UNIT 2

Question 1

Active Business

Answer 1

A business that actually does something, provides a service (i.e. consulting, manufacturing, restaurants etc.)

Question 2

Passive Business

Answer 2

A business that doesn’t actually create or provide anything of its own; is just an investment company

Question 3

Lifetime Capital Gains Exemption

Answer 3

A tax exemption of up to $883,384 (2020) of capital gains

• Designed to encourage active business – aimed to promote investment, promote small businesses
• One time use in an individual’s lifetime BUT can use again if the limit rises or if you only used part of it
• Ex: can apply multiple exempt amounts at different times, as long as in total you only use $883,384 once
• Exemption is only available on a share transaction, not an asset deal

Question 4

Requirements for using the Lifetime Cap Gains Exemption

Answer 4

(1) The Vendor must be a Canadian resident individual
(2) The Vendor disposed of shares of a Canadian Controlled Private Corporation
(3) At TIME OF SALE, at least 90% of assets (by value) were used in an active business in Canada [Determination Time Test]
(4) The Vendor held the shares disposed of for 24 months prior to the sale
(5) At all times in the 24 months before the sale, at least 50% of the assets (by value) were used in an active business carried in Canada [Holding Period Test]

• NOT available to corporations, partnerships, trusts
• CCPC = a corporation not controlled by non-residents or a public company
• Exemption not applicable to asset dispositions – but could structure a “synthetic share” transaction (e.g. hybrid transaction) to take advantage of the exemption
• Time of sale = when you closed the deal/exchanged the consideration in exchange for the shares

Question 5

QSBC Purification

Answer 5

To help meet the Determination Time Test and Holding Period Test

• “Purification” by increasing the percentage of “good assets” and/or removing “bad assets” prior to the sale (if above 90% [DTT]) and in some instances at least 24 months prior (if below 50% [HPT])

Question 6

“Good Assets” (QSBC Purification)

Answer 6

Assets used to carry on the business and earn an active business income.

Include: inventory, equipment, working capital (i.e. cash to pay employees– cannot be general/excess cash)

Note: shares are considered capital assets (i.e. “good assets”) for the purposes of this course

Question 7

“Bad Assets” (QSBC Purification)

Answer 7

Assets used to earn passive investment income that do not help your client meet their exemption.

Includes: excess cash, rental property (but only if such property isn’t considered inventory –
i.e. the business isn’t a rental company business – so if there’s a company whose sole operation is the rental of properties, then the rental properties would be inventory and therefore “good assets”)

Question 8

Purification Strategies’ help meet the Lifetime Cap Gain Exemption Tests:

Answer 8

[1] Reduction of “bad assets” (taking money out of the company and reducing the company’s assets):

• Payment of dividends/capital dividends – dividend out the asset
• Return of capital or redemption of shares
• Repayment of shareholder loans and payment of other liabilities – getting rid of debt
• Payment of bonuses

[2] Raising “good assets” (& reducing bad assets) (keeping money in the company, just redistributing it):
- Purchase of active business assets (i.e. equipment, inventory etc.) – taking money out of the corporation and reducing assets

Question 9

Business Clean Up (Seller Side Due Diligence) - Steps

Answer 9

(1) General
(2) Corporate Records
(3) Protecting and Accounting for Assets
(4) Removing Liabilities and Impediments to Sale
(5) Working Capital
(6) Employees
(7) Contracts
(8) Customers and Suppliers
(9) Privacy

Question 10

Business Clean Up - General (Rationale)

Answer 10

May increase the value, aid in obtaining financing, and/or increase the chances of sale

Question 11

Business Clean Up - General

Answer 11

To “clean-up” – owner should put themselves in the shoes of the purchaser:

• What things might cause purchaser to be concerned?
• What information will a purchaser ask for in the course of due diligence?
• What information will a purchaser need to evaluate the risks and strengths (i.e. various liabilities of the business and assets such as customer and supplier contracts)?

Ex: Do not include old contracts that have expired, instead include new and active ones.
Ex: Identify things that are missing (i.e. meeting minutes)

Question 12

Business Clean Up - General (Time Commitment)

Answer 12

Start early so that when you get closer to the sale you can be more organized and have the ability to continue operating the business (not focusing all your resources and time on this alone)

I.e. do the clean-up proactively over a period of time before any proposed sale – don’t wait until there’s a deal that you need to act on quickly as it can then be hard to get all this stuff done

Question 13

Business Clean Up - Corporate Records - (Minute Books - General)

Answer 13

Minute books record the existence and activities of the corporation

ABCA s.6 – requires minute books to be kept up to date

Minute books generally contain:

• articles,
• by-laws,
• any Unanimous Shareholder Agreement(s) (USA’s),
• extra-provincial registrations,
• minutes of directors and shareholders’ meetings or written resolutions in lieu of such meetings,
• director and officer registers,
• shareholder registers,
• share transfer ledgers (so you KNOW who has the shares) and
• copies of forms filed with government agencies

Question 14

Business Clean Up - Corporate Records (Minute Books -Deficiencies)

Answer 14

Deficiencies make it difficult to reconstruct the history and past activities
- I.e. directors and officers that should have signed resolutions and other documents in the past may no longer be available

Updating a minute book is relatively inexpensive and can avoid delays and unnecessary legal costs in the future, particularly in the course of audits, financings or other transactions

Question 15

Business Clean Up - Corporate Records (Minute Books -Rectifications)

Answer 15

Fact specific

[1] Ex: if resolutions are missing – may be possible to re-execute resolutions. BUT still need consent and signature of involved parties. Parties may have passed away, are otherwise unavailable, are now on bad terms with the company, etc

[2] Ex: If annual resolutions and filings are neglected – can then be executed and the corporate registry updated – but might need a ratification resolution. Note: ratifying resolutions could be challenged by former shareholders / directors depending on the circumstances (i.e. if a former shareholder challenged the election of a director, or the waiver of audit requirements in respect of which a ratification resolution was passed while that person was a shareholder)

Question 16

Business Clean Up - Protecting and accounting for assets

Answer 16

Value of business may be dependent on the value of its assets, therefore:

(1) Clean and repair equipment and premise (Unclean premises and poorly maintained equipment are red flags that buyers may assume are indicative of more serious problems)
(2) Protect intangible assets such as intellectual property by filling trademark registrations and patents, securing assignments of copyrights from contractors, waiver of moral rights from employees or contractors
(3) look at computer updates, anti-virus / anti-malware software / open source code (Computer systems are often critical to a business)

Question 17

Business Clean Up - Removing liabilities and impediments to sale

Answer 17

(1) Liens and PPSA registrations – seek discharges if possible
(2) Litigation – seek discontinuance, settlement if possible
(3) Payout letters – if bank financing is in place, payout letters will be required and should be requested early
(3) Guarantees – terminate / remove if possible
(4) Environmental liabilities – consider assessments if possible contamination

Question 18

Business Clean Up - Working Capital Issues

Answer 18

Determine “working capital” needs or deficiencies

• “working capital” generally means current assets minus current liabilities
• Includes current float/cash to keep the business running (i.e. to pay bills, employees, suppliers etc.)- Clean up obsolete inventory, uncollectible accounts receivable, etc.

Question 19

Business Clean Up - Employee Issues

Answer 19

Important because there can be entire transactions based upon obtaining key employees

(a) Ensuring proper classification (ex: Is an employee actually an employee, or an independent contractor?)
(b) Up to date employment records (ex: purchaser will need to know the salary, benefits and vacation time/ pay, disabilities, etc.)
(c) Unions – any labour grievances or union issues
(d) Employee Benefit Plans (including group benefit plans, pension plans, group RRSP’s etc. - Need to know what liabilities are attached to the employees. Do they have defined benefit pension plans, etc.?)
(e) If there are any stock options or other employee option plans (ex: need to check to see what conditions are attached to that)
(f) Vacation and sick leave records and policies should be up to date

(g) Employment agreements – make sure that they are sufficient to avoid issues in the event employees choose to leave like:
(i) Non-compete
(ii) non-solicit (no recruiting other employees),
(iii) confidentiality
(iv) change of control (golden parachute clause - on change of control, all options vest immediately or bonus; can be significant financial burden on the company if they decide to sell)
* *Especially in a merger of two companies with similar types of employees and employees know they will lose their jobs

Question 20

Business Clean Up - Contracts

Answer 20

(1) Is there a list of all the contracts?
(2) Which are the “material” contracts? — ex: key supplier contract; renew key contracts
(3) Written/term/termination — make oral contracts written, set terms and requirements for termination
(4) Consents to transfer such contracts (i.e. if they need assignment, consent, or a change of control consent to transfer)
(a) Assignment — asset transaction. May need consent to assign depending on if there’s an assignment provision in the contract
(b) Change of control — share transaction. There could be a change of control provision barring change of control

Question 21

Business Clean Up - Customers and Suppliers

Answer 21

[1] Purchaser will want to know details about relationships

• Relationship makes up a good part of goodwill
• Who are the customers? Who are the suppliers? Who does the company depend on?

[2] Consider how customers and suppliers will be informed

• May want to reach out to them to help smooth the transaction. Don’t want suppliers or customers to jump ship when they hear of the sale - try to get the transaction to a certain point before informing them
• Vendor may stay on post-sale in a type of consulting relationship to normalize relationships with third parties

Question 22

Business Clean Up - Privacy

Answer 22

[1] Personal Information Protection and Electronic Documents Act (Canada)
= No blanket exemption permitting disclosure of personal information for the purposes of purchase/sale due diligence
- Ex: no disclosure of personal info for purposes of due diligence by prospective purchaser during course of the sale of business.)
- However, the federal Privacy Commissioner’s Office has indicated that there is an implied consent for personal information to be disclosed for limited purposes in the course of the sale of a business or a financing

[2] AB & BC have exemptions for business transactions

• A limited amount of relevant personal information may be disclosed for the purpose of a transaction, but only information that’s actually relevant to the transaction.
• Only provide the purchaser with personal information that is actually necessary to effect the transaction

[3] Limit disclosure of personal information about customers and employees

• Often personal info can be redacted as it is not critical to the deal or due diligence
• I.e. disclose the least amount of personal information possible

[4] Ensure Privacy Policy of business is up to date and allows transfer of personal info in the event of a sale of the business.

Question 23

Confidential Information Memorandum (CIM)

Answer 23

[1] Used when a seller doesn’t necessarily know who they want to sell their company to and what amount of money potential purchasers would be willing to pay

• Generally used in a competitive bid process or where a broker is involved
• CIM is really just a big marketing packet, typically put together by investment bankers

[2] Typically, a CIM will not include a purchase price, but provides the prospective buyer sufficient information to value the acquisition. It is NOT a contract, it is purely informational

• CIM should articulate all of the company’s attributes in order to fetch a premium valuation
• CIM would generally identify the nature of its top customers (but not necessarily their names), financial results, future projects, strengths driving the company (management is often critical), scalability of operations, etc.

Question 24

Confidential Information Memorandum (CIM) Steps

Answer 24

• Teaser just provides a little bit of info about the company to help get an idea of who may be interested
• More of a marketing type document usually prepared by investment bankers/brokers
• Info may include: what industry the company is in, maybe the company’s name (but not always)
• Based on this limited info, can assess which potential purchasers are interested and want more information

• 1. Ensures confidential information is not used for any purpose other than the transaction in question
• 2. Ensures that you have legal rights of protection in the event that there is a breach of confidentiality agreement
• One-way CA: info seller is giving to a buyer; two-way CA: both sides are sharing information. Key terms:
• If the agreement is silent on the matter, then the duration is forever (indefinite)
• Requirements to return or destroy info on conclusion of negotiations or termination

• Provides enough info to generate an initial offer (highlights attractive attributes and justifies negatives)
• From the CIM the seller will want to gauge the type of buyer the potential purchaser is - seller wants to know:
• What the potential purchaser is willing to pay, AND how many changes they want to make to the purchase agreement template you provided them with
• If they require significant changes to the terms, you may prefer to take a lower price from a bidder whose proposed purchase agreement is more in line with the draft you offered – easier to negotiate with them

• If the bidder likes the CIM, they place an indicative bid = an expression of an early offer or price that indicates what someone might be prepared to pay for a business or for specific assets; not definitive

Question 25

CIM generally includes a description and commentary of the following:

Answer 25

[1] Top customers and suppliers
[2] Summary of financial results and projections;
[3] List of competitors and a summary of opportunities in the market place;
[4] Ability and plan to achieve future projections;
[5] Future growth opportunities;
[6] Barriers to entry from competitors;
[7] Strength of management team; and
[8] Scalability of operations

Question 26

Confidential Information Memorandum (CIM) Purchaser Types

Answer 26

[1] Strategic purchaser
[2] Private equity purchaser

Note: It’s important to understand who you’re pitching to. In the CIM, you’re pitching to both types of purchasers, so make sure to include things that would interest both groups

Question 27

Confidential Information Memorandum (CIM) - Strategic purchaser

Answer 27

Purchaser that is in the industry, has operational expertise. Therefore, likely interested in customers and suppliers, market share, etc. In addition, since they are already in the industry may be a lot of redundancy in management and thus employment agreements are important so you can terminate those employees

Question 28

Confidential Information Memorandum (CIM) - Private equity purchaser

Answer 28

Purchasers who do not have operational experience, therefore need strong management team/employees

Question 29

Letter of Intent (LOI) - General

Answer 29

[1] More applicable for when the vendor has already lined up a purchaser

• A LOI is a lot less competitive than a CIM; CIM is a competitive process, whereas LOI is more of a private, less competitive matter, created between the 2 parties (the potential purchaser and seller)
• Usually for smaller purchase – i.e. $50 million

[2] Can be called a “memorandum of understanding”
- NOT a sale document

[3] Useful to frame the parameters of the deal

• Demonstrates the parties’ agreement to certain key terms for the transaction
• Need to have some parameters on the deal terms to move forward, but need some flexibility since due diligence hasn’t yet been completed. A way to bridge expectations.
• Purchaser and vendor should have a good idea coming in as to what the major terms of the deal are expected to be. Otherwise, the lawyers will spin their wheels and bill out a whole bunch of fees that the client could have otherwise avoided

Question 30

Letter of Intent (LOI) - Process

Answer 30

Vendor finds potential buyer (maybe through broker but often not). The potential buyer and vendor draft a LOI between themselves that is intended to frame the terms of a potential future agreement if the purchaser chooses to buy the company after doing due diligence

Note: first step is to sign a Confidentiality Agreement

Question 31

Letter of Intent (LOI) - Common non-binding provisions

Answer 31

Non-binding terms are used to come to a general agreement on what should be in a purchase agreement, but parties should be prepared to be flexible as the deal progresses.

Includes:
[1] The subject matter of the sale – ex. “it is our intention to purchase all the shares of target co”
[2] Structure (asset vs share deal)
[3] The price and terms of payment
[4] Key representations and warranties
[5] The material conditions of closing – positive and negative covenants
[6] Can also include indemnification provisions – what happens if the deal goes bad (Idea is that these terms set up the framework for a future deal - parties should be flexible as the deal progresses)

Question 32

Letter of Intent (LOI) - Common binding provisions

Answer 32

These are typically in all LOIs - whether binding or non-binding…

[1] A period of exclusivity in dealing with a particular buyer (“no-shop”)
- Can include “fiduciary out” clause for vendor, and a “break fee and right to match” clause for purchaser
- Really important to a purchaser. While the purchaser is spending time and money investigating whether they want to buy the TC, the TC can’t sell to another party (both shares and assets)
- Exclusivity agreement may provide the potential purchaser with the option to match an unsolicited offer, or may prohibit all outside offers during the period which the LOI is in place. DEPENDS ON DRAFTING
[2] Access for due diligence
[3] Allocation of responsibility for expenses involved in closing the transaction
- Ex:. if really want to do deal, say you will pay for the first bit of the transaction
[4] Rules for public announcements
- Ex: disclosure requirements under securities law for public companies
[5] Outside “drop dead” date to enter into a definitive purchase agreement – so other party doesn’t stall for better deal
[6] Expense reimbursement and work fee if the transaction does not proceed – possibly break-up fees
- If the deal doesn’t close because of something the other side does, then they must pay a break-up fee
[7] Confidentiality provisions – built right into LOI if a separate confidentiality agreement has not already been executed
- Can also have a stand-alone confidentiality agreement, outside of the LOI
- Parties may enter into a confidentiality agreement, then vendor will disclose some information (at least enough info for the purchaser to formulate a LOI), then after LOI is entered into, full disclosure is provided
[8] Non-solicit of customers and employees (if not in separate confidentiality agreement)
- i.e. don’t exploit confidential info like employee salaries or customer base to steal employees / customers
[9] Conduct of the business in the ordinary course
[10] Certain boilerplate provisions – ex: agreement governed by the law of AB

Question 33

Letter of Intent (LOI) - binding or non-binding?

Answer 33

LOIs typically contain both non-binding and binding provisions

[1] Use caution to ensure it is not a binding purchase agreement – the name is irrelevant if the conditions for a contract are met.

[2] Make sure it can’t be mistaken for an offer; LOI should state in clear and unambiguous language that it is non-binding
- “This letter is not intended to evidence or give rise to any legally enforceable obligations whatsoever or any liability of any kind whatsoever, whether arising in contract, tort, by fiduciary obligation, or otherwise.”

[3] Clearly state conditions under which parties intend to be bound (e.g. letter is subject to due diligence; board or other approval; completion of legally binding documentation; etc.)
- “Would be” vs. “will” or “shall”; “this letter vs. “this agreement”; “it is intended” vs. “it is agreed”

Question 34

Letter of Intent (LOI) or Contract?

Answer 34

DETERMINED BY CONTENT NOT NAME

• The name (calling it a LOI) is irrelevant if the conditions for a contract are met
• Whether the LOI is a binding agreement is determined by resorting to the basic principles of contract law (An invitation to treat is not binding: an ITT expresses interest in a transaction and in further negotiations but is subject to the creation of formal binding documentation upon the conclusion of negotiations)
• Don’t want your LOI, as a whole, to be considered a binding contract (Purchaser will generally be hurt the most if the LOI is deemed to be binding)

Question 35

Letter of Intent (LOI) Best Practices

Answer 35

[1] LOI should state in clear, simple and unambiguous language that it is non-binding (if that is the intent).
- “This letter is not intended to evidence or give rise to any legally enforceable obligations whatsoever or any liability of any kind whatsoever, whether arising in contract, tort, by fiduciary obligation, or otherwise.”

[2] Clearly state conditions under which parties intend to be bound (e.g. letter is subject to due diligence; board or other approval; completion of legally binding documentation; etc.)

[3] Drafting considerations: be as clear as you can – use clear language, for example:

• “non-binding provisions are set forth in paragraphs…”; “binding provisions are…”
• “purpose of this letter is to set out mutual understanding which will provide for…” as opposed to “purchaser shall”
• “would be” vs. “will” or “shall“; “this letter” vs. “this agreement”; “it is intended” vs. “it is agreed“

Question 36

Letter of Intent (LOI) Disclosure Requirement under Securities Law

Answer 36

[1] Material change or a decision to implement a material change

[2] Special considerations apply to public companies that are subject to continuous disclosure.

Question 37

Confidentiality Agreements - General

Answer 37

[1] Ensures that all confidential information is held in confidence & not used for any purpose other than transaction in question

• Very important in protecting the vendor’s information from being abused
• Standard in Canada before discussing a deal

[2] Set out: (1) what information is confidential and (2) the terms upon which confidential information will be shared

[3] Often deal with the non-solicitation of employees and customers for a stipulated period of time, among other issues

• May include remedies available in the event the prospective purchaser misuses information
• Many are “catch and release” = take a broad approach initially and “release” anything down below in the agreement

Question 38

Confidentiality Agreements - Key Terms

Answer 38

[1] Purpose and permitted Uses
[2] Information covered 2(a) - Confidential Information
2(b) - Confidentiality Obligations
[3] Non-Solicit
[4] Remedies
[5] Duration

Question 39

Confidentiality Agreements - Key Term: Purpose and Permitted Uses

Answer 39

[1] Purpose to facilitate due diligence - Vendor must disclose information for a prospective purchaser to consider a bid. But this need must be balanced with the need to keep information controlled and protected from abuse

[2] Temporary permission to use (unless deal proceeds) controlled exchange of information

• No transfer of ownership of this information – it’s like a limited license
• As recipient you get no rights in the information

[3] Permitted use should be drafted with a limited scope so as to restrict use and protect disclosing party

• Should not be usable for another deal
• Limit scope to include only information relevant to allow the prospective purchaser to evaluate the potential purchase of the company

Question 40

Confidentiality Agreements - Key Term: Non-solicit

Answer 40

[1] Prevents purchaser from contacting customers, suppliers or hiring employees for stipulated period of time - I.e. no poaching

[2] Often there may be a number of exceptions including responding to ads, use of a headhunter, etc.

Question 41

Confidentiality Agreements - Key Term: Remedies

Answer 41

Particularly where there is an indemnity clause in the CA

[1] Damages: can sue for breach of contract (because confidentiality agreement = a contract)

[2] Injunction: prevents the party from disclosing information

• The ability to go after equitable relief is a key provision to have in a confidentiality agreement
• Why? (i) Because it is difficult to immediately quantify the type of damages (loss or reputation, etc.) and the scope of damages (ii) Because it allows you to stop the party immediately and seek damages later (remedy process is long; the more information that is leaked, the more damages occur and the harder the quantification = better to stop the dissemination of that information than wait and seek damages)

Question 42

Confidentiality Agreements - Key Term: Duration

Answer 42

[1] Often indefinite, or between 1 and 2 years
[2] Often depends on the nature of the items in question (Ex: technology companies often have a shorter period because of the evolving nature of the industry)
[3] If the agreement is silent on the matter, then the duration is forever (indefinite)
[4] Requirements to return or destroy info on conclusion of negotiations or termination

Question 43

Confidentiality Agreements - Key Term: Confidential Information

Answer 43

[1] Typically includes:

(i) All information in any form (written/oral) obtained by the receiving party in context of transaction
(ii) Derivatives of such info (ex: analysis, notes/other documents prepared by receiving party based on such information)

[2] Exclusions:

(i) Information that is or becomes publicly available through no fault of receiving party
- -> If info is already out in the public domain, makes no sense to protect its’ confidentiality.
(ii) Where the receiving party can establish that information is already known to it at the time of its disclosure and is not known by receiving party to be the subject of an obligation of confidence
(iii) Receiving party can establish information was independently developed without any use of or reference to the “confidential information”
(iv) That receiving party receives information without an obligation of confidence of any kind from a third party (and in possession of such third party free of any obligation of confidence)
(v) Permitted disclosures: may want exceptions that allow the prospective purchaser to disclose information to their bank, investors, lawyers, etc.

Question 44

Confidentiality Agreements - Key Term: Confidentiality Obligations

Answer 44

[1] Typically includes:

(i) No use of information other than permitted use (i.e. for evaluating a transaction)
(ii) Maintain the confidentiality of the information
(iii) Maintain appropriate security measures and manage information flow
- -> Standard of care is reasonableness – treat it as if it was your own confidential information
(iv) Permitted disclosures: lawyers, accountants, and disclosure that is legally required pursuant to a court order, securities law or stock exchange rules, or regulators
- -> Financing may be an issue as target may not want information disclosed to lenders
- -> For these, disclosing party will usually require written notice and opportunity to seek a protective order or other appropriate remedy (so that they can ensure as little info as possible is disclosed)
(v) Confidential considering the deal or entering into the confidentiality agreement
- -> Note: A provision that says “all items that are marked as confidential are confidential” should not be put in because it should be the premise that everything is confidential

[2] Exclusions:

(i) Disclosure that is legally required pursuant to a court order
- -> To the extent legally permitted, disclosing party will usually require written notice and an opportunity to seek a protective order or other appropriate remedy
- -> General process is that the prospective purchaser would have to tell the disclosing party to give the disclosing party as much notice as possible so they could make a protective order application to the court
(ii) Permitted Disclosures (i.e. lawyers, accountants)
- -> Financing may be an issue as target may not want info disclosed to lenders.
(iii) Carve-outs for disclosure required by securities law or stock exchange rules
(iv) Carve-outs for disclosure required by regulators