Crowdfunding, a concept that recently has become very popular, is the term used to describe raising small amounts of money from many people, usually over the Internet.
There are several models of crowdfunding:
- the donation model – donating to a project in exchange for nothing;
- the reward model – donating to a project in exchange for some tangible reward or perk;
- the pre-purchase model – donating to a project in exchange for a future tangible reward such as a consumer product;
- the peer-to-peer lending model – where an online intermediary facilitates money lending between individuals for the funding of a project; and
- the securities or equity-based model – investing in a business in exchange for securities e.g. shares.
In this article, we describe the equity version of crowdfunding, which start-ups and small and medium businesses hope will provide a mechanism for them to raise financing.
The equity-based model of crowdfunding must overcome a significant regulatory hurdle facing businesses that want to raise equity financing.
When a company issues securities, whether it is a public company or a private company, the company (or, in “securities speak,” the issuer) must comply with applicable securities laws. In Canada, this means that either a prospectus (filed with a provincial or territorial securities administrator) must be provided to the investor (with details about the securities, the issuer and other required information) or the securities must be issued in accordance with an exemption from the prospectus requirements. The preparation of a prospectus is a lengthy and costly exercise, so in many cases issuers look to find exemptions from the prospectus requirements.
There are a number of prospectus exemptions already in place, including the “accredited investor” exemption which is available if the investors are wealthy individuals or financially strong entities. There are no limits on the amounts that issuers may raise from accredited investors, and no limits on the number or amounts of investments that an individual accredited investor may make. But that group is estimated to represent only about four per cent of the investment community.
Issuers have limited access to the much larger pool of non-accredited investors, except for some subsets of that pool, such as “friends and family.” Correspondingly, would-be investors in that pool have few opportunities to become investors in private companies.
In March 2014, the Ontario Securities Commission (OSC) and a number of other members of the Canadian Securities Administrators (CSA) – namely, Saskatchewan, Manitoba, Quebec, New Brunswick and Nova Scotia – published for comment a proposal for an equity crowdfunding exemption.
This Crowdfunding Exemption would allow reporting and non-reporting issuers (i.e., public and private companies) to raise up to $1.5 million during any 12-month period. An investor would be permitted to invest $2,500 in any single issuer and no more than $10,000 in total in any calendar year in multiple issuers.
There will be a number of restrictions on the issuer and on the process it must follow, including:
- the issuer must be incorporated in Canada, its head office must be situated in Canada, and a majority of its directors must be resident in Canada;
- the issuer must prepare and provide to investors an offering document that includes a business plan;
- the issuer must include in or attach to the offering document certain financial information:
- if the issuer has not incurred any expenditures and cash is its only asset, disclosure of the issuer’s cash position with a third-party confirmation,
- annual financial statements if the issuer has incurred expenditures, or
- audited annual financial statements if the issuer has raised more than $500,000 under the Crowdfunding Exemption or any other prospectus exemption since its incorporation and has expended more than $150,000 since incorporation;
- the offering will be limited to a period of 90 days and must provide a minimum size of offering which corresponds with a description of the use of funds, and no funds may be released to the issuer until the minimum offering amount has been received; and
- the issuer will be required to provide ongoing financial reports to investors.
In addition to issuers and investors, there is another participant in the process, namely, portals through which the investments are made. A portal must register with the securities administrators in provinces where it proposes to carry on business and comply with various registrant requirements, which include minimum capital, insurance, regulatory reporting and record keeping and retention obligations.
As part of the objective of securities administrators to protect against potential fraud, portals will also be required to:
- conduct background checks on the issuer and its directors, officers, promoters and control persons; and
- have an understanding of the nature of the securities being offered and the related risks, and review the information on the portal’s website to confirm that the information adequately describes the securities, the issuer, the risks, the parties involved, potential conflicts of interest and the intended use of funds.
If the portal believes the issuer or its offering is fraudulent, it must deny access to the portal.
The portal will also be required to provide educational materials to the investor, written in plain language, and obtain a signed Risk Acknowledgement Form from an investor.
Portals are prohibited from:
- providing investment advice;
- holding investor funds; and
- investing or underwriting offerings.
Start-up Crowdfunding Exemption
In addition to their Crowdfunding Proposal, the CSA jurisdictions, other than Ontario, also proposed a crowdfunding “light” exemption for start-ups – the Start-up Crowdfunding Exemption.
The Start-up Crowdfunding Exemption is aimed at non-public issuers which are at a very early stage of development and, accordingly, the requirements for use by issuers and by their portals are less onerous.
Some of the differences under the Start-up Crowdfunding Exemption as contrasted with the Crowdfunding Exemption are:
- issuers will be limited to using the exemption twice in a 12-month period and may raise up to $150,000 per offering;
- investors will be limited to $1,500 per investment;
- issuers are not required to produce financial statements, and there are no ongoing disclosure requirements; and
- portals will be exempt from registration but will be required to meet certain requirements, including filing a form with the applicable securities regulator at least 30 days before assisting any start-up crowdfunding distribution.
Use of the Crowdfunding Exemption or the Start-up Crowdfunding Exemption by small and medium-sized private companies will result in these companies having large numbers of shareholders, many of whom will be both unsophisticated and unknown to the founders and management of these companies. For example, an issuer seeking to raise its annual limit of $1.5 million would need to access 600 investors at $2,500 each.
This will pose cost and administrative issues for the companies such as:
- the cost and effort of communicating with large numbers of shareholders;
- difficulties in obtaining the consents from shareholders (whether by a simple majority, a higher majority or unanimous) needed to make changes to the company’s capital or governance structure;
- difficulties in attracting more sophisticated investors willing to provide more significant amounts of financing;
- conflicts between the interests of the issuer’s crowdfunders and its other investors, including venture capital investors and angel investors;
- as the shares of private issuers are not freely tradable, difficulties in dealing with requests from investors for the transfer of their shares; and
- difficulties in completing a sale of the company, the preferred exit strategy for investors.
Service providers such as portals, law firms and accounting firms will have to develop cost-effective approaches to address these issues.
The securities administrators who have made these proposals will study the comments they received during the comment period, which ended on June 18, 2014, and publish more definitive versions of the proposed exemptions.
Since governments are motivated to respond to the needs of entrepreneurs and investors (and, in Canada, much of this motivation is driven by what Canadians read about equity crowdfunding initiatives in the United States), the proposals are expected to become a reality. Some believe this may occur in Canada as early as the first quarter of 2015. The U.S. version of equity crowdfunding continues to be a work in progress.