On March 22, 2012, the US Senate approved the Jump Start Our Business Start-Ups (JOBS) Act (the “JOBS Act”). Driven by economic interest and political motivations, the Jobs Act amends US securities laws by introducing a crowdfunding exemption. This exemption allows entrepreneurs to raise funds and issue securities publicly to a broad group of investors via an internet portal thus by-passing current exempt market securities requirements. Notwithstanding passage of the Jobs Act, equity crowdfunding is not available in the US until the Securities and Exchange Commission introduces rules governing the industry, which are expected in Q1 2014.
The JOBS Act is a significant departure from current securities laws and presents unique opportunities and challenges. As is often the case, amendments to US securities laws make their way north in similar fashion. Thus, it is no surprise that in December 2012, the Ontario Securities Commission solicited commentary on its consultation paper 45-710, Considerations for New Capital Raising Prospectus Exemptions, which outlines a similar crowdfunding concept framework for the Canadian marketplace.
The utility, desirability and availability of a similar crowdfunding framework for Canadian issuers and investors is uncertain and near term implementation is unlikely. Notwithstanding these hurdles, there is support for a crowdfunding exemption and issuers, dealers and industry professionals should be familiar with the underlying drive for crowdfunding, the potential framework and issues that may arise in the context of the Canadian marketplace.
What is equity-based crowdfunding?
The OSC Concept Framework
The OSC concept framework contemplates that Canadian reporting and non-reporting domestic issuers (other than investment funds) may be permitted to issue securities and raise up to CAD $1,500,000 in reliance on the proposed crowdfunding exemption in a given 12-month period. The OSC concept framework limits individual investments in a particular issuer to $2,500 and caps aggregate investments at $10,000 per individual in a given 12-month period.
One of the key aspects of the proposed exemption is the use of an online intermediary, also called a ‘funding portal’.1 The funding portal would process all transactions and would safeguard investors through the distribution of online disclosure materials2, by monitoring individual investor transactions and by implementing measures to reduce the risk of fraud such as performing regulatory checks of directors, officers and significant shareholders.
The JOBS Act
The JOBS Act is very similar to the OSC Concept Framework in many material respects. The JOBS Act will permit US domestic issuers (other than investment companies and issuers subject to public company reporting requirements) to issue securities under the crowdfunding exemption and provides that funding portals will be the means through which disclosure materials, regulatory functions and investments will be distributed, monitored and exercised.
Where the OSC concept framework differs from the JOBS Act is in respect of the financing features of the exemption. The JOBS Act caps annual financing amounts under the crowdfunding exemption at $1,000,0003 and, whereas the OSC concept framework contemplates bright-line investment limits, the JOBS Act breaks down individual investment limits by investor income. Securities sold to individual investors, in the aggregate, in any 12-month period in reliance on the crowdfunding exemption under the JOBS Act are limited to the following:
- the greater of $2,000 or 5% of the annual income or net worth of such investor, as applicable if either the annual income or the net worth of the investor is less than $100,000; and
- 10% of the annual income or net worth of such investor, as applicable, not exceeding a maximum aggregate investment amount of $100,000.
Further, one of the defining characteristics of equity and non-equity based crowdfunding is the requirement that the target amount initially set by the issuer must be reached in order to release the proceeds. This feature is built into the crowdfunding exemption under the JOBS Act however it is not clear whether such is contemplated under the OSC concept framework.
What are the potential issues?
Equity crowdfunding is certainly not without its critics and inherent faults. Much of the ongoing dialogue surrounds issuer fraud, managing bogus companies, and the increased difficulty imposed on companies associated with suddenly going from ten investors to potentially more than 600.
And these concerns are not without merit. Consider the following: Company Z proposes a revolutionary new widget. Initially it has no track record, no patent, no history of operations and zero revenue. Company Z’s entire value is purportedly held in an idea for a widget, and due diligence on Company Z would yield little results. Investor A, an unsophisticated individual with a baseline salary, reviews the offering and disclosure materials and proceeds to invest $2,500. Investor A is enthusiastic about the investment and encourages colleagues, friends and family to invest. Funding portals provide real-time tracking of investment amounts and, as investment amounts rise, a certain level of credibility is imputed to the company, driving others to invest. Upon closing of the targeted amount, Company Z now has 600+ investors to whom it is responsible. Should the widget fail to gain traction or find a market, Company Z will burn through its capital leaving investors with little to no recourse to recover their funds.
Another issue is the potential for fraud. Without the proper checks and balances it is possible that unscrupulous individuals, both as issuer and funding portal manager, could turn a blind eye to the credibility of the companies, allowing them to list on funding portals, thereby leaving investors blind to the validity of the advertised claims. Less sophisticated investors could get caught up in exaggerated or entirely false statements and invest in schemes that have no intention or zero likelihood of providing a return.
Additional issues arise from the potentially hundreds or even thousands of investors with whom these companies have to deal. Consider Company Z discussed above. It has two investors, a founder and his/her partner. In the short period of time in which it takes Company Z to reach their target amount, they quickly go from being a closely held company, to a company with more than 600 investors. Company Z is now suddenly faced with managing communications, deliveries and disclosure materials to their shareholder base. Such multiples of growth are difficult to manage in even the best run companies.
An increase in the shareholder pool also has consequences for subsequent transactions. The formal bid exemption for non-reporting issuers in respect of take-over and issuer bids is not available to issuers with more than 50 non-employee shareholders. As a result, takeovers and issuer buy-backs of shares are subject to the formal take-over or issuer bid regime.
Finally, entrepreneurs argue that raising money online would allow the start-up community to flourish and reduce the cost of capital. However, that may not be the case. Current donation-based US funding portals like Kickstarter and Indiegogo are charging between 7-12%4 of total proceeds. In addition, under the JOBS Act, any amount raised between $100,000-$500,000 will require a review of financial statements by a public accountant, and amounts raised over $500,000 will require audited financial statements. Both a review and audit of financials can be costly, ranging anywhere from $10,000 - $50,000, seriously eroding the proceeds of a small financing. Once funding portal fees of up to 12% are deducted from the proceeds, the upside appears to wane and more traditional means of financing appear all the more reasonable.
Learning from the UK experience
One of the benefits of not being the first out of the gate is that the OSC is able to monitor and apply techniques and rules from the United Kingdom where equity crowdfunding is operating as a legitimate option for financing. In the United Kingdom, online portals such as Seedrs and Crowdcube have created platforms that mitigate some of the concerns. For instance, Seedrs performs due diligence checks before accepting companies onto their website in order to validate claims and statements made by the company. If a company is accepted and reaches its investment target, closing will only occur following a successful legal due diligence review, otherwise funds are returned to investors. Furthermore, in an effort to assist companies in managing the growth in its investor base, Seedrs holds all shares as nominee trustee on behalf of investors and manages all dividend payments and disclosure material delivery through its online portal.
The UK system is not fault free, however, as potential issues may arise as a result of the alignment of interests between funding portals like Seedrs and other issuers. Seedrs earns a portion of the proceeds, and future dividends, only if the deals close. Although this conflict is not different from current financing practices in Canada since Law firms, brokerage firms and others have a vested interest in closing deals, in the current Canadian financing system there are statutory protections and obligations in place to protect investors from misrepresentation, negligence and fraud. While the OSC concept framework suggests that funding portals may be required to register as dealers or advisers, it also leaves open the possibility that a new category of registrant may be created and therefore the specific liabilities and obligations that might attach to a funding portal are not entirely clear.
Does equity-based crowdfunding have a place in Canada?
The introduction of any new crowdfunding exemption into the Canadian marketplace will be met with scepticism, applause and even incredulity as the exemption would be a significant departure from those currently available. However, the timing may be right in Canada for such an exemption.
A need exists for increased venture capital across Canada and particularly in the western provinces, where investment risk is measured by the prevailing price of commodities and natural resources. However, whether an exemption based on the equity crowdfunding model is most appropriate is much less certain.
Other countries like the US and UK have larger and more robust markets and industrial and technology sectors, and if the UK experience is any indication, crowdfunding may not be as desirable to the investment community as some might suggest. Consider Crowdcube, a leader in the UK crowdfunding space. In over two years, Crowdcube has closed on only $14.55 million Canadian dollars. Keep in mind this minimal amount is in a country with a population twice the size of Canada, with one of the world’s leading financial centres and with deep entrepreneurial roots. While still in its relative infancy, these numbers are underwhelming.
With Canada’s relatively small population, a question that needs to be addressed is whether there is enough interest among the average investing citizen to use the crowdfunding exemption. The $2,500 investment cap reduces an investor’s ability to gain any significant equity thus reducing the potential upside for the work required to analyze each investment opportunity. It is possible that the crowdfunding investor base would be spread too thin or there would be too few companies worthy of investment.
Recently, the OSC issued a decision exempting MARS VX from the know-your-client and suitability rules of NI 31-103 in respect of accredited investors that have been granted access to its online funding portal. The significance of the exemption granted by the OSC is twofold as it provides insight as to the potential framework under which future funding portals may operate and it suggests growing support within the OSC and CSA towards eventual implementation of an equity-based crowdfunding exemption.
Alternative measures - the ‘Registered Dealer/Adviser Exemption’
The start-up community in Canada requires greater access to capital. Implementing a workable crowdfunding scheme would be difficult, yet it is entirely possible - the UK experience confirms so. However, whether crowdfunding is something that the Canadian investor base can sustain, and whether it would affect significant growth in early stage funding are entirely different matters.
An alternative to the crowdfunding exemption could be to create a prospectus exemption that would see issuers raise funds from the public provided that it is done through a registered investment dealer/adviser. Such an exemption could draw from the OSC concept framework by imposing individual and or annual investment caps for both investors and issuers, along with additional disclosure materials and risk acknowledgements for private issuers.
Directing the sale of securities through an registered dealer/adviser creates an additional layer of safeguard. The ‘know your client’ rule imposed on registered dealers/advisers would safeguard investors from bad investment opportunities, and perhaps more importantly, from themselves, as the rule requires investment dealers/advisers to consider and instruct the investor on the suitability of the proposed investment.
Moving the advertisement and distribution of securities off the web and to a registered dealer/adviser adds a further layer of safeguard. The registered dealer/adviser reduces the possibility of investors purchasing on hype and hysteria, and shifts the initial onus of determining worthy investment opportunities from the investor to the registered dealer/adviser.
With these added layers of protection, it is arguable that the investment limits currently proposed by the OSC could be increased to three or four times the proposed maximums. Increasing investment limits would mitigate many of the issues associated with increasing the shareholder pool and, more importantly, it would provide a much more practical financing exemption to the Canadian issuer and investor base.
Ultimately the final decision as to whether a crowdfunding exemption is adopted in Canada rests with the provincial securities commissions. The introduction of a crowdfunding exemption will depend on whether the OSC considers crowdfunding the most appropriate option for the Canadian market, and whether it is able to develop a workable, secure and efficient framework to minimize fraud, maximize capital investment and minimize regulatory burdens.