Application of Securities Laws to Private Companies: Part II
Last month, we talked about the importance of making sure your privately-held company is in compliance with securities regulation—which, contrary to popular belief, apply to all entities that distribute securities, regardless of whether they are listed on a stock exchange. We set out the groundwork, discussing registration and prospectus requirements in BC and setting out some of the most common exemptions from the prospectus requirement. In this month’s article, we’re getting into the nuts and bolts of those exemptions and breaking down the requirements for each.
To recap, the most relevant exemptions for privately-held companies are the exemptions from the prospectus requirement, which include the following:
Private Issuer Exemption
Family, friends, and business associates exemption
Employee, director, officer, and consultant exemption
Accredited investor exemption
Offering memorandum exemption
Start-up crowdfunding exemption
Luckily, most of the provincial securities commissions across Canada have adopted uniform policies (called National Instruments) so that the criteria for these exemptions are the same.
Private Issuer Exemption
This is the most common exemption used by private companies. The private issuer exemption allows an issuer to sell securities without prospectus-level disclosure, provided that:
it has less than 50 security-holders (excluding employees or former employees),
it has only distributed its securities to a certain class of persons (see below), and
its charter documents contain restrictions on the ability of its security-holders to transfer their securities.
The classes of persons to whom a private issuer can sell securities are limited to:
directors, officers, employees or control persons of the issuer,
family members (spouses, parents, grandparents, sisters, brothers, or children) of the directors, senior officers, or control persons,
close personal friends or close business associates of the directors, senior officers, or control persons,
current security holders,
family members of the selling security holder, and
It is important to note that there are several restrictions placed on securities issued under the private issuer exemption. First, the securities are subject to restrictions on transfer. This usually means that the purchasers must obtain approval from the issuer’s board of directors prior to selling their securities. Second, under securities laws, the securities are subject to resale restrictions, meaning the purchaser is not permitted to resell the security to other persons unless that sale falls within the scope of another prospectus exemption.
Family, Friends, and Business Associates Exemption
This exemption is based on the close relationship between the directors and officers of the issuer with the purchaser of the securities. This exemption permits an issuer to sell securities without providing prospectus-level disclosure to the following people:
a director, senior officer, or control person of the issuer,
a family member (spouse, parent, grandparent, brother, sister or child) of a director, senior officer or control person of the issuer, and
a close personal friend or close business associate of a director, senior officer or control person of the issuer.
A “close personal friend” is defined as someone who has known the director, senior officer, or control person of the issuer for a sufficient period of time to be able to assess that person’s capabilities and trustworthiness. Similarly, a “close business associate” is someone who has had sufficient prior business dealings with the director, senior officer, or control person of the issuer to be able to assess that person’s capabilities and trustworthiness.
Employee, Director, Officer, and Consultant Exemption
Under this exemption, an issuer can sell securities without prospectus-level disclosure to its employees, directors, senior officers, or consultants as long as the purchase of the securities is voluntary. For example, the issuer cannot persuade the purchaser to buy the securities in return for continued employment or appointment by the issuer.
Accredited Investor Exemption
The accredited investor exemption is based on the assumption that certain purchasers of securities are sophisticated enough to not require the protections offered by the registration and prospectus requirements. This exemption is aimed at certain classes of persons such as large financial institutions or wealthy individuals.
An accredited investor includes:
registered advisers or dealers,
mutual funds selling only under a prospectus or to accredited investors or persons buying at least $150,000 of securities,
corporations, limited partnerships, trusts or estates having net assets of at least $5 million, and
individuals who meet certain wealth criteria (described below).
In order for individuals to be considered an accredited investor, they must meet either an income test or a financial asset test. The individual must either:
have made at least $200,000 each year for the last two years (or $300,000 combined income with spouse) and have the expectation to make the same amount this year, or
either have financial assets exceeding $1 million (excluding primary residence) or have net assets of at least $5 million (including net value of primary residence).
If a corporate entity, such as a company or limited partnership, wishes to rely on the accredited investor exemption, then the underlying owners of the purchaser (e.g. its shareholders or limited partners) must meet one of the tests under that exemption.
Under this exemption, an issuer can sell securities to non-individual investors without prospectus-level disclosure if the purchaser buys at least $150,000 worth of securities paid in cash at the time of the purchase. The basis for this exemption is that an investor risking a large sum of money will demand the information necessary to make an informed decision.
Offering Memorandum Exemption
Under the offering memorandum exemption, an issuer can sell its securities to anyone, regardless of their relationship, wealth, or minimum value of securities being purchased, provided that, before the purchaser signs the agreement to purchase the securities, the issuer:
obtains a signed risk acknowledgement form from the purchaser, and
delivers an offering memorandum to the purchaser.
The risk acknowledgement form is a short, clear statement of the risks associated with investing in the securities when they are sold under an exemption. It states in bold print immediately above where the purchaser is required to sign: "I acknowledge that this is a risky investment and that I could lose all the money I invest."
The offering memorandum is required to be prepared and delivered in the required form. There are two versions of the required form. One is for qualified issuers (i.e., those listed on the TSX or TSX Venture Exchange) and the other is for non-qualifying issuers (i.e., all other issuers). The main difference is that the form for qualified issuers allows certain information already provided in the issuer’s public disclosure record to be incorporated into the offering memorandum.
Start-up Crowdfunding Exemption
The start-up crowdfunding exemption is a relatively new addition to the BCSC’s list of prospectus exemptions.
This exemption is aimed at early-stage businesses and start-ups. It enables securities crowdfunding by allowing an issuer to distribute securities without prospectus-level disclosure, provided:
the issuer raises no more than $250,000 per offering and offers no more than twice per year,
no investor invests more than $1,500 per offering,
the offering is made on an on-line funding portal, and
the issuer provides a streamlined offering document to investors through the portal.
If you’re an early-stage businesses, don’t underestimate the importance of complying with the registration and prospectus requirements or relying on an exemption from those requirements. Our advice is to work with your lawyer from the beginning to identify and address potential securities issues and to make sure you have the right documentation in place. We say this all the time, but it bears repeating: reactive legal advice is always more expensive than proactive legal advice!