Accessing Cash South of the Border: Canadian Startups Increasingly Looking to Access U.S. Investors

The article originally published on Thomson Reuters Westlaw on October 26, 2021. It is republished here with permission. 

The Canadian startup market is on fire, and it is grabbing the attention of investors. According to CB Insights data, in just the first half of 2021, Canadian startups raised more than double what they raised in all of 2020.

CB Insights data also shows that investment in Canadian startups is on par with that of Latin America, raising $6.3 billion across 414 deals in the first half of this year.

So, is this investment coming from Canadian investors, or are U.S. venture capital firms sending their money cross border to these emerging companies? Canadian startups are increasingly looking south to the United States for angel investors, venture capital funding, as well as attractive exit deals.

With money flowing across the border, what do Canadian entrepreneurs need to know to entice American investors?

First, Canadian entrepreneurs must consider whether to incorporate their new venture in the United States or Canada. There are of course pros and cons either way that must all be weighed.

There are certainly corporate and personal tax benefits and government incentives that come with incorporating in Canada, but then there are also potential tax issues that can come about when U.S. investors look to take distributions or dividends or if the company is sold.

The location of incorporation does not necessarily serve as a deterrent for investors, but any kind of cross border investment is inherently going to be more complex.

Investors will have to look at whether an investment in a Canadian company makes sense for them as most tax issues do not arise at the time of investment, but rather when the investor takes their earnings out.

Incorporating a company in Canada comes with many attractive tax benefits and incentives. There are both personal and corporate tax benefits for Canadian-based companies, and research and development incentives that can be compelling.

For example, the Canadian government has an incentive program for Canadian Controlled Private Corporations (CCPCs) related to scientific research and experimental development. To qualify for these incentives, the company must be incorporated in Canada and cannot be controlled by nonresidents. This is often a strong draw for companies to incorporate their company in Canada. However, as companies experience significant growth, the availability of this can be diminished.

There are also significant corporate tax benefits for Canadian companies, as well as for resident shareholders. Additionally, the tax barriers that used to exist for nonresident investors have now been removed. There were previously large withholding requirements, but the removal of these requirements has made it much more favorable for U.S. investors.

While these benefits and incentives can certainly make incorporating in Canada an attractive option, entrepreneurs should consider whether these shorter-term benefits outweigh the potential issues that could arise with securing cross border funding.

Canadian entrepreneurs can also consider from a variety of methods for establishing a presence in the U.S. Some common structures include U.S. subsidiary, sister company, U.S. parent, direct U.S. incorporation or establishing a U.S. branch.

If a company chooses to establish a U.S. subsidiary, the Canadian parent company will not have to file U.S. tax returns, which is a major benefit. Another benefit is the ability to allocate income and expenses between parent and U.S. subsidiary for tax benefits.

However, the Canadian company would still be subject to U.S. corporate tax. The income of the U.S. subsidiary is sheltered from Canadian tax until it is repatriated to Canada. At that time, there would be another level of taxation.

Under the brother-sister structure, the Canadian company establishes a new U.S. corporation, generally mirroring the same capitalization of the Canadian company, which allows for director ownership in a U.S. entity.

Whereas under the U.S. parent structure (also referred to as a "Flip"), a U.S. parent is formed and owned by the Canadian shareholder and the Canadian company is owned by the U.S. parent. The U.S. parent is taxed at source, whereby Canadian sourced income is tax deferred, unless considered a deemed dividend.

The advantages of a direct U.S. corporation is simplicity, and places Canadian entrepreneurs in an ideal situation to receive U.S. investment. This structure, however, is not ideal if there is significant foreign source income and possible visa issues.

Direct incorporation is the exact opposite of the U.S. branch structure, whereby the Canadian company does not establish a U.S. entity, but rather has an office located in the U.S. Under this structure, the Canadian company would be directly subject to U.S. tax and required to file U.S. tax returns. The Canadian company would also be the direct target for claims.

Companies will have to consider the complexities of these cross-border structures and what kinds of implications they could have long-term. It is also important to remember that U.S. companies are subject to state laws, so choosing more tax friendly states as the location of incorporation is important as well.

Regardless of structure, one key consideration for U.S. investors is whether the entity in which they are investing owns, directly or indirectly, the business assets, e.g., IP, customers, revenue, etc.

In the investment context, patents can be an important tool to accomplish the business objective of securing funding, which is a sometimes overlooked use of a patent portfolio. One best practice is to focus on your innovations — technical solutions to technical problems — and weave those innovations into the investment narrative.

To do this, the entrepreneur just needs to identify differentiating technology that has been developed by your company, and to map this differentiating technology to some tangible business value. For example, the technology you have developed enables your product to be more accurate, less expensive, or to have a lighter carbon footprint than competitive products.

A patent portfolio built to protect this differentiator will allow you to maintain exclusivity of your innovative features. As such, a competitor will not be able to offer a product with the same advantages as your product.

Pointing out that this competitive advantage is secured by patent protection can be a key point of a pitch to an investor who is interested in your technology but is also talking to competitors that occupy the same general space.

This IP-for-investment narrative does not suffer from any cross-border drawbacks provided that the patent protection covers the appropriate market, including Canada, the U.S., or anywhere else where there is a business reason for patent protection.

Determining an IP strategy at an early stage offers additional benefits as well, for example by creating barriers to entry for your competition and helping to preserve market traction. Importantly, the investment can bring with it publicity and can gain the attention of larger companies that also operate in the space.

If (or when) they feel threatened by your entry into the marketplace, having a coherent patent portfolio can be a valuable tool for a defensive response should they attempt to pivot their product to capture some of your unique advantages.

Determining a patent strategy is not a complex undertaking. The hard part, actually coming up with the innovative technical solutions, has already been done. The patent strategy is just an effort to frame these existing innovations in legal documents that offer legal protection, designed to achieve an identified, known business objective.

When appropriate, the IP portion of an investor pitch can be condensed to an elevator pitch format. By pointing out your unique technical advantages, noting that they are incorporated in your patent strategy, and highlighting that competitive products lacking your unique features are inherently inferior, you will have confidently used your patent strategy to position yourself for a successful raise.

There are a myriad of considerations when determining whether to access funding south of the border. Key factors to consider include, stage of your company, location of IP, customers and revenue, and immigration. Regardless of the path you choose, there will be opportunities to access cash south of the border.