Obtaining Equity Investments for Your Corporation

Some day you hope your corporation might “go public” but for right now, it needs money.  You have decided that you don’t want to borrow money because you don’t know if your corporation will be always be able to repay the money when the bank demands it or because your corporation just can’t qualify to borrow enough money to see its business needs through. 

Your neighbour Bob and Bob’s brother, whom you’ve never met, believe that this is a great opportunity for an investment and you and Bob have agreed that Bob and his brother will have a small ownership interest in exchange for his and his brother’s investment.  You will be able to put the money to good use.  Your neighbour moves six months later and wants his money back.  You correctly point out that this was an equity investment and not a loan.  He calls the Ontario Securities Commission (“OSC”) and, after a brief OSC investigation, you are surprised to find you’ve been personally charged with several securities offences.   What went wrong?

A corporation that is not a public corporation can only sell shares if it fits within very tightly defined exemptions.  The two exemptions most often used in Ontario are: (i) “Private Issuer” when issuing shares to specific classes of people; and, (ii) “Accredited Investor”. 

Private Issuer exemptions require two steps for compliance:  The corporation must be a Private Issuer (that is, it must have restrictions on the transfer of its shares and have less then 50 shareholders) and the shares must be issued to only specific types of investors set out in a list in a governing National Instrument.  The list includes directors and employees of the corporation plus people who are in a defined relationship with a principal of the corporation such as “close personal friend”, “close business associate” or immediate relatives.   

You have no hope defending the OSC proceeding regarding Bob’s brother and so you give him back his original investment plus interest which hurts because the value of your corporation has declined.  You regard Bob as a personal friend; however, the OSC have published an interpretation that defines “close personal friend” as “an individual who knows the director of the corporation well enough and has known him for a sufficient period of time to be in a position to assess their capabilities and trustworthiness”.  Bob denies that he is your “close personal friend”.   

You next look at the “Accredited Investor” exemptions.  This permits corporations to issue shares to sophisticated investors or to individuals with enough wealth to know how to assess the investment in the absence of a prospectus.  Unfortunately, you don’t think that Bob or his brother have more than $5,000,000.00 in net assets or annual incomes of more than $200,000.00 or financial assets of $1,000,000.00. In any event, you never made the requisite OSC filing immediately after receiving Bob and his brother’s investments in which they would have confirmed their level of wealth.

You pay Bob back his investment and interest and hope for the best at your upcoming OSC hearing.

In general, in order for a corporation to sell shares it must disclose certain information to its buyers, such as financial information and information about the corporation itself and its business. The goals of the OSC in requiring this disclosure is to protect investors from a corporation’s unfair, improper or fraudulent practices and to maintain public confidence in this capital raising process, both of which are central to a healthy economy. Confidence in individual companies and in securities markets generally rests on adequate information about the company being available. Accordingly, securities laws require the investor/purchaser to have access to full and true information so that investors can make an informed decision about what they are buying.

While this seems like a great idea, in practice the cost of producing this documentation and making it available to investors and maintaining it is very expensive and can be a significant barrier to raising capital, especially for corporations that are just starting up. Small-medium sized companies simply do not have the resources to produce such information. Therefore, in recognition of the costliness of its requirements, the OSC makes available to corporations who fall within their strictly defined rules, certain exemptions from disclosure, such as the ‘private issuer’ and ‘accredited investor’ exemptions already mentioned.

The private issuer exemption allows a corporation to issue shares to family members, close personal friends and close business associates of the principals of the corporation.  By allowing this exemption, the OSC assumes that the principals of the corporation will not take advantage of or defraud their close friends, business associates or immediate family.  Furthermore, the OSC assumes that these individuals are close enough to the principals of the corporation that they can assess the investment that they are making on their own without the normal requirements.

The accredited investor exemption on the other hand, assumes that the investor is very sophisticated and knowledgeable, and therefore does not need protection like other investors do. The OSC presumes that sophisticated investors can take care of themselves and can take the temperature of the market and access in their own way information about the proposed investment.

By allowing for these exemptions, the OSC is essentially recognizing the limited capability that small companies have to access capital and takes the approach that there can be circumstances in which capital should be allowed to be raised without a requirement to provide a high level of disclosure to investors or register for public purposes. The exemptions are the OSC’s way of supporting businesses, particularly new start up businesses, by helping them grow, while at the same time providing investor protection and confidence in the capital markets. As a result, securities regulation attempts to draw a balance between protecting investors and enabling small-medium sized companies to raise capital as inexpensively as possible.

The exemptions available and OSC compliance rules have been revised frequently in the past and are often not straightforward.  Therefore, when attempting to raise capital for your company, it is important to seek the advice of someone knowledgeable with securities law requirements. Otherwise, like the businessman in the above example, you can put yourself and your company at risk of violating OSC rules and be subject to the consequences.

Bruce Duggan is a certified specialist in corporate and commercial law and a partner at Simmons da Silva & Sinton LLP.  This article by necessity is general in nature and is not intended to represent legal advice.  For more information see www.sdslawfirm.com

Simmons da Silva & Sinton provides legal services to entrepreneurial
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