Rewards Based Crowdfunding
The 2008 financial crisis left small businesses with little means to raise capital, the wells of capital dried up. So, it wasn’t a coincidence that a year later, in 2009, Kickstarter was founded on the basis it could be part of the solution to the access to capital problem.
Envisioned as an innovative way for founders to bring their projects to market, Kickstarter aimed to bridge the gap between ambitious ideas and the financial support required for their fruition.
Kickstarter’s unique approach allowed creators to present their products to the public, offering various rewards in return for pledges from backers. Over the years, the platform transformed countless product ideas into reality, proving instrumental in the success of numerous artistic, technological, and social ventures.
Rewards based crowdfunding flipped the normal product rollout for start-ups. That is, instead of spending thousands or hundreds of thousands of dollars designing, building and manufacturing a product to take to market, companies are able to take a concept, idea or prototype to market and find out if there was demand for it. In effect, crowdfunding allows a founder to create a market, and demand for a product, before formalizing it and committing to development.
Rewards based crowdfunding saw explosive growth from 2009 onwards. As of 2020, over 500,000 projects have been launched on Kickstarter to date, raising in excess of USD $5.4 billion. The platform boasts over 18 million total backers from around the world and nearly 64 million total pledges over the years, truly remarkable.
On Kickstarter, some projects are raising over $1.0 million (without giving up equity) from thousands of “funders” in less than 30 days. In fact, I have had multiple clients who came up with a product idea and before having to spend thousands of dollars on marketing, doing a large batch inventory order and taking a risk on a product that may not sell, they posted it on Kickstarter to realize there was massive demand for their products.
In effect, it allowed them to hit a threshold, pre-sell a product, rally a business around that product and put a plan in place to get the product made and delivered. Two great examples were:
- Venque (https://www.venque.ca) making stylish bags; and
- North Aware (https://northaware.com) making winter coats that raised over $3.5 million on Kickstarter.
One of the exciting projects of the day was a project by Double Fine which raised $3.3 million from over 87,000 people to develop a new computer game and again, gave up no equity in their company. The funders (or backers as they are sometimes called) received everything from t-shirts and copies of the video game, to limited edition games and signed memorabilia.
I have encouraged many clients I work with who have consumer facing products to consider crowdfunding, not only to raise money for the development of their business, but to get an understanding of how the market will accept their product before further capital is spent developing it.
Crowdfunding represents a significant disruption to the traditional models of funding businesses and will continue to grow as a means of raising capital.
Equity Crowdfunding
With the rise of Kickstarter, many started to ask, why can I pre-order a product I like, support the founders by buying their various rewards, like t-shirts, and not, at the same time, take a small amount of equity in exchange for a small investment.
With the rise of the Internet and the prospect of viral videos and viral product ideas, was there really that big of a risk to investors from contributing $100 to a team who could demonstrate a prototype?
Why should the ‘crowd’ be barred from investing small amounts of money in a product idea, while at the same time be permitted to take the risk that a founder isn’t able to actually deliver on their products promised.
So, in April 2012, the US JOBS Act, (specifically Title III, the Crowdfund Act) was signed by President Obama. The Crowdfund Act significantly changed U.S. securities laws. It permitted, for the first time, online funding “portals” to operate in which “emerging growth companies” could list their business with the prospect of raising up to $1 million from up to 2000 investors online. Since then, the US equity crowdfunding framework has changed. However, at the time, I grew jealous. Why didn’t Canada have something similar?
I saw a risk that there would be a move by Canadian founders to set-up US entities for the purpose of equity crowdfunding to the US market. With the age of the Internet, investment and business transcends international boundaries making it difficult for Canadian regulators to preclude Canadians from both setting up shop in the US and even investing in U.S. start-ups online.
Canada risked losing not only talented entrepreneurs, but also taxable revenue and job creating companies.
Realizing the amazing impact Kickstarter was having on funding great start-ups and new products, and the risk of losing Canadian founders to the US equity crowdfunding regime, in 2012 I wrote articles for the Toronto Star (Crowdfunding – Time for Canada to Jump Onboard)[3] and later the Globe and Mail (“The Economic Potential of Crowdfunding is Underrated”)[4] on why Canada should be pursuing equity crowdfunding to spark innovation and help further finance Canadian founders. In the Toronto Star article I said:
“The provincial legislatures should be racing to the front of the line to address crowdfunding legislation. The intent of which will be to generate an entirely new wave of crowdfunded businesses and divert the brain drain to flow inter-provincially as opposed to internationally.”
In 2013, I became involved with the founding members of the National Crowdfunding Association (now the National Crowdfunding and FinTech Association or “NCFA”). I had seen, firsthand, the immense impact rewards based crowdfunding platforms like Kickstarter were having, even on Canadian founders and I (like many others) wanted to be involved in advancing that progress with a shift to permitting equity crowdfunding.
My involvement with the NCFA led to a meeting with the Ontario Securities Commission (“OSC”) and ultimately the NCFA was successful in pushing for an equity crowdfunding regime in Saskatchewan first and later Ontario.
However, it was painful to watch the rollout from a securities law perspective. Clearly, the true power of equity crowdfunding would come from having the largest crowd possible to draw from. By having the individual provincial securities regulators create their own crowdfunding rules, it meant, initially, that founders could only raise money from the ‘crowd’ within their own province.
For example, in the Saskatchewan context, both the business and the investor had to be in Saskatchewan. With a small population of roughly 1,000,000 people, Saskatchewan clearly would not see a significant impact from crowdfunding, under their exemption, unless the framework was harmonized with other Canadian or international jurisdictions.
In context, the US (with much larger population and therefore larger potential crowd to raise money from) proceeded quickly, before Canada, with a national crowdfunding framework. So, when the first two provinces rolled out their own, I was heavily dissuaded, and lost interest in equity crowdfunding in Canada. In my view, the potential for equity crowdfunding in Canada was significantly curtailed. I was upset that Canadian securities regulators couldn’t come together to agree on a national framework.
In fact, for a long time, even after the Ontario exemption was passed, there were no registered crowdfunding portals that Ontario companies could even use. I viewed the OSC’s moves as having killed equity crowdfunding, at least in the short term.
A New National Crowdfunding Regime in Canada
The good news, however, is that as of September 2021 National Instrument 45-110, implemented by the Canadian Securities Administrators (“CSA”) harmonized the Canadian equity crowdfunding rules. National Instrument 45-110, aims to streamline the process for businesses to raise capital through crowdfunding by providing exemptions from registration and prospectus requirements, subject to certain conditions. The key features of Canada’s framework, as of September 2021 are:
- Registration Exemption: Early-stage companies and start-ups are exempted from the registration requirement, as long as they work with a registered funding portal and adhere to investment limits.
- Prospectus Exemption: Businesses meeting specific criteria are exempted from the prospectus requirement, enabling them to issue securities without a comprehensive prospectus. Instead, they must provide investors with a simplified offering document containing essential information about the business, management, and the offering. Google “Form 45-110F1 Offering Document” to see what is required in the disclosure.
- Investment Limits: The legislation sets investment limits. Non-accredited investors can invest up to $2,500 per investment and companies can raise up to $1.5 million within a 12-month period.
- Funding Portals: National Instrument 45-110 mandates that start-ups use registered funding portals to facilitate crowdfunding transactions. These portals ensure compliance with the regulatory framework, including investor eligibility verification, offering documents, and monitoring investment limits.
The new Canadian framework has much greater potential than the fractured provincial rules that came before it. Take for example, in December of 2021, PKA SoftTouch Corp raising over $1M from 662 investors with a minimum investment amount of $500.
In my view, equity crowdfunding presents a real opportunity, and if done right, can leave the company in a better position compared to taking on a sophisticated private equity or venture capital investor. There are two main potential benefits:
- Founders have the opportunity to achieve a better valuation. In fact, they can set the valuation and the crowd will either accept or reject it. Whereas with more sophisticated investors they may drive a harder bargain in terms of the valuation, and ultimately how much equity you give up. Or worse, they may try to have you sign some form of exclusivity period, where you agree to negotiate with them alone, for some period, to avoid you shopping a deal.
- Founders have the ability to protect against giving up a liquidation preference, control, management rights, or even a minority seat on the board. For example, there is a trend toward having the ‘crowd’ sign voting trust agreements. This means that while the crowd may still have the same economic benefits, in terms of share classes, dividends etc. as the founders, they effectively assign the right to vote those shares to a third party. This means that the founder can still exercise control over the company (and not dilute his or her ability to vote people onto the company’s board). It also means they can avoid painful negotiations with private equity and venture capital investors around things like giving up preference shares, or various other minority shareholder rights, like those canvassed in the chapter on negotiating founder and shareholder agreements.
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