Ten things to consider when acquiring the shares of a Canadian corporation
You have decided to purchase a private business in Canada. The first decision you will need to make as a purchaser of a Canadian business is how to structure the transaction. One such structure is a share purchase. This article will discuss ten of the key considerations that a purchaser must take into account when acquiring the shares of a Canadian business.1
#1 letter of intent
The first material step2 in a share purchase typically sees the seller and the purchaser enter into a letter of intent (“LOI”) (also known as a term sheet or memorandum of understanding), setting out the intention of the parties to subsequently enter into a definitive agreement. The LOI specifies the key terms and conditions of the transaction, including the purchase price, the type of transaction, and the indicative timeline for closing.
Although, in most cases, the LOI is not legally binding, it can specify that certain provisions are legally binding, for example, provisions relating to expenses, confidentiality and exclusivity. It is often in the best interests of the purchaser to include a binding exclusivity provision as it provides the purchaser with comfort that before the purchaser expends significant time or resources pursuing the transaction, the seller will not enter into an alternative transaction with another prospective purchaser.
For further information refer to our article on LOIs.
#2 do your due diligence
After entering into an LOI, the parties will engage in a period of due diligence. The purchaser’s due diligence can involve business, IT, human resources, real estate, financial, tax and legal specialists to investigate the target company. The scope of legal due diligence includes reviewing the target company’s corporate documents, contracts, licenses and permits, and any intellectual property owned or used by the target business. Additionally, public record searches will reveal, among other things, whether there is any registered security on assets of the target company, and whether there is any pending or past litigation involving the target company. The due diligence process also allows the purchaser to locate any impediments to the transaction such as, third-party consents (i.e. upon a change of control of the target), or prohibitions on transfer.
The purchaser’s due diligence review must be catered to the specific circumstances of the share acquisition itself, which can vary due to the size and complexity of the transaction, as well as the nature of the target’s business.
For further information refer to our article on the due diligence process.
#3 tax planning
There is always some tax planning that can be done to ensure the proper tax structure is utilized for purchasers. This is especially true in the case of cross-border transactions.
#4 parties and purchase price
Parties: The main parties in the share purchase agreement (“SPA”) are the purchaser and the seller(s) (i.e. the target company’s shareholders). However, the parties should consider whether the obligations of the other ought to be guaranteed by third parties, such as any principal of any selling party that is a corporation or trust, or regarding a non-compete. The first draft of the SPA is generally completed by the purchaser.
Price: When specifying the purchase price in the SPA, the parties should turn their attention to both the amount and the manner of payment. The purchase price can be paid entirely in cash, in shares of the purchaser (or an affiliated entity), in other property, in a vendor take-back (“VTB”)3 and contingent payment option, or in a combination of the foregoing. The timing of the payment may also be adjusted based on the parties’ circumstances. For example, a portion of the purchase price may be paid up front and the balance deferred in part and evidenced by a promissory note.
#5 working capital
The purchase price may be fixed or subject to adjustment. The most common purchase price adjustment is based on the target’s working capital, which allows the purchaser to ensure that the target has enough working capital to operate post-closing as it did prior to closing. If the working capital of the target is deficient, the purchaser will need to infuse more cash into the target, effectively increasing the purchase price. To avoid this, the purchaser will require a working capital adjustment to be built into the purchase price to decrease the purchase price if, as of the closing date, the working capital of the target or business is below a certain level. As the balance sheets and financial statements of the target as of the closing date often cannot be finalized at closing, the parties usually agree to adjust the purchase price after a specific period post closing (e.g. 60 days).
An earn-out provision is a negotiated arrangement whereby a portion of the purchase price is determined by the future performance of the target’s business and is used to bridge a valuation gap. The mechanism is usually determined by the revenue or EBITDA achieved by the business in a specified period post-closing. It is our observation that there has been a recent increase in the use of earn-outs. Care must be taken to negotiate these complicated provisions. As the structure of an earn-out may cause certain tax consequences, the parties ought to also consult with tax and/or accounting specialists.
#7 representations, warranties and indemnities
The representations and warranties are the “guarantees” that the seller makes to the purchaser about itself, the target business, the financial information that has been provided by the seller and the authority and ability of the seller to enter into the share purchase agreement. The representations and warranties are typically qualified by reference to disclosure schedules that contain additional information or qualifications to the representations and warranties being made. There is usually a great deal of back and forth about the representations being provided and the precise wording of each representation. Purchasers should specify any additional representations based on their due diligence and key components of the target’s business.
An indemnification provision serves to operate as a post-closing mechanism that addresses any damages that may be suffered pursuant to the SPA, following breaches of, or inaccuracies in, a representation or warranty provided by one of the parties, the failure to perform certain covenants, etc. The specific process set out in an indemnification provision is often heavily negotiated by the parties. Limitations are often set by way of caps, thresholds, and survival periods. Survival provisions provide for the expiration of indemnity claims under the SPA which often range depending on the type of representation and warranty. As well, certain provisions can be, and often are, excluded from the foregoing limitations on indemnification. Purchasers would also want there to be a right of set-off for any amounts owned by the indemnifying party in connection with indemnification obligations against any amounts owed by the indemnified party.
#8 conditions precedent
Condition precedents, relevant when signing and closing are split up, often include the requirement to obtain any necessary regulatory approvals, any third-party consents, confirmation that there has been no material adverse change, binding representation and warranty insurance and third party financing required to close the acquisition.
#9 employment considerations
In a share purchase transaction, the employment relationship between the target company and its employees is relatively unaffected.
At a minimum, the purchaser should identify key employees of the target company that it wishes to retain following the acquisition. The employment agreements of these key employees ought then be reviewed to determine whether a change in control of the target company would equate a termination of employment or trigger the employee’s ability to terminate the employment relationship. Even without a change of control, key employees could leave as a result of the uncertainty arising from the transaction. To address these concerns, the purchaser may wish to offer retention agreements or make the transaction conditional upon those key employees remaining with the target company post-closing or entering into new employment agreements.
#10 regulatory approvals
Under the Competition Act (Canada), where certain thresholds are met, parties to a SPA must notify the Competition Bureau and observe the 30-day statutory waiting period prior to completion of the transaction, unless the parties obtain an advance ruling certificate or a non-action letter from the Competition Bureau indicating that the Commissioner of Competition (“Commissioner”) does not presently intend to challenge the transaction. The Commissioner considers whether the notifiable transaction will have, or is likely to have, the effect of preventing or lessening substantially competition in a definable market. The filing fee for Competition Bureau review is significant and while typically born by the purchaser, the parties may agree to share the cost.
The Investment Canada Act (“ICA”) applies to share purchase transactions where the purchaser, or the purchaser’s ultimate controller, is a non-Canadian individual or entity, and directly or indirectly purchases all or substantially all of the voting shares of an existing Canadian business. The transaction may require review and approval by the federal government under certain circumstances, such as where certain monetary thresholds are exceeded. Where the target of the acquisition is a Canadian “cultural business” (as defined under section 14.1 of the ICA), the monetary threshold is much lower, and even where such a transaction falls below the threshold, the government may still order a review on a discretionary basis.
Where such governmental approval is required, the government must be satisfied that the acquisition is likely to be of “net benefit” to Canada. A share acquisition that is not reviewable is notifiable, and such notification must be filed with the Investment Review Division either any time prior to, or within 30 days following the closing of, the transaction.
In addition, if the government has reasonable grounds to believe an investment could be injurious to national security, the government may make an order for a review of the investment.
Post-closing considerations and conclusion
The parties may need to attend to a number of post-closing items which will be specific to the context and particular transaction itself, such as working capital, earn-outs, ICA notifications, etc.
There are numerous important considerations in deciding how to structure the purchase of a private Canadian business and this article has discussed a number of them.
This article provides only general information about legal issues and developments, and is not intended to provide specific legal advice. Please see our disclaimer for more details.