Why is Securities Law Relevant to Start-up Companies?
Securities law is relevant anytime a company finances itself. All start-up companies will need to raise money continuously in order to grow and that means that securities law must be an ongoing consideration. There are significant consequences for a company if securities law is contravened and it is paramount that the rules are understood and that legal counsel is obtained if necessary. The governing statute in Alberta is the Securities Act, RSA 2000, c S-4, but the instruments (both national and multilateral) and companion policies that accompany the statute are the most important resource for rules and procedure.
What is a security?
A security is a financial instrument. More specifically, it is any asset that is purchased where the performance of that asset is entirely in the hands of a third party. Control is a very important consideration in determining whether a financial instrument is a security. Some common examples include shares, derivatives, bonds, debentures, and notes, but certain types of investment property may also be securities.
The aim of securities law
The aim of securities law is to promote investor protection, public confidence, and an effective capital market. This is achieved through disclosure, amongst other processes, in both primary and secondary markets. The primary market relates to brand new issuances of shares from a company’s treasury and adequate disclosure is achieved through a prospectus filing (unless an exemption applies). The secondary market relates to trading in previously issued securities and adequate disclosure is achieved through continuous disclosure and other reporting requirements that companies must adhere to.
Advantages and Disadvantages to Going Public
There are many reasons why a company may choose to go public and other reasons that militate against it. Some of the pros of going public include the ability to raise money, to provide liquidity to the initial shareholders, and to improve the exposure and prestige of the company. On the flip side, some of the cons include the time and expensive of an initial public offering (commonly known as an “IPO”), the subsequent continuous disclosure and other reporting requirements, the addition of more stakeholders, and pressure to achieve short-term results.
Filing a Prospectus or Using an Exemption
When a company goes public, it must file a prospectus which is a document that provides all relevant information for assessing the value of the securities being offered for sale. A prospectus must provide full, true, and plain disclosure of all material facts, which are defined as any facts that would reasonably be expected to have a significant effect on the value of the securities. The prospectus must be filed with the appropriate securities commission(s) and provided to potential investors through an online filing.
All distributions of securities must meet the prospectus requirements unless an exemption applies. Any securities that are issued through an exemption have restrictions on resale. Securities can be traded within the closed system using another exemption or publicly if a prospectus is filed. Some of the most commonly used exemptions will be discussed below. The rationale behind the exemptions is that there are specific circumstances which limit the amount of risk posed to investors and removes the need for prospectus disclosure.
Firstly, the private issuer exemption can be used if a company has never been a reporting issuer or merged with one. There must be restrictions on the transfer of shares (which are typically found in the company’s articles of incorporation), no more than 50 shareholders, and no distribution to the public previously. Securities can be issued under this exemption to a wide variety of individuals, so long as the distribution is not made to the public at large.
Secondly, the accredited investor exemption encompasses a broad class of individuals. The most commonly used categories are an individual with at least $1 million in financial assets, an individual earning $200,000/year for the last two years or $300,000/year with a spouse for the last year, or an individual with $5 million in assets. The idea here is that an accredited investor is sophisticated and can absorb a loss.
Thirdly, the friends, family, and business associates exemption can be used by reporting issuers even after 50 shareholders have been reached or a distribution to the public has been made. This exemption is similar to the private issuer exemption except that this exemption captures a broader subset of people who can become security-holders. The idea with this exemption is that these individuals have common bonds with the issuer – either through a direct connection or a close relationship with a person who has a direct connection- that minimizes risk to them.
Finally, the employee, director, and consultant exemption is available, but participation must be voluntary. The idea with this exemption is that these individuals have knowledge of, or access to, information regarding the company which minimizes the risk they are exposed to.
This blog post should alert you to the fact that securities law is highly relevant to any start-up company. Once a start-up needs to raise money through a financing (which it will), securities law will be a primary consideration whether or not the company decides to go public at that time.
Natalie Holtby is a 3rd year student at the University of Calgary's Faculty of Law. She works for the BLG Business Venture Clinic for the 2017/2018 season.
Blog posts are by students at the Business Venture Clinic. Student bios appear under each post.