Convertible securities

How BC law treats it

Convertible notes, convertible debentures, convertible preferred shares, warrants and simple agreements for future equity (SAFEs) are all securities under the Securities Act, RSBC 1996, c 418. Issuing them is a distribution, and so are the shares issued on conversion. A distribution requires a prospectus unless an exemption applies. Most private BC companies rely on exemptions in National Instrument 45-106 Prospectus Exemptions. The private issuer exemption covers issuers whose securities are subject to transfer restrictions and held by a limited group, such as directors, employees, family, close friends, close business associates and accredited investors. Other common exemptions include the accredited investor exemption, the family, friends and business associates exemption and the offering memorandum exemption. Some exemptions require the issuer to file a report of exempt distribution with the BC Securities Commission and pay a fee within 10 days after the distribution; the private issuer exemption does not require a report, and securities issued under exemptions are usually subject to resale restrictions. Corporate law also applies. Under the Business Corporations Act, SBC 2002, c 57 (BCBCA), the company must have the authorized share structure to issue the conversion shares, and the directors must approve the issue and the consideration. Convertible preferred shares need special rights and restrictions set out in the articles. A convertible note is also a debt until it converts, so it should address maturity, interest, default, security and what happens on a sale of the company before conversion. Tax treatment on issue and conversion varies and should be reviewed by an accountant.

What it means for your business

Convertible instruments let early stage companies raise money quickly without agreeing on a valuation, but they carry hidden costs. Caps, discounts and most favoured nation terms can dilute founders more than expected at the next round. Skipping the prospectus exemption analysis or the exempt distribution filing can expose the company to regulatory sanctions and investor claims, and cause problems in later financings. Clean documentation and a cap table that models conversion make due diligence much easier for future investors. Example: A Vancouver fintech startup raises $500,000 on SAFEs from ten accredited investors. It relies on the accredited investor exemption, files a report of exempt distribution with the BC Securities Commission, and later converts the SAFEs into preferred shares at its seed round.

Risks and common mistakes

Treating a SAFE or convertible note as a simple loan that is not a security. Issuing securities without confirming a prospectus exemption applies to each investor. Missing the deadline to file a report of exempt distribution with the BC Securities Commission. Failing to model how valuation caps and discounts dilute founders on conversion. Not having enough authorized shares, or the right share class, for the conversion.