Most industry professionals rely on a comparative approach to explain what the “exempt market” is. At some point in the conversation, they end up telling investors that exempt market securities differ from public market stocks because they: (1) are sold without a prospectus disclosure document and (2) aren’t available to be traded on a stock exchange. While this helps explain the “exempt” part and leads to some important discussion about risk and liquidity, it leaves most investors confused as to what the “market” is and how it works.
Anchoring to the concept of a public company prospectus isn’t very helpful because most retail investors have never actually purchased investments in direct reliance on prospectus disclosure - even if they do have experience with publicly traded stocks. It’s sort of like explaining scuba diving to someone by comparing the experience to being an astronaut floating in space. Accurate? Maybe [footnote 1]. Relatable? Not so much. Investors leave the discussion feeling overwhelmed, and it can scare them away.
Instead, this article intends to take a “how it works” approach to describing the exempt market. Our hope is that it will demystify the process for new investors and frame their expectations.
The Exempt Market as a “Primary Market”
The first thing that new investors need to understand about the exempt market is that they will (probably) be purchasing the investment from previously unissued shares or units of the private company or fund. It’s where the stock market analogy breaks down because the issuing company itself is the counterparty to your transaction instead of a third party already owning the investment.
This is what is known as a “primary market” – a transactional space made up of companies raising money for their own purposes from investors that buy into the fund manager or operator’s business vision. By contrast, a stock exchange like the TSX or CSE is a “secondary market” made up of investors buying and selling investments to each other through an intermediary. In a secondary market, money and investments change hands between investors and do not directly benefit the issuer [footnote 2]. Typically, retail investors’ public stock portfolios (with the exception of mutual funds) are acquired through secondary markets, while their exempt purchases are acquired through primary markets.
Pre-Trade Promotional and Disclosure Information
Since there’s no real “marketplace” for these exempt securities, someone has to promote the investment opportunity to potential investors. This is where pre-trade disclosure and marketing materials are used.
Term sheets, investment summaries, pitch decks, live presentations and other promotional materials are used to drive interest in the investment opportunity. Unlike with reporting issuers though, none of these documents is a prospectus under securities regulation, and they cannot be relied upon as “full, true and plain disclosure of all material facts.”
It's important to recognize that this doesn’t make these disclosures inherently untrustworthy – simply unique in their risk and potentially incomplete depending on the investor’s expectations. Securities laws are in place to prohibit an exempt market issuer from making promotional statements that they knew or ought to have known were misleading or untrue [footnote 3]. In some cases (like with a form-based offering memorandum commonly used in the retail exempt market) they also contain prescribed risk and other disclosures about the business and are prohibited from containing any misrepresentations. For investors, it’s important to recognize the disclosures and promotional materials being presented in order to give appropriate weight to their influence over the decision of whether or not to invest.
The diagram below generalizes the standards associated with various primary market disclosure documents in the exempt market.
The Subscription Agreement
If (after learning about the investment opportunity) an investor wants to purchase securities, they will be given something called a “subscription agreement.” This is essentially the purchase contract between the issuing company and the investor.
The subscription agreement is a long and often very “legalese” document. While there is no prescribed form, they tend to follow standard formats:
- The first page will typically set out the price and number of securities being purchased and collect personal information for registration of the investment on the books and records of the issuer.
- An accompanying schedule to the agreement will then go on to contain acknowledgements, covenants, representations and warranties that the investor must give to the issuing company around things like tax residency, reliance on the promotional and disclosure documents provided, the closing process and the method by which the investor is qualifying to purchase a prospectus exempt security in accordance with Canadian securities regulations.
This last element is fundamentally important to the exempt market process. A fulsome discussion of the exemptions available would be a topic unto itself, but it’s worth noting that much of the subscription agreement is dedicated to identifying how an investor is legally eligible to participate in the investment under Canadian securities laws. This is almost always accompanied by a “choose your own adventure” approach to qualifying the investor through a series of schedules, appendices and exhibits to the agreement that must be signed or initialed differently depending on the investor’s circumstances. As a result, the subscription agreement can be intimidatingly long and technical, requiring multiple signatures and initials. It is not unusual for investors to need a bit of guidance along the way.
Once a subscription agreement has been signed by the investor, it must usually be delivered together with a cheque, bank draft or wire transfer to the issuer directly or to a custodian, transfer agent, or legal counsel. While direct payment to the issuing company remains a common practice in the exempt market, it can nonetheless be disconcerting to investors because they might be asked to deliver payment for the investment before the subscription agreement has been fully accepted or any proof of investment ownership has been returned to them.
Transaction Closing and Ownership
Signing the subscription agreement and delivering the purchase price to the issuing company does not automatically settle the transaction. The issuer first has to accept the subscription agreement and “close” the purchase by depositing funds and issuing securities in the investor’s name.
On a stock exchange, this may occur quite quickly; however, prospectus exempt primary markets often have notable delays between the date of subscription agreement delivery and the actual closing date on which the investment is recorded. Some issuers will wait until a minimum investment amount has been received from all participating investors before closing any purchases, and others will settle trades on a monthly or quarterly basis. There are different reasons for the delay, but new investors can find the gap period between execution and closing to be a worrying experience. Paying for something and not immediately knowing whether or not they own it typically makes investors uncomfortable. For this reason, it’s prudent to discuss expectations around closing with the issuing company or advisor in advance and to follow up to ensure closing dates have been met.
Uncertainty of ownership can also be reduced by working with a registered dealer or custodian that either holds the securities on their own books and records or provides you with ongoing reporting of your holdings. For many new investors, this is a preferred method of accessing the exempt market because it offers greater comfort and certainty in the process.
Investment and then…?
Once an investor has successfully purchased an exempt market investment, there are two things that they should always keep in mind:
- They may not receive updates or material information about how their investment is performing.
- It can be very difficult to sell the investment if it’s not performing as expected or the cash value is needed for personal reasons.
While many private market issuers strive to give their investors post-trade information and liquidity options, it’s generally not required by law. Sometimes the silence can be deafening [footnote 4]. It’s usually better to view these as “buy and hold” investments that generate income or reach a liquidation event like a sale or windup.
The exempt market is unique and not always relatable to traditional investing practices - but that can be a good thing. By taking an informed position and working with experienced professionals, private capital investors can access investment opportunities with unique risk-reward characteristics. Impartial information about Canadian securities markets can be found with your local securities regulator and on the Canadian Securities Administrator’s website. As with all investing, a little due diligence and preparation in advance can go a long way to protecting your future.