There is a wide range of financing options available in Canada for new and expanding businesses. These options range from shareholder infusions of capital to sophisticated institutional financing.
A subsidiary corporation (or other business entity) operating as a new business in a Canadian province such as Ontario often is initially funded solely by its shareholders by way of equity, debt or a combination of the two. In a liquidation, debt will be paid out before any return of equity. A shareholder can also take security (usually by way of a general security agreement or debenture) over all the assets of the subsidiary company to secure repayment of the debt.
When the company needs external financing, all shareholder loans (and any security for such loans) typically will have to be subordinated to the third-party debt; however, shareholders will still have priority for secured loans over other unsecured creditors of the company.
External Debt Financing
Types of Loans
Third-party financiers typically offer a business an operating or term loan, or a combination of the two, which can be provided on an unsecured or secured basis.
“Operating loans” are revolving loans usually provided on a short- to medium-term basis and to finance the company’s and its subsidiaries’ working capital needs. If the loan is an “asset based” loan, borrowing availability is based on a “borrowing base.” This type of loan may be used to finance working capital requirements, acquisitions, recapitalizations and capital expenditure projects. It often will not contain financial covenants, other than a minimum excess borrowing availability (i.e., liquidity) covenant. Such a loan can provide for larger distributions to equity sponsors than competing loan products (i.e., a “cash flow” loan), because the available credit is based on collateral values rather than cash flow or leverage.
“Term loans” are typically medium- to long-term loans that are available for a fixed period of time and repayable on the occurrence of prescribed events of default or on demand. They often are amortized over the term of the loan, with required periodic payments of principal and then a “bullet” payment at the end of the term. Regularly scheduled interest payments are usually required; however, a portion of interest frequently may be capitalized. These loans may be borrowed in “tranches” and often finance an acquisition, expansion or other specific capital projects.
Many lenders require a borrower to provide, at a minimum, security over the assets being financed and, in many cases, over all of the borrower’s personal property, including after-acquired property and real property. If operating financing is being provided to a company by a different lender than the term lender, the term lender may require a second lien on the “primary” collateral security of the operating lender and, although less frequently, vice-versa. Lenders also may require parent holding companies, subsidiary companies and individual shareholders to provide guarantees and security as additional credit support.
Each of the common-law provinces in Canada has enacted personal property security legislation that is similar to the U.S. Uniform Commercial Code Art. 9 regime and that governs the creation, registration and enforcement of security on personal property. The Civil Code of Québec governs such matters in Québec. The federal Bank Act also permits banks to receive security in raw materials, work in progress and finished goods inventory, as well as other specified assets and equipment. Sources of debt financing include Canadian chartered banks, foreign banks, “near” banks and other financial institutions.
Domestic and Foreign Banks
A few very large, domestic chartered banks that are regulated by the federal government offer debt financing and provide cash management and investment services. Most Canadian chartered banks have a highly developed network of branch operations throughout the country. Since some of them also have a presence in the U.S. and internationally, these banks can be a useful liaison for a foreign investor establishing a business in Canada.
The federal Bank Act governs the activities of domestic and foreign banks operating in Canada. It authorizes Schedule I (domestic) banks and Schedule II (foreign subsidiary) banks that are controlled by eligible foreign institutions to accept deposits and Schedule III banks (foreign bank branches of foreign institutions) to do banking business in Canada. Neither Schedule II nor Schedule III banks are non-residents of Canada for withholding tax purposes.
Foreign banks concentrate mainly on commercial (not retail) banking activities. Increasing competition in this field provides commercial business borrowers a broader range of institutional lenders to turn to. Foreign banks operating in Canada often provide the necessary financial liaison with the foreign investor and the opportunity to deal with the same bank in the investor’s home country when a new Canadian business is established.
While unable to take deposits, life insurance companies in Canada manage segregated investment funds, including pension funds, and provide medium- to long-term financing. Trust and loan companies in Canada are generally incorporated under the federal Trust and Loan Companies Act and take deposits and provide debt financing.
Credit unions, “caisses populaires” in Québec and the financing arms of major industrial companies and hedge funds also provide financing. In addition, financing can be secured from conventional real estate mortgage lenders for real property. Some large corporations sponsor “incubator” projects, investing funds (and often human capital) in new companies in the hopes of receiving a return on their investment.
Other Financing Sources
Acquiring capital assets from a manufacturer on a conditional sale basis or by way of a lease, either on an operating or capital basis, allows a company to pay for assets from its regular cash flow over time, reduce or eliminate the need for a substantial initial payment, and secure tax and/or accounting advantages. Many lease finance companies will buy assets specified by the company and then lease those assets to the company, allowing the company to convert its existing assets to capital while retaining use of those underlying assets in the business.
A company may sell its accounts receivables to a factor who will advance a percentage of the amount of the receivables. When its receivables are paid in full, the company will receive the balance of the amount, less any fees and interest charged by the factor.
In a securitization, certain assets of a corporation are pooled and transferred into a separate legal entity which finances the purchase of this portfolio by issuing debt or debt-like instruments into the capital markets, secured by the portfolio assets. Securitization can offer competitive pricing since pricing is based on the quality of the assets and credit enhancements, rather than on a company’s corporate covenants. It may also permit smaller companies to grow more quickly, since a more traditional bank loan might impose more limiting financial covenants (such as a leverage ratio).
External Equity Financing
External equity financing options include: venture capital firms, merchant banks and private or public offerings.
Companies willing to provide venture capital to new businesses, venture capitalists (VCs) are private or publicly sponsored pools of capital that are interested in taking a minority equity position in a company (and, oftentimes, in making some debt financing available) in exchange for significant influence over the management and direction of the company.
The investment timeline is typically five to seven years. VCs often invest in a company at the early stages of development, before sufficient predictable cash flows have been generated to attract institutional debt financing. VCs have a fairly strong presence in the technology and bio-science sectors, despite a decline in other sectors.
While they do not take deposits, merchant banks frequently take an equity stake in the business. Particularly active in financing buyouts, M&As, workout or turnaround situations and strategic alliances, they often provide subordinated debt, or mezzanine financing, ranking behind any senior debt of the company but ahead of the company’s equity holders. This is frequently tied to an “equity kicker,” such as warrants or options to acquire equity in the company.
Merchant banks typically provide “patient” money with a five- to seven-year timeline. If an equity interest is taken in the company, a shareholders’ agreement with other equity stakeholders often is required to address issues such as control of the company, restrictions on the transfers of shares and requirements for further injections of capital.
Private Placements and Public Financing
Brokers and investment dealers usually handle public fundraising (i.e., a private placement of securities to a few sophisticated investors or a more general distribution to the public through a prospectus). Since associated fees and expenses tend to be substantial, this financing route is suitable where large sums of money are to be raised but may not be appropriate for a new company. Institutional investors who provide equity financing may be more attractive to some companies given their sophistication and disinclination to seek an active role in the management of the company.
The viability of a public offering to raise capital depends on the general condition of the financial and stock markets, the health and prospects of the particular industry, internal factors pertaining to the company, etc. In addition to the costs of “going public,” the costs of staying public include ensuring the company maintains its listing and is in compliance with the continuous disclosure requirements imposed under securities legislation, as well as ongoing professional fees for preparing financial statements, reports, circulars, etc. Note that a public offering often may be the exit strategy for venture capitalists, merchant bankers or other early-stage investors in the company.
Valued at over $200 billion at their peak, Income Funds or income trusts were the dominant form of equity financing in Canada until the Government of Canada announced its proposal to impose an entity-level tax on income trusts on October 31, 2006. Trust valuations plunged thereafter and, in subsequent months, acquirors employed available private debt to finance income trust acquisitions.
On July 14, 2008 Canada’s Minister of Finance released draft tax rules that would generally allow existing income trusts to convert to corporate form on a tax-efficient basis during a five-year window that would end on December 31, 2012. In a troubled global economic climate where credit is not readily available, Trustees of Income Funds will face challenging strategic decisions over the next several years, including: whether (or when) to convert such funds to a corporate structure, whether to pursue growth opportunities or whether to sell.
Unlike the national regulation of securities by the SEC in the United States, securities are regulated by the provinces in Canada. Although securities regulation does vary from province to province, provincial regulatory authorities work closely together through the Canadian Securities Administrators to create a cohesively regulated Canadian securities market.
There are three main stock exchanges in Canada: the Toronto Stock Exchange, the TSX Venture Exchange (trading in small-cap Canadian stocks and many high-risk penny stocks) and the Montreal Exchange (trading in derivatives only).
Government Assistance Programs
Some federal and provincial government assistance programs targeted at small- and medium-sized businesses have been cut to balance budgets and reduce debt.
Many federal direct subsidy programs have shifted toward repayable loans. Others no longer offer government loans, facilitating financing through commercial loans and bank financing. The federal Business Development Bank of Canada provides business loans, loan guarantees and export financing; offers management training programs; and has formed strategic alliances with many domestic banks.
Although a Canadian corporation’s operations are based in one particular province, assistance from another province may be possible where the corporation’s marketing will be done nationally through branch operations.