Education Centre

Breaking Down the Offering Memorandum

By Gregory M. Colford, B.A., J.D., C.I.M.®

What is an Offering Memorandum?

To learn how Canadians raise money for investment in Canada read our article here. It will provide you a fine introduction to offering memorandums. In summary, if a company wants to raise money from investors, it will generally provide them some kind of information about the venture. How the information is relayed to investors is governed by our rules regulating the securities industry. The rules vary per jurisdiction, but in general securities regulators want to ensure that prospective investors know enough about the business to make an informed decision if issuers are providing them information. This is a concept called “disclosure”.

One of the ways for privately-held firms to meet these disclosure requirements is to issue an offering memorandum (“OM”). OMs come in two flavours: prescribed form and non-prescribed form. “Prescribed form” simply means the document must be prepared according to a guideline required by the regulators. This article will address the prescribed form of OM.

An OM covers a substantial amount of legal and marketing material, including an executive summary, deal structure details, risks and disclosures sections, and an investor suitability form. It can be overwhelming to digest, but we’re here to break it down for you and highlight the crucial elements every investor should be aware of. You’ll likely find it useful not only for researching opportunities from Exempt Market Dealers (like Fundscraper!), but also private placement issuers, private equity and capital firms, and private mortgage funds.

Tip: The entity in which investments are being solicited is called an “issuer,” because it is issuing securities.

Why does it matter to me?

In theory, OMs should provide investors with as much relevant information as possible. In practice, they are complex documents written by lawyers for regulators. Many everyday investors do not have the experience or legal/financial/accounting training necessary to decipher 60+ pages of fine print. Oftentimes they don’t understand what an OM is or why they’re receiving it. To many, it’s just part of an investment package.

Since investors can only rely on an OM to make their decision, the reality is that many retail buyers do not know what they’re investing in unless they read the OM! They may grasp the concept in general (“I am investing in real estate”), but are unaware of the minutiae that can alter the outcome of a deal. When they later discover unfavourable elements about the project, they often feel lied to and dismayed. Lack of awareness is one of the greatest risks associated with private investments.

Due Diligence Matters! 

An investor cannot make a good decision without knowing all of the facts. You may want to understand the following before deciding to purchase:

  • Management fees
  • Investors’ voting rights
  • Indebtedness of the business
  • How the investment will be repaid
  • Conflicts of interest

The OM is just part of the equation

All investors should know that it is impossible to disclose everything about an opportunity. A proscribed OM is designed by the regulators to at least deliver to investors the minimum information the regulator believes a reasonable investor would require to make an informed investment decision. But the OM should not be the beginning and end of your due diligence on an investment opportunity! While an issuer may do its best to produce quality information, you should never assume that you know everything about the opportunity.

With that in mind, use the OM as part of your due diligence before making an investment decision. You’ll want to investigate the industry, past performance and the firm’s management team as well. Download Fundscraper Due Diligence Checklist.

Read Other Referenced Documentation

The OM may refer to additional documents that prospective investors can receive upon request. For example, if the issuer is a trust (rather than a corporation or partnership, etc.), the OM might reference a declaration of trust or a trust indenture – documents that govern its mandate and management. You may want to understand exactly what the powers of the managers are and how the business must be run in far greater detail than what’s being disclosed. Investors should therefore scour through an offering memorandum for any mention of additional documentation.

So, for example, the OM may read, “ABC Trust will issue 1,000,000 trust units, pursuant to Section 4.1.3 of the Declaration of Trust.” While the declaration of trust is technically being disclosed, many investors will not realize that there is an entirely separate set of documentation that they should read before investing.

To find these documents, look for a section in the OM called “Material Agreements. At Fundscraper we endeavor to make the Material Agreements available to us under our “Documents” tab seen below.

Read Other Referenced Documentation

While an offering memorandum may reference securities regulators and state that it has been filed with the authorities, that should not be construed as being endorsed by the regulator as a good investment.

The Canadian Securities Administrators, the body representing the 13 provincial and territorial securities regulatory authorities across Canada are not responsible for performing due diligence on behalf of investors with respect to offering memorandums. Rather, it and its members exist to protect the integrity of the capital markets and to enforce the law.

Do you have independent counsel or advice?

While an offering memorandum may contain dozens of pages written by lawyers, accountants and auditors, those professionals are representing the issuer and not the individual investor.

Thus, investors should hire their own advisors before deciding to invest. Do not allow yourself to feel a false sense of security by knowing that the investment was assembled by professionals.

Have there been any penalties, sanctions and bankruptcies?

An offering memorandum should disclose whether any members of management have any legal or serious financial blemishes. Use that information to help form an opinion about whether your money would fall into reliable hands.

How are funds being used?

Investors should be aware of how their money will be used. Never assume that all or even most of your money will be deployed into the targeted undertaking.

The offering memorandum should disclose what, if any, fees will be paid to sales agents, how much will be advanced towards legal and administrative costs, whether there is any debt to service and how much will actually be deployed into the targeted undertaking.

Moreover, investors should also understand what the continuing expenses of the venture will be over and above administration fees. These expenses can seriously dilute any available returns.

How is Cash being distributed?

An offering memorandum will disclose the kind of securities investors are subscribing for and how the issuer proposes to use the investors investment to generate the return hoped for by the investor. An investor will want to know and an issuer should endeavor to explain how returns will be distributed.
When investing in a fund, like Fundscraper, an investor is entrusting a third party (Fundscraper in this example!) with the investor’s investment dollars to earn a return on those investment dollars. The investor has no business in the actual business of Fundscraper!

As such, an investor should have a good understanding of how the fund receives income, how it intends to employ it and how the fund will then distribute to investors any return generated by the investments made by the fund with the investment dollars. Once the underlying investments make returns to the fund, how much of those returns will be passed onto individual investors and how is that calculation determined? Do the managers earn a piece of the returns? Are there other parties that will share in those returns?

Never assume that all or even most of the returns earned by the issuer will be passed onto investors. The flow of funds can turn a seemingly lucrative investment into a poor one.

Do you know your rights?

As an investor, you can never assume that you have the ability to voice your opinions or influence management decisions. In fact, the opposite is frequently true with private placements. It’s important to search within the offering memorandum for your rights as an investor. For example, do you have the ability to vote, and if so, on what issues? How powerful is each individual vote? Can you attend annual general meetings? Are you able to request financial statements and other internal documents?

Search for sections in the OM similar to “rights and characteristics of units/shares” to find this information.

Under an OM, investors have a unique set of rights. Under the law of the Provinces and Territories wherever an offering memorandum is used the issuer MUST (except in very limited circumstances) provide to potential purchasers various contractual rights of action and rescission for any misrepresentation. The actual granting of the right will often be found in the subscription agreement (the agreement by which one purchases the relevant securities).The requirement to provide these contractual rights of action and rescission (and to mandate their disclosure in offering documents) was an enormous advance for investor protection. Briefly, what these rights provide is the right to (i) sue an issuer or (ii) rescind the contract if a misrepresentation had been made in the offering document WITHOUT having to demonstrate reliance on the misrepresentation!

How liquid is my investment?

Investments made via offering memorandum are less liquid than publicly-traded securities on large stock markets. It is not uncommon for one’s capital to be locked up for a period of years in a given investment. For example, in real estate development, the developer expects an investor not to look for a return until AFTER the real estate project is built and leased up. That could take three-to-five years! Whether the investor can afford to keep the investment locked up that long is a very important consideration. Thus, an investor’s ability, or lack thereof, to sell the holding should be clearly disclosed in the OM.

Note: Even in offerings where investors can easily redeem their shares, management usually reserves the right to reject redemption requests at their sole discretion.

How am I being taxed?

Investors and the issuer will often be taxed differently. The offering memorandum should disclose any known information about the issuer’s tax status and what the implications may be for investors.

A prescribed OM will often have a section dedicated to tax. Similarly, transactions that are “tax driven” will explain why they are such.

The tax implications of any investment are critically important for every investor to understand. What might be “tax advantageous” for one investor may be a disaster for another. Many “middle class” investors have suffered tremendous losses by investing in transactions that are uniquely structured for individuals and entities of high net worth.

Further, certain issuers promise tax advantages or benefits that they claim are unique to them! Sometimes that is the case. Other times it’s baloney. Where an issuer can provide a legitimate tax advantage to an investor, the investor must be fully aware of what the consequences might be if the issuer was to lose its unique tax status.

Before investing, it is really important that the investor consult a professional about the tax consequences of the investment.

Typical Components

The following are typical elements in a prescribed OM for a typical real estate investment in a hard asset like a building or development.

Executive Summary
The Offering Memorandum begins with an executive summary, which lays out the high-level. In simple terms, the acquiring entity is seeking capital and there’s a brief description of your investment company (which may control or be the acquiring entity), its mission, the deal you’re pitching, a detailed description of the executives’ industry experience, and finally, deal financing requirements.  

Location
Where the OM is promoting a real estate opportunity, one will often see after the executive summary the location of the asset. These images may include the property’s location on a map, an aerial view of the site, and a second map highlighting important  places near the property such as an airport, public transportation, restaurants and stores.

Investment Summary
The investment summary section covers various subtopics, each of which has its own separate section and brief description

Property Description
Describes where the property is located, when it was built, how large it is, any repairs it may need, and the current occupancy. 

Purchase Price
The price for which the property will be purchased and how the purchased price will be financed. The financing raised under the OM may only be one part of the purchase price.  The remainder may be made up debt, the promoter’s own equity, the vendor’s retained interest, if any, etc.  If proceeds of the raise are being used to finance an acquisition, understand very well what is necessary to satisfy the purchase price!

Total Capitalization
The total capitalization of the real estate will typically describe what is referred to as the “capital stack”.  The capital stack shows the different layers in the financing of the project. Typically it would be first mortgage debt, next second mortgage, next preferred equity then finally equity. It’s really important to know where  your investment dollars are in the “capital stack”.  Traditional investment wisdom says the higher up you are, the safer your return.

Preferred Return
An investor who earns a “preferred return” means they will get a return on their money before ordinary investors.  A “preferred investor” generally comes after debt and before a common investor. Preferred investors will have different return expectations than ordinary investors.

Projected Returns
Sometimes an OM will provide an indication of return.  It is important for the investor to read the fine print wherever performance returns are disclosed.  In a prescribed OM, certain kinds of “future oriented financial information” has to be prepared in accordance with strict guidelines.  A licensed advisor can help an investor understand what is really behind an issuer’s projected return boast.  

Manager or Sponsor
The sponsor company that controls the investment entity.  This entity is often referred to as the “promoter”.

Property or Asset manager
Description of the asset manager and their fees.  Review fees closely. They are  generally paid to the issuer, manager, promoter, etc. before anything is paid to the investor.  Good deals can often be “fee’d to death”.  Beware.

Proposed Structure
The structure of the deal between investors, sponsors, asset management, and property management. An old adage to understand a deal is “follow the money”.  Get comfortable with who gets paid what when.  

Distributions
How surplus cash, i.e., the profits (!), are distributed to parties is, of course, a key consideration for every party.  

Acquisition Fee
An “acquisition fee” can be anything. It is imperative for investors to understand how fees work.  Sometimes it’s a flat sum paid on closing. Sometimes, it’s a flat fee plus a continuing interest.  A “continuing interest” can kill return!  Always ask why are these fees being paid this way and is it reasonable.

Management Authority
Description of how the manager holds control over the management and affairs of the property.

Proposed Use of Proceeds
How your investment dollars are being used. This could include acquiring the property, making repairs, maintaining the property, etc.  See, in part, the discussion of “acquisition price” above. 

Estimated Sources and Uses
This section shows the amount of equity and debt to be raised, which then adds up to form the total sources of funds. You can copy and paste a screenshot into your OM from an excel model. Also included should be the uses of funds, including purchase price, closing costs, acquisition fee, working capital and fronted capital expenditure.

Loan Terms
Where applicable or relevant, the loan terms section is broken into the following subtopics:

  • Loan amount: What is the approximate loan amount and the percentage of the purchase price it makes up?
  • Borrower: Which entity will be borrowing and what kind of company it is?
  • Interest rate: What is the locked interest rate?
  • Term: How long is the term, and is it a fixed rate or variable rate?
  • Amortization: Does amortization begin right away, or is there a period of interest-only servicing?
  • Collateral: What collateral does the lender have on the deal?

Competitive Set
This table depicts the competitors in the Issuer’s market.

Industry Overview
Every industry is different, whether residential, retail or another niche. This section describes what the specific industry for the property type is like in today’s market. 

Market Overview
Similar to the industry overview, the market overview gives geographic specific insight on the real estate market where the building is located. 

Risk Factors
Every real estate deal has multiple risk factors. This section should include every risk related to the business, tax, accounting, and legality of the property. There are often 10 to 20+ risks and each one should have its own paragraph description. 

Investor Suitability
Real estate deals frequently receive support from accredited investors. This last section in the OM describes what types of investors the deal is suited for, and may be based on rules and regulations with regards to investor accreditation or general solicitation. These are the guidelines that concern the investors’ financial status and their ability to bear the risk of losing an investment.

It is critical to have a licensed dealer assess whether the investor is first eligible to participate in the investment and then,secondly, whether the investment is a suitable invest for the investor.

If you’d like to learn more about private real estate investment, visit www.fundscraper.com and sign up.

Once you are part of our community, you’ll have access to the tools and resources our members enjoy that help them reap the benefits of real estate investing.

ABOUT THE AUTHOR

Gregory Colford
Gregory Colford

PRINCIPAL BROKER, EXECUTIVE VICE-PRESIDENT & CHIEF COMPLIANCE OFFICER

Gregory Colford, JD, CIM, was a senior partner at Heenan Blaikie LLP, once one of Canada’s ten largest law firms. Over his 12 years at Heenan Blaikie LLP, he headed the Toronto Securities Department, the Corporate Services Department, the Precedent Committee, the Legal Opinion Precedent Committee, and was the Toronto representative on the firm’s Stock Trading Committee. Through the course of his practice, he brought many companies to the public capital markets and advised extensively on corporate governance, board integrity, and market compliance. He was also the co-founder of Carlisle Capital Structures Corporation and helped the company grow to over $1 billion CAD in AUM of mortgage securities on behalf of a top tier Ontario pension fund.

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