By: Conflict Analytics Lab Securities Team
Anyone in the business world has heard that their connections will make or break their future career. For most students, this advice is daunting. But for Canadian entrepreneurs, as daunting as it is, it’s actually some of the best advice they can get.
For an entrepreneur, an accredited investor connection is like the holy grail. Maybe that’s a bit of an exaggeration, but having strong connections to accredited investors can take their company from mom and dad’s garage to an upscale office tower in the downtown Toronto core. These investors, because of their profile/characteristics, can be with the company from its start until its ready for an IPO. This is incredibly valuable, not only because of the money they can continually put in, but also because these investors have been through the process before, understand the exempt markets, and can help guide a business through its growth. The term accredited investor has been thrown around a lot now, but what on earth is it? Who qualifies as an ‘accredited investor’ under the Securities Act? What is the accredited investor exemption?
The accredited investor is defined in National Instrument 45-106 Prospectus Exemptions. This is the dominant Securities Law/Legislation for capital raising in the Exempt Markets. It’s a hefty definition, with many different provisions. Some of the people who count as accredited investors include banks and specified financial institutions, investment funds, some insurance companies, pension funds and mutual funds, governments, municipalities, financial advisers/investment dealers, and the list goes on. For most start-ups, this isn’t helpful. Who actually has connections with 90% of the people who qualify as accredited investors, close enough connections that they’d actually get an investment? We’d venture to say very minimal people.
Luckily, there are some normal people, who may actually qualify as accredited investors, who could invest in start-ups with relative ease. The definition of accredited investor, which applies in Ontario, and most other parts of Canada like Alberta, is an investor who meets the following criteria:
- Income Test – An accredited investor must meet one of the two income requirements:
- Individually earned net income before taxes in excess of $200,000 in each of the most recent 2 tax years (recent tax year = recent calendar year), and reasonably expects to exceed that net income level in the current tax year; OR
- The individual, combined with their spouse, earned a combined net income before taxes exceeding $300,000 in each of the most recent 2 tax years, and reasonably expects to exceed that income level again in the current tax year
- Asset Test – An accredited investor, in addition to meeting one of the two parts of the income text, is also expected to meet at least one of the following asset tests/asset thresholds:
- Individual or combined with their spouse, has net financial assets exceeding at least $1,000,000, OR
- Individual or combined with their spouse, has net assets of $5,000,000.
Note that neither definition mentions the phrase net worth. Net worth is often thrown around to include family money and potential inheritance, but the Securities Act is a lot more narrow than this. As you might be able to tell, this definition significantly narrows the pool of people who may qualify as accredited investors. It’s not to say there aren’t any out there, but it’s a narrow pool of people who can actually satisfy both tests. Entrepreneurs, if they find someone who meets these criteria, have found the grail, and a potential source of capital for their business.
Making the Investment
So how does an accredited investor make an investment in a start-up? It’s not as hard as you may think. It’s important to always seek professional legal advice first, and ensure that the investor meets the requirements, and that necessary documents and paperwork are appropriately drafted and filed. You should always seek professional legal counsel, and at every stage of the process ensure you are meeting relevant reporting requirements. Here are some key steps in the process:
- Meeting the investor – At this stage, the entrepreneurs are meeting the investor, and seeing if the investor is interested in what they’re doing and can make contributions that are not only financial, i.e., someone who can contribute business advice
- Agreement – if both parties are on the same page about a potential investment, that’s great. Now they need to discuss the key terms of the investment, i.e. payment schedules, interest rates, board seats, and equity stake in the business.
- Written agreement – having verbally discussed the terms of their agreement, its time to get the agreement made in writing.
- Risk acknowledgement forms – Accredited investors are required to sign risk acknowledgement forms when making investments under exempt distributions.
- Investment Agreement – once the investor has signed a risk acknowledgement form, it’s finally time to sign an investment agreement
- Exempt Distribution report – When you take an investment from an accredited investor, you are required to file an exempt distribution report with the local securities regulator within 10 days of accepting the investment. In Ontario, the local securities regulator is the Ontario Securities Commission.
As we know, the OSC is always working to protect the markets, foster investor confidence and enhance investor protection. At the same time, they’re also working to try to make a fair regulatory burden for issuers who want to access the public markets. Recently, the OSC put a task force in place to try to modernize the capital markets and securities legislation, and one part of modernization focused on making the markets more accessible for small and medium issuers. One part of this was trying to find additional accredited investor categories, which would make the definition broader, capturing more people and making more capital available. There’s no guarantee that any of the proposals or recommendations actually become law, but what we can take for now is that people have recognized markets need to be more accessible for small companies, and are willing to suggest changes to make.
Interested in learning more about exemptions? We have a number of articles written on the subject, including exemptions for friends, family members and business associates, and what prospectus exemptions are in general.
Considering raising money? We’ve built a tool that can help small business owners understand whether a potential investor may qualify under the exemptions.
We have included exemptions such as friends, family and business associates, employee/director/executive officers, crowdfunding, offering memorandum, minimum amount investment, and some of the basic investment disclosure requirements.
To learn more about MyOpenCourt’s free legal aid tools, click here.
 Prospectus Exemptions, OSC NI 45-106, s.1.1
 Prospectus Exemptions, OSC NI 45-106, s.6.1(1)(a)