Canada’s tech sector is in more demand than ever before, with a rise in IPOs and M&As leading to soaring investment in the market. This has led to new trends emerging, changes in regulatory approaches, and a shift in how market players have approached going public and acquiring assets. We asked Stikeman Elliott partner Jared Bachynski to walk us through what this means for Canadian firms and investors.
How does the increase in tech sector IPOs benefit the current M&A marketplace, and does it impact the sector going forward?
Successful IPOs boost the entire Canadian tech sector by providing a halo effect. For one, they provide substantial liquidity to founders, investors and early employees, seeding the next generation of angel investors and startup founders. Successful strong independent Canadian public companies are important for the Canadian tech sector and they provide benefits across the tech ecosystem on an ongoing basis beyond the IPO as well. Canadian public companies can inspire, train, and finance the next generation of entrepreneurs who will go on to build the companies that will fuel the Canadian tech sector in years to come. Public companies also, of course, can be active venture investors and M&A acquirers in their own right. With easier access to public capital markets and the ability to use their own stock as currency, Canadian public companies are formidable players in the tech M&A market.
Staying with that point, what factors should start-ups and mid-level corporate clients consider when taking their company public? Is there an accurate way to gauge valuation before IPOs are launched?
Canada’s venture markets are special in that they provide early access to capital and liquidity at much smaller valuations (compared to U.S. markets) which may be tempting for some startups. However, it is important for a company to have reached a certain size and momentum before going public to maximize public interest and trading volume, attract analyst coverage and ensure ongoing success of the listing. The high overhead and compliance costs can be a challenge for venture issuers who IPO too early if they are not able to capture the full potential of being a publicly traded company. In terms of valuation, while of course the most recent private investment round can be a proxy, they are not necessarily indicative given the preferred share terms that are prevalent in privately financed tech companies. A good investment bank (with tech experience) will be able to give guidance on valuation based on comparables and the company’s own trajectory.
Do you see the Canadian tech market following “traditional” M&A practices or will 2021 see a rise in Special Purpose Acquisition Company (SPAC) deals? What are the benefits of each approach for tech firms?
We are continuing to see an insatiable appetite for Canadian M&A targets from private equity buyers. If January and February are any indicator, the hot market from 2020 will continue apace in 2021. From relatively small startups to very large established enterprises, Canadian tech companies continue to be sought out as platform acquisitions and bolt-ons by private equity from around the world. SPACs raised an enormous amount of capital in 2020, many of them are technology focused, and there is no doubt that SPAC acquisitions will be a major part of the IPO story of 2021. For many Canadian tech companies, M&A has traditionally been regarded as the path to liquidity. However, with the enormous growth in SPACs, there will be a lot of hungry acquirors with capital and a path to a public listing looking for their investment opportunity. We can expect SPACs to exert upwards pressure on valuations for the best acquisition targets. SPACs present an opportunity for leading privately held Canadian tech companies to maintain independence while providing growth financing and liquidity to their shareholder base, while reducing the risks associated with pricing and launching a traditional IPO. On the smaller end of the market, the TSX-V also recently rebooted the CPC program, doubling the amount of investment permitted at the IPO stage and ending the process of downlisting CPCs to the NEX board after two years. These welcome changes have improved this made-in-Canada path for Canadian tech companies to access the venture markets with reduced regulatory burden.
How can Canadian tech companies make themselves more attractive to cross-border investment, and what are the risks associated with acquisition by foreign firms?
Nothing beats strong business fundamentals – growing revenue, barriers to entry, and compelling product-market fit. Many Canadian businesses have seized on the great opportunity to sell to a cross-border buyer since the larger pool of potential acquirors in the U.S., and around the world, allows them to find the ideal acquiror, whether strategic or financial. From a legal perspective, preparation is the key to seizing opportunity. Taking the time to make sure that your company is investment-ready from a capital structure, governance and IP ownership perspective will let you move and close a deal quickly. There are of course some risks specifically associated with selling to a foreign buyer. From a financial standpoint, Canadian firms that rely on Canadian governmental assistance such as SRED credits need to be aware of the potential loss or reduction of incentives if they cease to be a Canadian controlled private corporation. For many firms, these incentives are a bonus, but for others they can be must-haves, which requires making strategic decisions around transaction structuring or can even make a foreign takeover financially unviable. Further, from a regulatory perspective, we are seeing more national security reviews under the Investment Canada Act than we have ever seen before. Canadian companies, especially in potentially sensitive industries, should be aware of Canada’s national security review process under our foreign investment statute when considering investment from outside of Canada.
What advice could you offer firms that operate in the subsectors that are most vulnerable to market “bubbles” or fluctuations?
From the company’s perspective, it can be tempting to take as much investment as possible at a high valuation while the capital is there. A high valuation minimizes dilution and many tech companies expect to burn cash in pursuit of growth for extended periods of time, so shoring up the balance sheet while the market is hot can seem to be a sound strategy. But be careful about the deal terms – many investors will insist on investing in preferred shares with special protections that can be a minefield if the bubble bursts. Typical preferred shares would have the same value as a common share if the company continues to be a growing success, but have serious downside protections such as liquidity preferences, IPO return guarantees, vetoes over down-round financings or IPOs, and seniority to all other investors if the company falters. Even if the company is only moderately successful, preferred shares can eat into the common equity in order to provide minimum returns to the investors. It’s not uncommon for a company to guarantee a certain level of return on investment in exchange for new money – and if the promised success does not materialize, the common shares are underwater. We have seen several examples of Canadian founders selling preferred stock to investors and retaining common stock, only to end up with the common stock being worthless on the ultimate exit.
What factors should private equity clients consider before entering the tech sector? How will debt, interest rates, and regulations impact the market?
Many private equity funds have deep domain expertise in technology, so Canadian private equity entering the tech sector for the first time should ensure that they have access to technology industry expertise, as they will be competing with established technology investors. As this remains a sellers’ market, many founders are increasingly looking for the right partners in terms of networking, access to markets, advice and other “services” – as well as continued exposure to the upside of the business through equity retention. As a private equity investor in this market it may not be sufficient – or desirable – to simply try to compete on valuation. Making the pitch for why your firm is a great fit with respect to these soft factors may be key to landing a deal. Of course, valuation at closing is still important. In this low interest rate environment, capital remains readily available and leading tech companies will be expected to continue to trade at robust valuations.
Do you have any other insights on the technology sector’s legal landscape post/during COVID?
From a business and legal perspective, one fascinating aspect of the story of COVID has been the resurgence of crypto. Investors have predicted higher inflation on fiat currencies as the inevitable consequence of the debts that governments have incurred to support expanded social welfare programs during COVID. Bitcoin and other cryptocurrencies have been seen as a hedge against inflation. High profile investors like Elon Musk and Tesla and Canadian public companies like Mogo have announced investments in Bitcoin and other cryptocurrencies. While investment in crypto is creeping toward the mainstream, the underlying technology is still not well understood by the general public, and regulatory and infrastructure risks remain significant. In particular, the interface between fiat currencies and crypto remains challenging, driving many investors to grey market exchanges with attendant risks and transaction costs.
Jared Bachynski is a partner in the Corporate and Securities Group at Stikeman Elliott and is also a member of the Technology Group. He advises clients on a range of Canadian and cross-border transactional matters, including public and private M&A, public and private equity financing, growth equity investments, joint ventures and general corporate and securities law matters. He also has experience advising private equity funds on completing investments and managing portfolio companies across a range of industries. In addition, Jared works with founders of startup companies in formation and financing of new ventures.