Crowdfunding may not be all it’s cracked up to be

On the plus side, many people would like to be able to assist a friend or neighbour launch a new business, product, or idea, help someone in need, or pre-purchase the latest innovative product, such as the Pebble smartwatch — and crowdfunding can do just that. These are all examples of good crowdfunding.

However, the deregulation of securities laws to allow anyone to make investments via equity crowdfunding is a like the Titanic heading into iceberg alley. Equity crowdfunding abandons fundamental principles that have made Canadian markets among the most successful at raising risk capital, including full disclosure, due diligence, insider regulation and the role of a professional financial advisor. These are the negatives of crowdfunding.

Crowdfunding combines the ease of technology with the promise of potential lottery-sized winnings. However, in a lottery, there is a regulator that ensures the integrity of the system, including money coming into the lottery and money paid to vendors and to winning players. Deregulated securities rules will not prevent crowdfunding from being a rigged game.

Equity crowdfunding through a “portal” will expose thousands of individuals to investments in startup businesses through the Internet. With crowdfunding, investors send money in exchange for an intangible right — and they will not know what happens to their money. Will the company use the money for the purpose for which it was intended, or will it end up sending the funds offshore or moving it to another project? Will the company simply pay its executives’ and friends’ large salaries or fees? How will the investor or the regulators ever know?

Regulators are proposing investment limits of $2,500 per investment and $10,000 in a calendar year per person. Although these limits may be small by Bay Street standards, they’re quite high for the majority of Canadians. Recent statistics show the median individual income of Canadians at $27,600 and the median family income is $76,000. Given the very high risk and illiquid nature of any crowdfunding investment — even if the investment limits are complied with (and regulators have not proposed robust measures to ensure they will be) — many investors may lose much more than they can afford to.

Instead of seeking professional advice and putting their money into lower-risk investments that will allow them to accumulate savings for their retirement or other financial goals, investors will be gambling with high-risk speculative investments. Not only is a return unlikely; there is also a high probability that they will lose their entire investment.

Many consumers will not understand the high risk of failure and fraud, or the fact that they cannot resell the investment. They will not have sufficient skepticism of the unrealistic returns touted by promoters — and there will be “promoters.”

A recent investor survey commissioned by the Ontario Securities Commission demonstrates that people interested in equity crowdfunding do not know how risky it is. (Only 52% deemed it high risk while 45% thought it was medium risk.) Even more disturbing is that 12% of the respondents who identified themselves as having “low-risk” tolerance were strongly interested in equity crowdfunding.

Proponents of equity crowdfunding suggest that the crowd will be able to detect fraud and weed out the bad actors. Experience and research clearly demonstrate that this is not the case. Instead, investors become victims of fraud at an alarming rate.

Regulators are likely to proceed with implementing an equity crowdfunding model. Although the Canadian Foundation for Advancement of Investor Rights does not support an equity crowdfunding exemption, we have suggestions to limit fraud and potential losses including:

• Limit crowdfunding to projects in which the money will be spent in Canada to fund local Canadian entrepreneurs and jobs, and the funds will be held in a Canadian bank.
• Require people who sign up with a crowdfunding portal to complete an interactive questionnaire to ensure they understand the risks and that they qualify. The regulators should send an official confirmation to the investor and require confirm action by the investor before being registered with the portal.
• Limit crowdfunding to 5% of income or financial assets and to people who have a high-risk tolerance and can afford to lose 100% of their investment.
• Set high registration standards for the portal, including fidelity insurance, due diligence on the issuer’s directors, officers and shareholders, expert review of the business plan and standardized anti-dilution and related protections that any venture capitalist would demand. The portal should be required to keep tracking failure rates, bankruptcy filing, claims of fraud and returns on investment.

With contributions from Marian Passmore, associate director at the Canadian Foundation for Advancement of Investor Rights.