Sandra Richmond and Glen Johnson are associates in the Toronto law firm McMillan Binch. Richmond practises in the KNOWlaw group and Johnson practises in the Public Markets group.

Like small businesses anywhere, Ontario businesses looking for start-up or growth financing have always had to be innovative. But often their efforts have been hindered by the effect of securities laws that regulate (among other things) the issuing of shares to investors in a company.

The guiding principles of securities regulation in Ontario are the protection of potential investors and the promotion of efficient capital markets. It’s a balancing act, to be sure, and if you’re trying to raise funds for a start-up company or a specific project, you might think that the balance is tipped against you.

On the investor protection side, the Securities Act provides that, with limited exceptions, a company may not issue shares unless it has filed a prospectus with the Ontario Securities Commission, which administers the Act.

Preparing a prospectus – a document that is designed to provide comprehensive information to potential investors about the company and its assets, management, financial history and business plans – is a major undertaking. It’s time-consuming, it diverts management’s attention from actually running the business, and it can be prohibitively expensive. For small businesses, the amount of investment they need might be outweighed by the cost of the prospectus.

The Act does provide some exemptions from the prospectus requirements, known as ‘private placement exemptions,’ and smaller companies have tended to rely on these exemptions to the extent they could fit under them. In the past, some provinces, like British Columbia and Alberta, have developed a number of private placement exemptions that were more flexible than their Ontario equivalents.

The osc has recognized that the current exemptions may not provide the right balance between protecting investors and helping small and medium-sized businesses secure financing. The osc’s Task Force on Small Business Financing has reviewed the effectiveness of the current exemptions and has proposed that they be replaced with new exemptions.

The current exemptions are based on the premise that because of the investor’s wealth or sophistication, or the investor’s relationship with the issuing company, the investor does not need the protection of mandatory disclosure – he or she is considered to be able to assess the merits of the investment without a prospectus.

$150,000 exemption

For example, one current exemption arises when a company is selling shares to an investor who buys shares for a total purchase price of at least $150,000. Presumably, an investor who is prepared to invest that much money is sophisticated enough not to require the protection offered by a prospectus.

However, that minimum purchase price may drive individuals to invest more than they want to or ought to in a particular case, simply so that they meet the qualification.

And it’s not clear that the existing $150,000 threshold is a good proxy for sophistication. The osc has suggested that some high-income earners, such as lottery winners, athletes or entertainers, may not necessarily be sophisticated investors.

It’s worth noting that in 1966 the minimum investment under this exemption was set at $97,000 – adjusted for inflation, the minimum would now be $500,000.

Seed capital exemption

The seed capital exemption, which can be used only once, does not require a minimum investment but comes with its own limitations. Under this exemption, a company cannot solicit more than 50 potential investors and cannot sell shares to more than 25 investors.

Each purchaser must have access to substantially the same information about the company that a prospectus would provide. Generally, this has been interpreted to require the preparation of an offering memorandum that contains the same level of disclosure that would be found in a prospectus, so there is little advantage to not having to prepare an actual prospectus.

In addition, the class of investors is restricted. An investor must be an executive of the company or an executive’s child or spouse, or an investor who, because of his or her net worth and sophistication or because of advice received from a securities dealer, is able to evaluate the investment on the basis of information provided by the issuer. Although there’s no bright line test to help assess an investor’s ‘net worth and sophistication,’ an issuer should err on the side of caution when considering whether it can use this exemption in its financing efforts.

On the other hand, the class of investors, while restricted, is slightly broader than that allowed under the private issuer exemption.

Private issuer exemption

Under the private issuer exemption, a prospectus is not required if the shares being sold are shares in a private issuer and are not being offered to the public.

A private issuer is a corporation whose governing documents impose restrictions on the transfer of shares, prohibit the offer of shares in the issuer to ‘the public’ and limit the number of non-employee shareholders to no more than 50. (A private issuer can also be a partnership or other entity that offers securities in itself.)

The difficulty in using this exemption comes from the uncertainty in determining who ‘the public’ is. Typically it has been defined broadly – generally, potential investors are considered to be ‘the public’ unless they have ‘common bonds of association or interest’ with the issuer.

That common bond cannot be simply a slight business or social acquaintance. In some cases, even previous business dealings with the principals of the issuer will not be enough to qualify the potential investor as having a common bond unless the investor has some knowledge of the issuer’s current business. Such a strict interpretation can severely limit the pool of potential investors.

In addition, an issuer can lose the benefit of this exemption even though it has not made a general offer to the public, if it removes the private issuer restrictions from its governing documents when obtaining financing from non-bank sources, such as venture capital funds and commercial credit operations.

Proposed exemptions

One of the goals of the task force was to ensure that the regulatory regime for securities facilitates small business access to financing without compromising the Act’s investor protection objective.

The task force released its final report in late 1996 and in 1999, staff of the osc issued a Concept Paper based on the report. The Concept Paper proposed eliminating a number of existing prospectus exemptions (including the private placement exemptions described above) and replacing them with two new exemptions.

Accredited investor exemption

One proposed exemption would allow companies to raise any amount of money from any person or company that meets the definition of ‘accredited investor.’

Accredited investors would include:

* certain institutions that would be prescribed under the Act and that would include financial institutions, governments, mutual funds, certain pension funds and charities;

* corporations with more than $5 million in assets;

* individuals with a net worth of at least $1 million, or income that is over a specified threshold; and

* the management of the company.

Generally, the company would not be required to provide a prospectus or any other disclosure materials to accredited investors.

Closely held issuer exemption

The closely held issuer exemption would allow an issuer to raise up to $3 million from a small number of investors without regard to their sophistication or other qualifications.

Under this exemption, a company would be able to sell shares to up to 35 non-accredited investors, including employees but excluding directors and officers. The company would also be able to sell shares to an unlimited number of accredited investors for an unlimited amount of investment.

Although no prospectus would be required, if there were more than five shareholders in the company, the company would have to provide potential investors with a generic information statement indicating the nature of the information they should ask for and assess in making their investment decision. This would include information about the financial state, management and operating history of the company, the liquidity of the shares, whether the company is involved in any litigation, and how the company proposes to use the investment.

As with the existing exemptions, any shares acquired would be subject to restrictions on resale including approvals of the board of directors.

Looking ahead

While the good news is that the regulators have recognized a problem for small businesses in raising investment money, the bad news is that it’s not clear if and when these new exemptions might be available.

A working group of osc staff is currently reviewing comments on the proposal that have been received from interested parties and are preparing a draft rule that would implement the proposal in Ontario. (It’s possible that other provinces might sign on to the initiative as it moves forward.)

At this point, it’s unlikely that the new exemptions would come into force this year. In the meantime, small businesses hoping to raise money in a public financing will have to keep trying to fit themselves under the current exemptions.

This article contains general comments only. It is not intended to be exhaustive and should not be considered as advice on any particular situation.