|August 1, 2014|
Previously published on July 25, 2014
In March of this year, the Ontario Securities Commission published a proposed new exemption from the prospectus filing requirement to permit equity-based Crowdfunding in Ontario. The proposed exemption was open for comment until June 18. There has been a fair amount of “buzz” about equity Crowdfunding since Obama introduced the concept in the JOBS Act in 2012. So what is the buzz about? What is equity based Crowdfunding anyway? Will the new Crowdfunding exemption open the floodgates in Ontario or is it all much-a-do about nothing?
Crowdfunding is a term used to describe a method of raising small amounts of money from many people over the internet. Although traditional on-line rewards-based Crowdfunding has certainly garnered attention as campaigns on platforms such as Kickstarter and Indiegogo have facilitated the raising of millions by Canadian companies in the past few years, it remains to be seen whether the ability to sell equity in a company in this manner will share a similar level of success. The regulators have a difficult balance to strike between investor protection and access to capital for small companies in establishing guidelines for equity based Crowdfunding.
Traditional Crowdfunding has been focussed on non-equity based funding ¿ funding particular products under development or projects. The risks in this type of funding relate primarily to the feasibility of, and the creator’s ability to deliver, a product. With this new ability to sell securities the risks extend beyond just delivery of a product, to the creator’s ability to generate equity value by building a company. Whether large numbers of people will be willing to take small equity stakes in companies at the risk of never seeing any return whatsoever on their investment is hard to predict ¿ it is a substantially higher risk-reward profile than paying $10 or $50 for an advance order of a product.
Investors will receive a small share of a company that has no liquid market. So what does an investor really get for their money? In the traditional Crowdfunding model, investors receive a product or something of some value to them. In equity based Crowdfunding, they receive a share in a company that may never have any realizable value and will very likely be subjected to significant dilution as the company undertakes subsequent capital raising efforts.
With this as the backdrop, the key investor protection measures proposed by the regulators include:
- Relatively small investment limits of $2,500 per investment; $10,000 per year
- Requirements to provide investors with certain limited disclosures at the time of sale and on an on-going basis
- A requirement for investors to sign a risk acknowledgement form highlighting the key risks associated with the investment
- A requirement that all investments be made through a registered Crowdfunding portal.
Registered funding portals are intended to address several basic investor protection issues, including: (a) due diligence on issuers and their management including background checks on the issuer, its directors and key executives. These individuals may be required to complete personal information forms for the portal to verify their background information; (b) due diligence on the business, given the risk that issuers seeking Crowdfunding may be doing so because inexperienced management has been unable to secure other equity funding, the portals will need to assess the viability of the issuer’s business. This could include requiring a comprehensive business plan, historical financial information and forecasts that are reviewed by an accountant; (c) due diligence on investors ¿ the OSC review process generated concerns that a significant percentage of retail or non-accredited investors will not fully understand the risks associated with Crowdfunding and investing in a small private company. Portals will therefore need to conduct some level of screening or vetting of investors before they are permitted to invest through the portal. This may extend to having investors answer questionnaires that demonstrate the investors’ understanding of the risks of investing, including dilution, illiquidity and risk of loss.
If a portal has a relatively low acceptance rate of issuers, it might appear to host smarter investments compared to those with lenient filters. If investors believe the portals have done the due diligence for them, they may feel less inclined to do the due diligence themselves. If start-ups on a portal fail, investors may blame the website for their losses, generating poor publicity for the portal, which would be a huge deal in Crowdfunding.
On the company side, there are governance and disclosure requirements to consider, and the costs associated with those. The costs of producing financial statements (and depending on the amount to be raised, audited statements) and the articulation of the risks of the investment to investors as well as the use of proceeds and the due diligence that a company will need to go through to be permitted access to an on-line portal. All of these factors raise an interesting question about the challenges that will face the on-line portals in terms of due diligence both on the companies and the investors. How will the portals be compensated for this diligence? Fees will necessarily be charged by the portals to cover these costs.
With all of this in mind, it becomes clear that equity-based Crowdfunding may very well not be the panacea that the hype may be portraying. While it will not be as expensive as an IPO, there will be costs associated with this type of funding which in the end may discourage companies from utilizing this method of capital raising. Investors themselves may not be all that keen to open their wallets to support (even in relatively small amounts) a company with no proven track record, particularly in light of the very real risk that their investment will suffer significant dilution as the company grows and attracts other forms of equity investment. One thing is certain however, it will be interesting to see the actual impact of this new exemption once the legislation permitting it takes effect.