The Exempt Market: Dragon Slayer
By: Harvey Kraft
Recently I was watching an episode of the Dragon’s Den where a young entrepreneur had an idea in the auto supply industry. The Dragons were salivating over the deal and wanted in badly. The young fellow held his ground and ended up getting $3,000,000 for a 20% equity stake in his company. From what I have seen of the show, this is the exception rather than the rule. Most of the deals are pure entertainment somewhat like watching a combination of the Gong Show and Canadian Idol and in those rare cases where a deal is struck, it is almost never what the entrepreneur wants and usually not in his/her favor (as they have little bargaining power due to feeling that they’re out of options). Most entrepreneurs’ biggest obstacle is finding ways to fund their start-up. The banks really only want to provide financing after you have already succeeded and in the current economy most people are holding on to their excess cash just in case a ‘rainy day’ unexpectedly shows up. That doesn’t mean there’s no capital to be had though. Why not forego dragons, vultures, and even ‘angels’ and offer up equity in your business little by little to investors from one of the biggest pools of capital in Canada, the RRSP and TFSA pool?
A big opportunity is emerging now to jump start your ideas and fund the growth. It is the Exempt Market. It has been around for a while but only recently became much more regulated. The credibility that came with tighter regulation has attracted a lot of advisors and investors that wouldn’t have looked here otherwise and the ripple effects have created a viable brokerage industry willing to fund small to medium businesses, and even start ups. A huge source of capital for these brokerages (known as Exempt Market Dealers) is RRSP and TFSA capital. There’s a common misconception that RRSPs and TFSAs can only invest in the public markets, mutual funds, and GICs but subject to a few restrictions, investors can in fact use their RRSPs and TFSAs to purchase shares in a private company/start up.
While there are a number of RRSP and TFSA eligible structures available outside of the public markets, the one most commonly used by small business and startups is called the specified small business corporation. This structure is also commonly referred to as a Canadian Controlled Private Corporation (CCPC). Subject to a few restrictions relating to the type of underlying business and individual investor ownership, this structure is one of the eligible ones listed in the CRA’s list of qualified investments for both RRSPs and a TFSA. This structure is popular with entrepreneurs who wish to have investors join their small business as an equity partner.
There are many different business types that are going this route that I have reviewed in my role with Olympia Trust. In addition to the more common real estate and oil and gas offerings I see, there are many other examples of funded entrepreneurial businesses by RSPs and TFSAs in the exempt market. For example, I have reviewed offerings related to:
Pubs and restaurants
Medical & Scientific Research
Television & Film
It is important to keep in mind that no one investor or those related to them collectively can own 10% or more of any class of shares of this issuer in their registered account in this structure. Severe penalties can be encountered through CRA prohibited investment rules if an investor goes offside with this threshold investment level. Another important CRA rule for this particular qualified investment is that substantially all of the fair market asset value of the business must be principally used in an active business in Canada. Active business is defined by CRA regulations.
It is common that businesses utilizing this structure are established with two or more different classes of shares. Often they are structured this way to exclude voting rights from those shares purchased by investors (to retain control) and in some cases to cap investor returns at a certain threshold as well. While the ways in which a company can be structured are effectively endless, in basic terms there are generally two types of shares that are issued: Common Shares (both Voting and Non-Voting) and Preferred Shares. By purchasing Common Shares investors are generally entitled to a piece of the business on an ongoing basis and are not capped on the types of returns they can receive. Preferred Shares on the other hand typically come with a capped return in exchange for precedence over the common shares in the event of the company winding up.
Raising money from multiple individual investors can put an entrepreneur in a better negotiating position than dealing with a couple of “Dragons” but it’s important to ensure your company is structured so that you treat investors fairly and don’t become a “Dragon” yourself. In reviewing some issuers, I occasionally encounter unscrupulous individuals who have their interests first and foremost, and the investors’ interests somewhere more distant. I look closely at the ownership structure and too often have seen deals structured with large dilution to the investors in favor of the promoters. For example I recently reviewed a startup that issued management 5,000,000 shares for a total of $500 ($.0001/share) and then intended to sell shares to investors for $1.00 each when the company didn’t have any real assets to speak of yet.
Imagine the shares of your start-up of choice growing into the next Apple or Google while parked in an investors’ RRSP or TFSA? Investors today are faced with the volatility of the public markets and poor yields on savings. If structured properly, funded adequately, and executed according to their business plans, shares in a small business could prove to be a viable place to invest a portion of one’s retirement funds. The exempt market is a growing segment of the investment world and should continue to offer a solid funding alternative for the astute entrepreneur.