des incitatifs visant des structures financieres precises, cet article pose les bases pour des recherches et analyses plus poussees.

I INTRODUCTION II EMPIRICAL EVIDENCE OF CAPITAL STRUCTURE IN THE UNITED STATES AND CANADA III POSSIBLE NON-TAX REASONS FOR DIFFERENCE IN CAPITAL STRUCTURE CHOICES IV TAXATION REASONS FOR DIFFERENCE IN CAPITAL STRUCTURE CHOICES Taxation Strategies for Stock-Based Employee Compensation in the United States Tax Treatment of Common Share Grants Tax Treatment of ISOs Tax Treatment of NQOs How Convertible Preferred Shares Can Lower the Value of Common Shares Taxation of Stock-Based Employee Compensation in Canada Taxation of Stock Compensation for CCPCs Taxation of Stock Compensation for Non-CCPCs Taxation of "Out of the Money" Stock Compensation for Non-CCPCs Taxation of "In the Money" Stock Compensation for Non-CCPCs Does the "Price Wedge" Strategy Work in Canada? Summary of Canadian Taxation of Equity Compensation Tax Structuring to Qualify as a CCPC Other Tax Benefits of a CCPC Choosing a Capital Structure to Facilitate CCPC status Other Tax Provisions Relevant to Capital Structure Choice Direct Tax Credits Taxable Preferred Shares Uncertainty with Regard to Capital Gains Treatment of Venture Capital Investments Conclusions with Regard to Tax Influences on Capital Structure V TAX POLICY AND VENTURE CAPITAL FINANCING STRUCTURES VI CONCLUSION I INTRODUCTION

Broadly, venture capital refers to the pooling of private capital for investment in early-stage companies with a high potential for capital growth. In a typical venture capital arrangement, investors contribute to a fund (known as a "venture capital fund") managed by venture capitalists, (1) which makes investments in early-stage companies (known as "portfolio companies") with three- to ten-year investment horizons. (2) Venture capitalists typically play active roles in the portfolio companies, utilizing their experience and networks to help the portfolio companies' management succeed. (3) In the past several decades, the venture capital industry has emerged as a critical player in the advancement of innovation and technology in the economy, giving modern technology giants such as Microsoft, Google, and Research in Motion, their starts. (4) Among the many facets of venture capital finance, capital structure and financial contracting choices have provided particularly good fodder for discussion and analysis. Extensive literature has been devoted to how the venture capital fund and the portfolio company can structure their relationship to minimize agency costs and information asymmetries and to align the incentives for the parties to create the optimal environment for the growth and success of the venture. (5)

One of the most important choices in venture capital contracting is selecting a method of financing. The parties have a wide range of choices and can tailor agreements to the particular circumstances in which they find themselves. Empirical evidence has shown that the choice of financing varies from country to country; in particular, convertible preferred shares are used in the vast majority of venture capital investments in the U.S., (6) while a wider range of structures is used in Canada. (7)

In a well-known article, Ronald Gilson and David Schizer argue that, by issuing convertible preferred stock rather than common shares, portfolio companies in the U.S. can reduce the tax burden on employee stock compensation, providing a benefit that can be shared between the venture capital fund and portfolio company employees. (8) The authors assert that portfolio companies can take advantage of lax enforcement by the Internal Revenue Service (IRS) and use differences in the valuation of common and preferred shares to lower the effective tax on employee stock options and grants. This article addresses the question of whether differences in taxation regimes between Canada and the U.S. may help to explain the different financing structure choices made by venture capitalists in the two countries.

First, this article discusses differences in the two tax regimes with regard to stock-based employee compensation. On this point, it concludes that the incentives to pursue such a strategy in Canada are not as strong. This is true despite the fact that neither the courts nor the Canada Revenue Agency (CRA) have addressed this issue and that it is uncertain how they would react to a U.S.-style low valuation of common equity compared to convertible preferred equity. Second, because there are other areas where tax incentives (or disincentives) may militate against convertible preferred shares, venture capitalists investing in Canada may choose different capital structures to take advantage of those incentives (or to avoid the disincentives). Finally, assuming...