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Assessing Capital Structure Before an Initial Public Offering: Factors Considered by the Canadian Securities Administrators

The Canadian Securities Administrators (CSA) published Staff Notice 41-305 - Share Structure Issues – Initial Public Offerings on September 24, 2010, in order to provide indications to IPO candidates and their advisors as to the factors the securities regulatory authorities will consider when assessing the proposed share structure of an IPO candidate.

Over the last year, we have encountered instances where, when acting for IPO candidates or their underwriters, information on the IPO candidates’ capital structure was required by the securities regulatory authorities. Reference was made to the securities regulatory authorities, referring to their need to assess the appropriateness of an IPO candidate capital structure in the name of the public interest. Areas of interest included the history and development of a corporation and investments made by the founders as well as on any prior valuation. More specifically, instances where the proposed IPO candidate never benefited from the support of venture capital or from a third party investment were a concern for the securities regulatory authorities as such investments are of assistance in the determination of the valuation of the proposed share capital IPO structure.

CSA Staff Notice 41-305 confirms that this concern has now reached a stage where industry participants must be made aware of the CSA position on this issue. It is intended to provide guidance to IPO candidates and their advisors on how to best address the acceptability of an IPO candidate share capital structure.

This notice mentions that issues regarding shares issued for a nominal cost consideration were better addressed by the underwriters, as indicated in National Policy 46-201 - Escrow for Initial Public Offerings, and that these issues were also examined by the TSX Venture Exchange and the CNSX as part of their review of the listing conditions. However, notwithstanding those policies and guidelines regarding the assessment of the appropriateness of a share capital structure, the CSA indicated that there are still IPO candidates with capital structure that raise public interest concerns and that the regulatory authorities may object to granting a receipt when the IPO price significantly exceeds the average price paid by the founders. In particular, before granting a receipt, the CSA will consider the average capital contributed per share for all issued and outstanding shares on completion of the IPO and compare it to the purchase price of the IPO, thereby assessing the dilution suffered by the IPO purchasers.

However, other factors considered by the CSA in evaluating acceptable share capital structures in those circumstances include the prior development and history of the business, including whether there exists third-party corroboration of the value proposed from significant pre-IPO arms-length financing activities, as noted above, the involvement and sums invested by the founders, and the length of time and development of the business since its inception.

In addition, outstanding convertible securities with an exercise price at a significant discount from the IPO price will also be considered when assessing the capital structure of an IPO candidate. As a result, if the number of convertible securities is large enough, or the exercise price is low enough, and if such convertible securities resulted in a substantial dilution for the subscribers in the IPO, the securities regulatory authorities may object to an otherwise acceptable share structure.

This notice brings back to the forefront certain issues regarding the pre-IPO pricing of convertible securities and escrow requirements, which had been erased from the minds of industry participants by previous modifications to the prospectus regime. As mentioned in this notice, it is not the intention of the CSA to provide certainty for every possible scenario and to definitively determine whether a given structure is acceptable, but to provide some insights regarding factors considered by the securities regulatory authorities in this respect. These factors should be kept in mind by potential IPO candidates and their advisors at the structuring stage of the transactions.