Originally Published on Equities.com by Gary Bizzo
You have it good and bad when it comes to financing your new startup. Sure, you can go to the bank, but from my experience and that of my clients, you might as well ask your barber for the money… you’ll get the same results.
Startup Founders know about the primary finance avenue from the get–go. It’s the one that also happens to be the first that’s open to them — friends and family!
When the Securities Commissions, in their quest for compliance, came up with exemptions that allowed the average guy to invest in private companies, it provided a great way to finance startups over a longer term. Friends and family investing is one of these exemptions.
Friends and family are not to be taken lightly though. Unless you really are a close friend, or legitimate family member of the people involved in the startup, you will run afoul of the law. As Todd Buchanan, Managing Partner of Liquidity Event Planners, Equifaira, told me, “unless you know the location of your friend’s bathroom in his house, he’s not your friend”.
The second way to get investment in your startup is by selling your private shares in your company to Accredited Investors. Accredited Investors are high net-worth individuals who theoretically can afford to invest, and possibly lose, without too much hardship. Every province in Canada has had this exemption in place to allow investors to put money into private companies with the potential for better growth than the immediacy of public shareholdings.
The Securities Commissions believe that an Accredited Investor who may regularly make investments in companies will need less information to make an informed decision about buying stock. Each Accredited Investor must attest to the fact that they meet the definition of an Accredited Investor.
A company should consider the Accredited Investor route. Primarily, by offering shares to sophisticated (in terms of investing only) investors, start-ups can avoid professional fees of up to $150k and more on professional accounting and legal fees to prepare an Offering Memorandum and need only provide a term sheet to the investor to raise capital.
The third way the private company can raise money through exemptions is by preparing an Offering Memorandum (OM). Investopedia says this about an OM:
“An offering memorandum is a legal document that states the objectives, risks and terms of an investment involved with a private placement. This document includes items such as a company’s audited financial statements, management biographies, a detailed description of the business operations and more”.
This requires full disclosure of everything to do with the investment opportunity for the safety of the smaller investor.
The start-up (the issuer) takes the OM to an Exempt Market Dealer who, assuming that it passes their stringent due diligence review, then has its Dealing Representatives distribute the offered shares to ‘suitable’ candidates. The Dealing Representatives need to make a determination as to which of their clients is a suitable candidate to invest in the startup. An 88-year-old man may not be considered a suitable candidate for a private offering that has a 5–10 year timeframe for the return of the investment.
Investors looking at an OM can be anyone of a legal age, so they need to make an informed decision. The risks need to be disclosed, and it’s the Dealing Representative’s responsibility to make sure that the investor qualifies under one of the exemptions, and that the investment is a suitable one for each respective client. Minimum purchases through OM’s are usually $5000-$10,000, so many small or first time investors can take advantage of this exemption.
The OM Exemption had been in every province of Canada with the exception of Ontario. In 2016, Ontario finally passed the Offering Memorandum Exemption that now allows companies to access private capital from smaller players — not just high worth individuals. The Exempt Market may be a relatively new term to Ontarians. It’s commonly referred to as private capital or alternative investments.
Opening up this exemption has taken the investor pool of a couple hundred thousand and opened it up to over 3.8M people in Ontario. Investors in Ontario can now be anyone with $5000 in their pocket — not only high net individuals.
What are the advantages of private capital investing versus a public offering? OMERS, the retirement plan for Ontario Municipal employees with more than $85B in net assets, recently released a report that said they were 45% invested in private markets with the remainder in public investments. This is staggering, considering the differential in their public investments in 2015 was around 0.7%, return while their private investments returned 14.5%.
Investing in public market gives zero control to the shareholder, provides stress to the company that must perform for the shareholders every quarter and is very exposed to outside influences. The private capital market may sometimes be riskier, but they usually offer better returns through a liquidity event. One of the Ontario Dealing Representatives, Stephen Freedman, who has been registered through the Securities Commission for over 40 years, works with private startup Surgically Clean Air. The Toronto-based Surgically Clean Air (SCA) products offer superior air cleaning through sophisticated filtration systems, high volume air flow capacity and lower sound levels than any other premium air cleaner on the market. SCA has been so successful at improving the quality of interior air that their systems are being used by numerous sports teams, including the Toronto Raptors, Toronto Maple Leafs, Toronto Blue Jays, Montreal Canadians, as well as over 1000 dental offices and many more.
In the private capital market, you can get to know more about the company, they are usually more of a long-term investment, the shares are often lower in price to purchase and the returns can be higher. Instead of trying to raise capital and ‘perform’ like the pubco’s, companies like SCA can afford to take the time to ‘do business’. Being private allows them to pivot easily and gives them more freedom to expand than if quarterly reporting and short-term, quarterly results had bound them. Private companies are usually looking for a liquidity event. The definition of a startup is an innovative idea, fast growth and a timeline to liquidity in 3–5 years. The liquidity event can be in the form of a merger and acquisition, a dividend to investors or the sale of the company. This gives investing in the private company a more long-term investment.
Stephen Freedman said, “SCA as an Exempt Market investment doesn’t trade on the stock exchange but investors love it because of its potential opportunity for growth”.
Why would investing in a private company be that exciting? The private capital market allows you to know the principals easily. They have smaller group Meetups where they present their business to investors. Like Surgically Clean Air, many show great growth, have a great story and a talented management team.
Ontario’s introduction of the Offering Memorandum Exemption allows investors to be able to tap into investment offerings that everyday investors could not previously access. Prior to the OM exemption, it was mainly Accredited Investors who were allowed to invest in the Exempt Market in Ontario. Investors had to be worth over $5M, have $1M in cash or securities or earn more than $200,000 a year. That certainly excluded a lot of people who have some money to invest in the next big thing.
Mr. Freedman told me that up until a year ago, few in Ontario could qualify to buy the private investments. With the changes in place, they now can invest, but they need to be educated. Websites need to educate the Exempt Market as an alternative investment so the average guy can put money into long-term investments besides their TFSA or RRSP.
The Ontario Offering Memorandum Exemption has done more than allow small or first-time investors the opportunity to invest in startups, it’s provided small to medium companies the opportunity to find another source of capital that they normally wouldn’t be able to find. Freedman’s website does a great job of educating investors on this exemption and more.
Watch as the Exempt Market explodes in Canada’s biggest province!
I’m a partner at Equifaira Advisors Inc. — Liquidity Event Planners