This article was originally published in an abbreviated form on the Financial Post website.
By John Wires and Craig Asano
Utter the word “crowdfunding” to anyone trying to raise capital for a worthwhile start-up and you’ll see a sour face turn hopeful. While it’s hard to nail down a definition, equity Crowdfunding refers to raising small amounts of capital from a large number of people by leveraging the internet and social media. It entails a significant change to existing securities laws that prohibit the general solicitation of securities without a prospectus (an expensive disclosure document).
Crowdfunding is becoming all the rage largely because the venture capital industry is broken. In fact, in 2011, the Business Development Bank of Canada retained McKinsey & Company to draft a report, which concluded just that.
According to Industry Canada, in 2011 there were only 176 venture capital financings under $1 million. The bulk of which were made with government funds; making them the largest gatekeeper to accessing capital and spurring economic development.
Aside from friends and family, the only other real hope for raising equity is to turn to public markets. As Jeffery MacIntosh put it in his recent National Post article advocating against crowdfunding, raising money from public markets is expensive:
… Because of arcane securities laws whose full import is only understood by two or three Tibetan monks, this is expensive. Even Buy-Rite-Cut-and-Paste-Prospectuses [disclosure documents] will charge you about a hundred grand, and the bulge-bracket firms reportedly like to take an option on your first-born child. Understandably, the prospectus option is not the first choice of start-up firms looking to raise money.
With existing securities laws, even raising small amounts of capital in Canada is a complex and costly process. As a result, small business are often precluded from raising equity financing to expand; whether for hiring new employees, purchasing assets or inventory.
For entrepreneurs, crowdfunding marks the end of the arcane securities law framework and a real chance at properly financing their business. However, for Bay Street securities lawyers, crowdfunding represents a shift towards deregulation of the securities market and an open door for investors to lose their shirts.
MacIntosh raised three points in his opinion piece, “Extraordinary Popular Delusions and the Madness of Crowdfunding” worth considering. He contends:
- Crowds don’t have the skill or expertise to invest in start-ups;
- Even if they did, they can’t make a good investment decision without a proper disclosure document (i.e. a costly prospectus); and
- Small companies can’t manage a large crowd of investors anyways.
Are Crowds Qualified to Invest?
MacIntosh argues that ill-witted crowds aren’t qualified to assess investment opportunities properly. That is, reviewing investment opportunities requires the skill and expertise of a VC with well-polished shoes; and even they get it wrong the majority of the time.
The irony is that VC’s are paid to figure out whether a market (read crowd) would actually buy the product or service offering being pitched. With crowdfunding, the argument goes that if thousands of people are willing to invest in a product or service, they in turn validate a demand for it and increase the prospect of a successful product offering. While this by no means suggests that all crowdfunded companies will attract success, it certainly gives them an advantage out of the gate.
For proof that there are a lot of bad ideas out there looking for funding MacIntosh points to the fact that the vast majority of companies who pitch VC’s are promptly shown the door. He asks how will the lowly crowd manage to weed out those bad investments?
Like VC’s, online crowdfunding portals offering securities have an interest in making sure that unqualified companies aren’t listed. The more companies that list and fail to raise money, or worse, list, raise money and then fail, the fewer prospects the portal has at surviving.
For this reason, portals like CircleUp in the US and Seedrs or Crowdcube in the UK report rejection rates between 80-98% of all issuer applications and a further fraction actually being funded.
In Canada, some have called for existing incubator and accelerator programs like MaRs, the Ryerson Digital Media Zone and Incubes to be involved in the weeding out process. Others have suggested incubators get involved in running portals and have successful issuers be required to work with them to properly grow their business.
More importantly, under Ontario’s proposed framework, regulators will also be involved in regulating crowdfunding portals and not just the issuers.
But regardless of whether the crowd is qualified or not, the real question is what justifies limiting the crowd’s opportunity to invest in start-ups? If being “qualified” or “smart enough” to invest in a startup is the bar to entry, how do we justify all the unqualified crowds who continue to invest in penny stocks, the TSX Venture Exchange, junior mining companies and even the Nortel’s of the world?
Is the public somehow qualified to invest their life savings in public companies but not qualified to contribute a $1,000 convertible loan to a local startup? It’s important to remember that the proposed crowdfunding frameworks in Canada only permit investors to contribute a few thousand dollars each year.
Does Crowdfunding result in Inadequate Disclosure?
MacIntosh argues that even if the crowd were qualified to assess crowdfunding investments they could never make an educated decision without the disclosure information required by existing securities laws. He says crowdfunding will require little, if any, disclosure of the facts necessary to make a good investment decision.
But are regulators really considering a crowdfunding framework with no disclosure requirement? In fact, for over a year now, the US Securities Exchange Commission (“SEC”) has been considering what the disclosure requirements for equity-based crowdfunding will be. At the moment, we don’t know what path US regulators will take.
We do know that regulators in Canada have been consulting the public on how a crowdfunding framework and disclosure obligations might work at home.
The difficult task for regulators is to ensure that the crowdfunding disclosure process isn’t too similar to the prospectus requirement in which “dusty old-fashioned securities lawyers” are made wealthy for producing “truck loads” of disclosure documents that few people actually read (or understand). Even the “qualified” people who do read them, like the auditors of Sino-Forest Corp., apparently get confused.
With caps on the amount an issuer can raise under Ontario’s proposed crowdfunding framework ($1.5 million) and the Saskatchewan framework (up to $100,000 twice a year), it doesn’t make sense to spend hundreds of thousands of dollars just to be afforded the right to try to raise money. To make equity crowdfunding viable, disclosure obligations need to be simplified.
Some have proposed a sliding scale in which the more money you raise the tougher the disclosure and audit requirements will be. That is, a company who raises $1.5 million should have more onerous reporting obligations than a college dorm-room startup going after $10,000.
The Ontario Security Commission’s (“OSC’s”) public consultation on their proposed framework generated thoughtful ideas on producing low-cost disclosure obligations which they now have the task of reviewing. But when it comes to the OSC finding the right balance, the dichotomy should not be between over and under regulation of the securities market but rather a focus on shifting the paradigm to find smarter, simplified and more cost effective ways at regulating against fraud and protecting vulnerable investors in the digital age.
Can Small Companies Manage the Crowd?
Rightfully so, MacIntosh raises concerns about how small companies will manage a large number of investors, or more particularly, questions who will challenge rookie management teams on a shareholder’s behalf.
In the UK, Seedrs, a leading equity crowdfunding portal, uses a trustee or nominee structure where the crowd appoints Seedrs itself to hold legal title of the securities on behalf of investors. Investors are still able to vote but are relieved of the burden of investment administration and imposing checks and balances on management. Depending on the amount of capital raised, other companies may also offer a seat on the board of directors for a nominee of the crowd.
Looking ahead, the new generation of crowdfunding regulation should focus more on finding cost effective means of making simplified and meaningful disclosure to investors. While undoubtedly the crowdfunding industry will have its fair share of failures, can we really say that the benefits of creating a new generation of companies, jobs and economic development in Canada isn’t worth exploring a new era of securities regulation for?
John Wires is a Canadian lawyer and founder of Wires Law a firm providing corporate legal services services to emerging growth companies. John comes from a background of courtroom experience in complex corporate commercial litigation.
Craig Asano is the founder of the National Crowdfunding Association of Canada, a not-for-profit focused on building a crowdfunding industry in Canada which takes into consideration both economic development and investor protection.
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