Securities Laws and Startups: The Nuts and Bolts

Securities Laws and Startups: The Nuts and Bolts

In our previous blog post, we talked about the importance of making sure your startup 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 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 following:

• Private Issuer Exemption
• Employee, director, officer, and consultant exemption
• Family, friends, and business associates exemption
• Accredited investor exemption

Even though securities regulation is province-specific, 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 you to sell securities without prospectus-level disclosure, as long as your company:

• has less than 50 security-holders (excluding employees or former employees),
• has only distributed its securities to specific categories of persons (see below), and
• has restrictions on the ability of its securities-holder to transfer their securities.

The categories of persons that a private issuer can sell securities to are:

• 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
• accredited investors.

It is important to remember that there are 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 get 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 their securities to other persons unless that sale falls within the scope of another prospectus exemption.

Employee, Director, Officer, and Consultant Exemption

Under this exemption, you can sell securities without prospectus-level disclosure to your employees, directors, senior officers, or consultants as long as the purchase of the securities is voluntary. For example, you cannot persuade the purchaser to buy the securities in return for continued employment or appointment. This is important, because it means the offer of securities has to be structured as an added incentive rather than as compensation for services.

Family, Friends, and Business Associates Exemption

This exemption is based on the close relationship between your directors and officers with the purchaser of the securities. This exemption allows you to sell securities without providing prospectus-level disclosure to the following people:

• a director, senior officer, or control person of your company,
• a family member (spouse, parent, grandparent, brother, sister or child) of a director, senior officer or control person of your company, and
• a close personal friend or close business associate of a director, senior officer or control person of your company.

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.

When is “sufficient” sufficient? If an investor wants to rely on this exemption because they are a “close personal friend” of one of your directors, ask them to tell you where the bathroom is in that director’s house. That’ll give you a good sense of the nature of the relationship.

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 categories of persons such as financial institutions or wealthy individuals.

An accredited investor includes:

• financial institutions,

• registered advisers or dealers,

• pension funds,

• 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, wants to rely on the accredited investor exemption, then the underlying owners (e.g., its shareholders or limited partners) must meet one of the tests under that exemption.

Final Thoughts

If you’re an early-stage startup, 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!