If you have a private corporation looking to raise capital, here's a list of common pitfalls to watch for. Securities laws are a collection of laws, regulations, policy statements, instruments and rules that regulate, among other things, a corporation's sale and issuance of "securities". Securities are broadly defined and can include shares, bonds, and options. In Canada, each province and territory has its own securities act and securities regulator. Some securities law matters have also been agreed upon by some or all provinces and territories and are drawn up in multilateral instruments and national instruments.
Fundamentally, securities laws seek to protect the interest of the investing public and provide financing opportunities for corporations through capital raising transactions while maintaining the integrity of the capital markets. However, there is a tendency to think that securities laws are only applicable to large corporations or public companies, which is untrue. Most private corporations overlook the importance of certain corporate and securities law matters in the early stages, which can pose problems as they continue to grow.
In Canada, regardless of the stage of growth of a corporation looking to raise capital from the public or private markets, some form of securities laws at the provincial or national level will be applicable. Below are some of the common mistakes that private corporations should endeavour to avoid.
1. Issuing Securities Without Specifically Relying on a Prospectus Exemption
In Canada, a corporation issuing or selling its securities is required to file a prospectus unless an exemption to this requirement is available. The prospectus requirement ensures that the issuing corporation provides comprehensive information about its affairs to investors to help them make informed investment decisions. Regulators understand that the prospectus requirement can be quite expensive, time consuming and onerous in certain circumstances. As a result, exemptions from the prospectus requirements have been made available to issuers in certain circumstances. However, it is important to ensure that for every financing round and securities issuance, the right exemption is identified and relied upon, and that the requirements for such exemption are met.
As an example, when issuing securities to close friends, in order for the potential investor to qualify as a "close personal friend", the relationship between the individual and the director, executive officer, founder or control person of the corporation must be direct. A relationship that is primarily founded on participation in an internet forum (e.g., Instagram or LinkedIn) will not necessarily be considered by regulators to be that of a close personal friend.
If a corporation does not pay attention to the applicable prospectus exemption and requirements when issuing securities to founders, employees or early-stage investors, the corporation may end up being subject to regulatory sanctions and penalties.
2. Issuing Securities in Breach of Existing Contracts or Constating Documents
This might seem like an item too obvious to miss. However, when management does not pay attention to, or understand the implication of, existing contractual or governance arrangements, it is possible to make such a mistake. An example is when existing security holders have pre-emptive rights in respect of the issuance of new securities by a corporation and the corporation fails to give the required notice to such security holders, who in turn miss the opportunity to participate in financing rounds. Another example is where the corporation has a unanimous shareholder agreement ("USA") in place and new shareholders did not execute a USA counterpart in accordance with the terms of the USA. Such breaches and oversight might be grounds for future disputes or litigation which could have been avoided.
3. Issuing Non-Existent Securities
Some private corporations have inadvertently issued securities that are non-existent. A good example is where the corporation issues securities – for example, Class "X" shares – that have not been created or authorized under the corporation's articles. It is also common to see private corporations issue preference shares or other classes of shares which are not provided for in the articles of the corporation, or where preference shares are issuable in series, the series issued had not been validly created. As such, it is important to ensure that securities being issued are validly created and exist in accordance with applicable laws.
4. Relinquishing Control Too Early by Issuing Securities as Employee Compensation or as Incentives
Many early-stage corporations have limited capital to attract highly skilled and experienced employees or consultants. They sometimes resort to offering some form of securities like stocks, stock options, etc. to such employees and consultants as compensation in lieu of cash. While that approach is common, it is important for founders to pay attention to the impact of such issuances on the ownership structure of the corporation, and to understand how such securities issuances can gradually dilute the founders' positions. An alternative to securities compensation would be a long-term cash incentive plan tied to the corporation's performance over time.
5. Not Requiring or Not Documenting Payment for Securities Issued to Founders
Often, consideration is not properly paid by founders for the securities issued at incorporation. Section 27(3) of the Business Corporations Act (Alberta) requires that some form of consideration, whether in cash or kind, is paid upon the issuance of shares. To this end, whether at incorporation or down the line, where required by applicable laws, it is important that securities being issued are valued at a certain price and that consideration is paid to the corporation (even if it is nominal) and such payment is properly documented.
6. Not Keeping Up-To-Date Securities Registers
Having an up-to-date securities register that shows the capitalization structure of the corporation at any particular time is very important. Sophisticated seed or venture capital investors, as well as potential purchasers and lenders, often require a copy of the corporation's capitalization table as part of their due diligence exercise and failure to produce a current and accurate securities register may influence their decision to enter into a definitive agreement with the corporation or not. Having an up-to-date capitalization table also helps the corporation's accountants and auditors to ensure the financial records of the corporation are accurate. Further, an up-to-date securities register accessible to security holders helps to avoid conflicts among security holders as to the ownership structure of the corporation.
7. Not Filing Requisite Documents Within the Specified Period
Currently, most of the prospectus exemptions in Canada require filing of certain forms or reports of exempt distribution with relevant regulator(s) within a specific period. For instance, where securities are issued relying on prospectus exemptions other than the private issuer or the employee, executive officer, director and consultant exemptions, the issuer is required to file exempt distribution reports in the form of Form 45-106F1 with the applicable securities regulator(s) within 10 days of the distribution. Oftentimes, this is missed for early-stage issuances. The associated monetary penalties can cause issues for the corporation when it becomes a reporting issuer, is coordinating larger financings, or when it attempts to list on a stock exchange. Such penalties are avoidable if appropriate guidance is sought early on.
8. Advertisement or Solicitation of Investors
Under Canadian securities laws, firms or individuals in the business of trading securities are required to register with the applicable authorities. "Trading" securities includes a broad range of activities such as:
- any sale or disposition of a security for valuable consideration,
- any receipt of an order to buy or sell a security, and
- any act, advertisement, solicitation, conduct or negotiation directly or indirectly in furtherance of such activities.
As advertisement or solicitation of investors is strictly within the purview of registrants pursuant to applicable securities laws, founders and private corporations should be wary of advertising funding rounds or soliciting investors, not even through their social media channels, unless a registrant is engaged by the issuer for that purpose.
It is clear that private corporations need to pay attention to securities law issues as they run their affairs and engage with the public and private capital markets. Being on top of things could save the corporation money in the long run and prevent penalties, future regulatory actions, and loss of opportunities. Private corporations should seek guidance from securities lawyers whenever capital is being raised and/or when securities are being issued by the corporation, even if it is to founders, family or friends.
While most of the identified mistakes and pitfalls as well as the consequences are avoidable, it is important to point out that most can be remedied and, with adequate legal guidance, the negative impact can be managed considerably. Contact us today if you have any questions.
 Section 2.7 of the Companion Policy to National Instrument 45-106 Prospectus Exemptions.
 Section 1(jjj) of the Securities Act (Alberta).