January 26th, 2021

Things Not to Say to An Investor
What Are Prohibited Representations, Why Are They Bad, and How Do I Mitigate Against Them?

​How Prohibited Representations AriseSecuring investments is essential for a start-up. Often characterized by their rapid growth, start-ups experience a pressing need to obtain outside financings since their internal revenue flow is often insufficient to fuel their continued growth.[i] While securing investments to finance the growth of the business is a crucial part of the entrepreneurial journey, there are various risks associated with soliciting, facilitating, and accepting investments.

This blog focuses on the first step of obtaining an investment – soliciting someone to finance the business. When to comes to soliciting an investment, a major risk that entrepreneurs must keep in mind are prohibited representations. Prohibited representations are representations often made by a business or one of its stakeholders to a potential investor for the purpose of securing financing which cannot be made according to Canadian securities laws. There two major prohibited representations with respect to communicating with potential investors: a plan to list the company on a public market, and the future price of securities.[ii]

Cannot Represent an Intention to Go Public
The prohibition on representing a business’s intention to become publicly listed is quite extensive. In addition to being prohibited from stating that a security will be on a public market or quotation system in the future, businesses also cannot state that they will apply to become publicly listed in the future.[iii] This prohibition includes merely discussing the possibility of an initial public offering in the future.[iv]

This restriction is deeply problematic for growth businesses as investment decisions often hinge on whether a business with have reliable access to future financing opportunities and if a business can provide its investors with an exit event. Due to the absence of venture capital and similar sources of financing in Western Canada,[v] the public markets can be the only reliable future source of financing. Consequently, the absence or perceived absence due representation restrictions, of a business’s intention to enter the public markets can deter investors and stunt business growth.[vi]

Cannot Represent Future Prices of Security
Being unable to discuss the future prices of securities or derivatives can have a major negative impact on soliciting investments. Since start-up businesses grow rapidly, historical financial information is not an accurate indication of how the business will perform in the future. As a result, investors frequently valuate start-ups based on their anticipated future value through discounted cash flow (“DCF”) models, terminal values, and other calculations derived from forward-facing financial information.[vii] While future securities prices may not necessarily be used in arriving at these calculations, it can be easily calculated from these valuations. [viii] As a result, entrepreneurs must be cautious about what information they provide to potential investors concerning the anticipated future value of their business.
This obligation extends to all representations concerning the future price of securities, including representations made during financing negotiations. This can stall negotiates and prevent a financing from taking place.[ix] Consequently, violations of this prohibition can be attractive to start-ups, however, as discussed below, this early securities law violation can have major repercussions down the road – both for the initial investment and subsequent financing rounds.

Cannot Misrepresent Information Affecting Security Prices
Before discussing the consequences of making a prohibited representation, it is also worthwhile noting that there is a broad prohibited representations rule which prohibits misrepresenting information that could affect the price of a business’s securities. There are two elements to this prohibition. First is that unless a security has redemption or retraction right attached to it, no person can represent that business will resell it, repurchase it, or refund any portion of its costs[x]. Second, there is an obligation that no person may make a statement they know to be untrue, misleading, and that would be reasonably expected to have a significant effect on price/value of a security.[xi] This obligation applies to not just the business’s directors and officers, but also includes other stakeholders irrespective of their relationship to the business, capturing people like the shareholders and agents of the business. 

Consequences of Making a Prohibited RepresentationTwo key risks arise if a business makes a prohibited representation. If a prohibited representation is made in connection with an investment, then the affected investor can use that securities law violation to make the investment contract voidable. This means that the investor can require the business to repurchase their shares and allow the investor to exit the business which grants the investor an immense amount of power over the business.[xii] Secondly, if the securities violations become public knowledge it can deter future investors from investing in the business. This can occur if an investor in the company reports the violation to the securities commission.[xiii]

How to Navigate the RulesGiven how central these rules are to soliciting a financing and how catastrophic their breach can be, how can a business mitigate the risk of making a prohibited representation? Unfortunately, there is no silver bullet solution, but there are some steps that businesses can take to mitigate the risk of making a prohibited representation. These can include restricting the disclosure of and regularly attaching disclaimers to the information which may contain prohibited representations, warning management about the risks of using this information, and ensuring that no prohibited representations are included in any offering memorandums.[xiv]
 
Author: Duncan Pardoe is a caseworker at the BLG Business Venture Clinic and a second-year law student at the Faculty of Law, University of Calgary.

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[i] Bryce C Tingle, Start-up and Growth Companies in Canada: A Guide to Legal and Business Practice, 3rd ed (Canada: LexisNexis Canada, 2018) at 9-10 [Tingle].
[ii] Securities Act, RSA 2000, c S-4, at s 92(3)(a-b) [Securities Act]; Tingle, at 284-285.
[iii] Securities Act, at s 92(3)(b).
[iv] Tingle, at 284-285.
[v] Ibid, at 297-301.
[vi] Ibid, at 284-285.
[vii] Ibid, at 321-324.
[viii] Ibid, at 285-286.
[ix] Ibid, at 286.
[x] Securities Act, at ss 92(1)-(2.1).
[xi] Tingle, at 286.
[xii] Ibid.
[xiii] Ibid, at 249-251.
[xiv] Ibid, at 286.