Legal Considerations in Tech Lending
Canada’s tech industry is booming. The last census estimated that Canada’s tech sector contributed $83.5 billion to national GDP. Growth in Canadian tech is expected to continue. Employment in digital occupations is expected to rise by 8% by 2026 according to Employment and Social Development Canada’s (ESDC) Canadian Occupational Projection. The federal government has also pledged to invest $950 million as part of its superclusters initiative in furtherance of Canada’s world-leading position in quantum computing and artificial intelligence.
Growing technology companies need capital and, as a result, there has also been growth in financing tech enterprises. Financing options include raising equity on the public markets, venture capital, private equity, and debt financing.
While growth stage technology companies have traditionally looked to equity capital, there are several underlying drivers of debt financing as well. Since equity financing is dilutive of a founder’s equity and control, entrepreneurs are highly concerned with the valuation of their company at each financing round. Non-dilutive debt financing is therefore attractive to founders who believe that they can scale their business further in order to achieve a higher valuation in subsequent equity financings. For example, in 2008 Facebook leveraged $100 million in venture debt to buy additional servers in order to scale its business before conducting equity financing at a significantly higher valuation. Lending can also help to extend the time period before the next raise or exit.
While debt financing may be attractive to some entrepreneurs, it also raises legal considerations which are slightly different from a traditional bank debt financing; a few of which are outlined below:
1. Financial & Legal Due Diligence
Technology companies differ from traditional brick and mortar businesses because they have few, if any, tangible or hard assets. As a result, valuing the business is difficult both for purposes of mergers and acquisitions and financing arrangements. It is important to ensure that proper due diligence is done beforehand.
The legal portion of the financial due diligence on tech companies usually involves a review of all of the borrower’s customer agreements (revenues) and supplier agreements (operational expenses). For example, if the borrower is a software as a service (SaaS) provider, the borrower will typically have significant IT infrastructure/hosting expenses. The reviews are done to confirm and verify that the business’ financial model has legs to stand on. Understanding the mechanics of a borrower’s revenue model is a critical first step.
Technology lending transactions also see significant focus on intellectual property (IP) diligence, including the legal ownership and location of any IP assets. The expense of diligence on IP ownership will be impacted by the jurisdictions involved. Where a borrower is a later-stage company which has already completed a series of capital raises, lenders will expect that a borrower has registered its IP with applicable IP offices. Lenders will usually use patents, trademarks, domain names, branding, and other IP assets, as security for their loans.
Since every organization today depends on data, the quality and sources of an organization’s underlying data is another key area of due diligence. This is particularly relevant for technology companies who depend on data to train their algorithms in order to develop products. Significant gaps in data, insufficient cyber risk controls, or collection via screen-scraping may raise concerns for data quality and user privacy. This can affect the underlying valuation of an organization and terms of financing.
If warrants or equity sweeteners are involved in the financing, there will be a need for diligence and equity expertise. Considerations include terms for preferred equity issued to financiers, minority shareholder approval rights, and potential board observer rights for lenders.
2. Focus on the Founder
Focusing on founders is important for early state companies, as a company’s success is usually correlated to its founders’ prior entrepreneurial experience. To ensure that loans are used to drive growth in a company, lenders may require founders to personally guarantee the loan and impose negative covenants on the founder’s salary, distributions to its shareholders and affiliates, and business expenses. Further, credit agreements may include terms specific to a founder, such as the assignment of key-person life insurance and a pledge of its debt and equity in a borrower, as part of collateral, and specific change of control covenants and other events of default tied to the founder. The scope of these terms may be broadened to a company’s key team members, as lenders may be concerned about the loss of critical personnel and the knowledge they hold.
3. Focus on the Products and Services
For early stage companies, lenders should also assess a company’s product and service offerings. For example, lenders should consider the offering’s life cycle, as the value of the products and services typically diminish as they close in on the end of their life cycle. Lenders should also assess a company’s underlying third party services, which may be critical to a company’s product and services, such as manufacturing services or software platforms which the product relies upon. Strains on a company’s relationship with providers of such third party services may affect the production or operability of a company’s offering, which may hinder the bottom line. As the success of a company’s offerings is often unpredictable, lenders may require companies to make mandatory prepayments and related prepayment premiums at certain intervals, as a method of building additional certainty into the financing transaction.
Lenders should also consider the amount of technical debt that an early stage company’s product may incur. Technical debt arises when the development team takes shortcuts to bring a product to market sooner. Over time, these shortcuts accrue “interest” by becoming a greater drag on the product if they are not updated or “paid back”. This can impact longer term operating margins, particularly, if the product is not easily integrable following an acquisition. Minimizing technical debt is key in order to being an attractive financing candidate.
Lending agreements involving early stage companies also pose challenges if a borrower is still posting negative EBITDA or cash burn. These metrics indicate how quickly a company is depleting shareholder capital before achieving profitability or entering a further financing or wind-up. This will have an impact on financial covenants and triggers. Lenders and borrowers party to credit agreements may want to stipulate what is permitted to be excluded/added back for EBITDA calculations, what are to be included as fixed charges for fixed charge coverage ratio calculations and whether IP can be included in tangible net worth calculations.
4. Tax Considerations
Certain qualifying companies in the digital media space can qualify for significant tax credits such as the Ontario Interactive Digital Media Tax Credit (OIDMTC) and Telefilm Canada grants. The OIDMTC is a refundable tax credit available to qualifying corporations for expenditures related to the creation of eligible interactive digital media products in Ontario.
Types of interactive digital media products that may be eligible for the tax credit include, but are not restricted to, digital games, mobile applications and e-learning products for children.
If underwriting against these credits, lenders should seek a comfort letter from the borrower’s accounting firm to confirm that such claims have been filed and are available. Lenders may also want to underwrite against Scientific Research and Experimental Development (SR&ED) tax credits. The SR&ED program is intended to encourage small to medium and start-up firms, to conduct research and development (R&D) that will lead to new, improved, or technologically advanced products, processes, devices, and materials. Businesses may access a range of tax incentives through this program.
Debt financing of technology companies is a rapidly growing area in the Canadian financial and technology landscape. However, there are nuances regarding the founding team, the product or service, and tax considerations which merit careful due diligence. Having effective counsel who know the industry well can be a significant asset and help get a deal done faster.