There is a common misconception that securities laws are only relevant for companies listed on a stock exchange; however, the fact is that securities laws apply to all companies, whether public or private.

Securities laws have two fundamental elements, both aimed at protecting the investing public and maintaining market integrity. The first is the requirement that anyone in the business of trading in securities must be registered with securities regulators (the registration requirement, not discussed here), and the second is the prospectus requirement.

The prospectus requirement is the legal requirement that every person who “distributes” (sells) new securities being issued for the first time must file and obtain a receipt for a prospectus with the securities regulator (in BC, the BC Securities Commission). A prospectus is a comprehensive document that discloses all material information about the issuer and the securities being sold. The purpose of the prospectus requirement is to ensure that investors have sufficient information to allow them to make an informed investment decision. Once a company obtains a receipt for a prospectus, the company becomes a reporting issuer.

What is a security?

The term “security” is an extremely broadly defined term that includes many types of financial assets that can be bought and sold. An early stage private company might issue any of the following securities:

  • common and preferred shares
  • options, warrants and other convertible instruments, including SAFEs (simple agreement for future equity)
  • debentures, notes and other instruments of indebtedness

While many early stage private companies “accidentally” comply with securities laws because of the various exemptions for issuing securities without a prospectus that exist under securities laws, many other early stage private companies unintentionally breach securities laws because they think that securities laws do not apply to them.

When can an issuer sell its securities without filing a prospectus?

There are a number of exemptions from the prospectus requirement that permit an issuer to sell its securities without a prospectus in circumstances where regulators determine that investors are able to make informed investment decisions without receiving all the information contained in a prospectus. A few of the most commonly relied-upon prospectus exemptions are as follows:

  • Private issuer exemption
  • Family, friends and business associates exemption
  • Employee, executive officer, director and consultant exemption
  • Accredited investor exemption
  • $150,000 exemption
  • Offering memorandum exemption
  • Start-up crowdfunding exemption

What are the most common prospectus exemptions for an early stage company?

For an early stage company, the most commonly used exemptions are the private issuer exemption, the family, friends and business associates exemption, and the accredited investor exemption. Another exemption of interest to an issuer that may be planning to go public is the crowdfunding exemption.

What is the private issuer exemption?

The private issuer exemption is the exemption most frequently used by private companies to sell securities without a prospectus. A private issuer means an issuer that:

  • is not a reporting issuer or an investment fund
  • whose equity securities are:
    • subject to restrictions on transfer that are contained in the issuer’s articles, memorandum, bylaws or its shareholders agreement, and
    • are beneficially owned by not more than 50 persons, not including employees and former employees of the issuer or its affiliates
  • has distributed its securities only to certain categories of purchasers, including:
    • directors, officers, employees, founders or control persons of the issuer
    • Specified close family members of a director, officer, founder, or control person or their spouses
    • close personal friends or close business associates of a director, officer, founder or control person of the issuer
    • existing security holders of the issuer, and
    • accredited investors

Once an issuer loses its private issuer status, which happens most commonly when it exceeds the maximum 50 shareholder limitation, it cannot rely on this exemption to issue additional securities and will have to find some other available exemption. Otherwise, there is no limit on the amount of securities an issuer can sell and no filing is required with the BC Securities Commission in connection with sales under this exemption.

What is the family, friends and business associates exemption?

The family, friends and business associates exemption allows an issuer to sell securities without a prospectus to:

  • directors, executive officers, founders or control persons of the issuer (or an affiliate)
  • specified family members of a director, executive officer, founder or control person of the issuer (or an affiliate)
  • close personal friends or close business associates of a director, senior officer, founder or control person of the issuer

The rationale behind this exemption is that the close relationship between this type of purchaser and a person who has all important knowledge about the issuer, namely a director, senior officer, or control person, makes a prospectus unnecessary.

While the eligible family members are specified, the terms close personal friend and close business associate are qualitative. Casual relationships are not sufficient and the investor needs to have had sufficient direct dealings of a personal or business nature with the director, senior officer, founder, or control person’s to enable the investor to assess that person’s capabilities and trustworthiness. The issuer needs to document as appropriate the nature of the relationship between the investor and the director, senior officer, founder or control person to establish that the exemption is available for the investor’s purchase.

There is no limit on the amount of securities an issuer can sell and no filing is required with the BC Securities Commission in connection with sales under this exemption.

What is the accredited investor exemption?

The accredited investor exemption allows an issuer to sell securities without a prospectus to specified sophisticated or professional or “high net worth” investors, on the rationale that their professional qualification or status as high net worth investors means they do not require the protection afforded by a prospectus.

The exemption covers sales to financial institutions, various government entities, and pension funds. It also covers sales to:

  • corporations and other non-individuals with net assets (total assets minus total liabilities) of at least $5 million, as shown on their most recently prepared financial statements
  • individuals (either alone or with a spouse) with at least $1 million in financial assets (cash and securities) before taxes but net of related liabilities
  • individuals whose net income before taxes exceeds $200,000 (or $300,000 combined income with spouse) in each of the two most recent years and who reasonably expects to exceed that net income in the current year
  • individuals (either alone or with a spouse) with at least $5 million in net assets

There is no limit on the amount that an issuer can raise under this exemption, but the issuer is required to file a report of exemption distribution with the BC Securities Commission and other relevant securities regulators within 10 days of the distribution.

What is the crowdfunding exemption?

The crowdfunding exemption is a relatively new exemption that allows issuers to raise limited funds from a large number of investors without a prospectus, and without the purchasers having a close relationship with the issuer. There are two regimes for crowdfunding in Canada; one applies in British Columbia and Saskatchewan (as well as Alberta, Manitoba, Québec, New Brunswick, and Nova Scotia), and the other applies in Ontario (as well as Alberta, Manitoba, Québec, New Brunswick, and Nova Scotia).

In British Columbia, a company can raise funds from the public through an online funding portal using a simple offering document in a prescribed form. The following restrictions apply:

  • the issuer may only raise a maximum of $250,000 twice per calendar year (total of $500,000)
  • the issuer must set a minimum amount and raise that amount within a maximum of 90 days or all investors funds must be returned
  • only certain securities can be sold (common shares, non-convertible preferred shares, securities convertible into common shares or non-convertible preferred shares (for example, special warrants), non-convertible debt securities, and limited partnership units )
  • each investor can invest a maximum of $1,500 in a raise (there is a limited exception in BC and Alberta where certain investors can invest up to $5,000)
  • purchasers have a contractual right to withdraw their offer to buy for a period of 48 hours from when the purchase subscribes (or from the time an offering document is amended after the purchaser has subscribed)

Following completion of a crowdfunding distribution, the issuer is required to make certain filings with the BC Securities Commission and the regulators in the provinces where purchasers are resident.

Do resale restrictions apply to securities purchased under prospectus exemptions?

Purchasers of securities from a non-reporting issuer under a prospectus exemption have very limited ability to sell their securities unless and until the issuer becomes a reporting issuer. Until then, such securities can only be resold under another prospectus exemption, which does not have to be the same exemption under which the securities were originally sold. For example, an accredited investor can sell her shares to another accredited investor or to someone who qualifies under some other exemption, such as a director of the issuer.

Conclusion

Securities laws apply to all issuers and it is a private company’s obligation to make sure it is in compliance with securities laws when it issues any of its securities without filing a prospectus. Securities laws are complex and issuers should consult legal counsel experienced in securities law for advice. Please contact a member of our securities group for specific advice about your plans for any distribution of securities by your company. You can reach our office directly at 1-800-604-1312 or [email protected]

Article written by Evie Sheppard, Corporate, Commercial and Securities Lawyer.

Disclaimer

***The above blog post is provided for informational purposes only and has not been tailored to your specific circumstances.  This blog post does not constitute legal advice or other professional advice and may not be relied upon as such. ***