Tear It Apart: The Anatomy of an OM | and the importance of investors understanding it
By: Randy McCord & Alixe Cormick
The alternative investment environment is home to some of the most lucrative and creative investments in Canada. Many of these investments are non-correlated to the stock or bond markets, which can make these investments an attractive addition to an investor’s portfolio if the risks and rewards are fully understood. It is key for investors to carefully read the offering memorandum (OM) describing the business and investment opportunity and to confirm all questions they have are answered to their satisfaction before investing. Advisors call this process of due diligence ‘tearing the OM apart,’ or really getting to know the anatomy of a deal before investing one’s hard-earned dollars.
The OM is one of the most important documents for private capital placement in Canada today. The primary reason is it allows issuers to offer their securities to the largest number of potential investors in Canada without filing a prospectus. Subject to a few restrictions, providing an OM allows anyone to invest in an issuer regardless of his or her relationship, wealth or total value of the investment made. The OM exemption is one of the exemptions in National Instrument 45 – 106 Prospectus and Registration Exemptions (NI 45-106). The OM exemption is available in all provinces in Canada except Ontario, which is currently looking at adopting it in one form or another. The required content of an OM is standard in all provinces with some minor variations depending on the type of security being offered and the location of the issuer. An OM allows issuers to control with certainty the information prospective investors receive so as to make an informed decision about their investment. It also allows for a one page subscription agreement with no investor questionnaire simplifying the investment process for investors.
The benefit of an OM to investors is that it opens the door to many more investment possibilities while providing pertinent information about the offering that will help them decide whether to invest or not. Investors must take the time to fully read and understand the OM when reviewing an investment offered by an OM.
NI 45-106 has two versions of the required form for an OM: (1) is for qualifying issuers (Form 45-106F3); and (2) the other is for non-qualifying issuers (Form 45-106F2). Qualifying issuers are issuers listed on the TSX or TSX Venture Exchange. Non-qualifying issuers are for all other securities issuers. Issuers in the alternative investment environment use Form 45-106F2. The disclosure required in an OM is less than that required in a prospectus, but it is still a robust document.
An OM in the required form in Canada includes the following sections:
Item 1: Use of Available Funds;
Item 2: Description of Business;
Item 3: Interests of Directors, Management, Promoters and Principal Holders;
Item 4: Capital Structure;
Item 5: Securities Offered;
Item 6: Income Tax Consequences and RRSP Eligibility;
Item 7: Compensation Paid to Sellers and Finders;
Item 8: Risk Factors;
Item 9: Reporting Obligations;
Item 10: Resale Restrictions;
Item 11: Purchasers’ Rights;
Item 12: Financial Statements; and
Item 13: Date and Certificate;
A lot of the information required in an OM is also contained in an issuer’s financial statements, corporate record book, business plan, and investment project material. The expectation is that the OM will contain enough information in a concise form so investors can make an informed decision about the securities offered without referring to other documents.
Although all the items of the OM should to be read with care, a few key items need extra attention and due diligence. We will review why these items are significant and why investors should pay particular attention to these items.
Item 1: Use of Available Funds
It is vital that investors understand how an issuer intends to use the funds raised. An OM must contain enough detail for investors to understand why the issuer is raising the money and how the issuer will use it. For example, it is not enough to say the issuer will use the funds to construct a building when the funds will simply be a down payment and the issuer plans to borrow additional money to construct the building through standard lenders. These details should be clarified to enable investors to understand the business risk should more funding not be available or insufficient to fund the project.
Item 2: Description of Business
In the description of the business, the OM must give enough detail so investors can properly evaluate and understand the business and its prospects for success. This includes a detailed description of the issuer’s products or services, properties or property development, the strategies behind the business and the issuer’s plans for marketing. This is one of the most important sections in the OM. It is in this section where investors can make an assessment in their own mind if they understand and appreciate the business they are about to invest in. Investors should understand how the issuer plans to make money, how the investors will make money and how this dynamic works. More and more, issuers today are trying to produce business plans where the interests of the management company and the investors are closely aligned, but that is not always the case.
It is also important to make sure that the issuer plans to use the funds raised for a specific business purpose. Sometimes issuer’s raise venture capital using an OM for a non-specified business purpose; in these circumstances there is a general description of the types of businesses that the management team are interested in acquiring with the funds raised. More due diligence is necessary in cases like this where there is no specific property, product or service that is the basis of the business.
Item 3: Interests of Directors, Management, Promoters, and Principal Holders
Perhaps the most important information, other than understanding the business and the use of the funds, is getting to know the key people involved in the business. Investors should check into the background, history and experience of the management team, the directors, the promoters and the principal holders of the management company. A management team with a long and successful record of accomplishment is preferable to a team with no record of accomplishment or a record of disappointing returns or outright failures.
A management team with a strong record of accomplishment is a plus when investing in a company. A young management team could produce good results and an unsuccessful team in the past could do well in the future, but the past is often indicative of future success or likelihood of failure. As an investor, you want a strong management team. If possible, investors should try to meet with the management team face-to-face and get a feel for their style and for their commitment to their business. First impressions count. If investors get a bad feeling having met with management there may be a reason. Usually it means further due diligence is required or an investor is just not right for this investment. Either way, trust in the management team is essential to making an investment commitment one that allows investors to sleep comfortably at night.
Item 5: Securities Offered
Investors should clearly understand the nature of the securities offered. If the investment is in the form of a loan or debentures, what is the attached interest rate, how it is to be paid, and are the securities redeemable. There should also be a clear timeline and a clear exit.
Issuers cannot guarantee or promise a specific rate of return on equity securities under Canadian securities laws. An investment in common shares means investors are buying the right to pro-rata profits in the company should it succeed. Investors’ returns are related to the underlying profits generated by the operation of the business. Investors may receive these profits either through a declared dividend, an increase in share price, or on the sale of the company.
Many alternative investments are not redeemable and as such are illiquid investments, which make them higher risk. This should be set out as one of the risk factors in Item 8 of the OM.
Other vital red flags investors should not ignore
A common red flag investors should be aware of relates to compensation for management before commencement of a project or investment itself. The common term for a management team taking fees up front is a ‘lift.’ Expecting payment as a management company for work done such as acquiring land and setting up a structure by which investors may benefit from ownership of that land through a syndication, is not unreasonable. The issue is whether this payment is reasonable under the circumstances.
The risk factor section in an OM often contains a list of red flags that can have a significant impact on an investment. A given risk factor may raise concerns about liquidity, fees, foreign currency risk, possible conflicts of interests and the relative inexperience of the issuer’s management team. Investors may fail to recognize the potential impact of these risks to their peril. If a risk is set out an OM, then investors must fully understand the ramifications of this risk before moving forward.
Some of the issues raised above should give investors an idea of how a management team expects to make money, what sort of exit strategy investors will have and what sort of return on investment they can expect. If these factors seem to align and make sense to an individual investor, it may be a good investment opportunity for them. Once again, if the management team’s incentive is in line with the results for investors and the history of the management team shows experience and success, then investors may be confident their investment dollars are well placed and the investment should help them build their wealth should the company succeed. Investors should remember, however, that all investments carry risk and there can be no guarantee of success even in the best of circumstances.