Regulation: New rules to tame the crowd

The new exemption (which also will be available in Quebec, Manitoba, New Brunswick and Nova Scotia) will take effect on Jan. 26 of next year – and it’s not the only new financing framework to be introduced.

Regulators in several provinces (British Columbia, Saskatchewan, Manitoba, Quebec, Nova Scotia and New Brunswick) adopted a so-called “startup crowdfunding exemption” in May. In mid-October, Alberta and Nunavut proposed their own new exemption, which is similar to the existing startup exemption (albeit with a higher ceiling on the amount of capital a company can raise, and not limited to crowdfunded financings).

The U.S. Securities and Exchange Commission (SEC) also has issued its own long-awaited crowdfunding rules, which will take effect next year.

Until now, lack of regulation has been a fundamental impediment to the development of crowdfunding as a viable source of capital for small businesses. With the regulators getting on board with the crowdfunding concept, the economics of these sorts of deals will be the factor that determines whether crowdfunding works.

So far, the concept remains relatively untested. Investor advocates such as the Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada) have lobbied vigorously against the idea, arguing that crowdfunding has significant potential for serious investor harm.

“The decision to allow equity crowdfunding is truly unfortunate,” says Neil Gross, executive director of FAIR Canada. “It’s already widely acknowledged that the failure rate for crowdfunded ventures will likely be extremely high, investors will get fairly limited information to go on, most [investors] will end up trapped in completely illiquid shares and some [issues] will be massively diluted in subsequent rounds of financing. On top of that, there’ll be a huge risk of fraud.”

Whether or not crowdfunding is a good way for a company to raise money also is not clear. Having a relatively large, diverse group of shareholders may prove an unwelcome burden for a small firm.

In the U.K., companies have been able to raise capital from the crowd since 2011. Most of the firms that have done so still are in business, but very few are producing returns for investors, according to research from AltFi.com, a London, U.K.-based firm that monitors alternative finance.

Of the 431 financings that have taken place in the U.K. since 2011, one provided a successful exit when the company was acquired, and its early-stage investors received a return, according to AltFi’s research. Another 58 firms have raised additional capital at higher valuations and slightly more than 300 firms still are operating, while the rest have gone out of business or are on their way out of business.

It’s too early to say whether crowdfunding will be successful in Canada. So far, only a handful of companies have gone this route.

Regulators in B.C. say that they have had one issuer use the startup exemption since it was launched in May. That deal raised less than $50,000, and not all of that came under the startup exemption.

In Saskatchewan, there is one funding portal operating under the startup exemption; so far, two issuers have made offerings available through that portal. But the province’s Financial and Consumer Affairs Authority says that it has not yet received any reports of investors relying on the startup exemption.

The Nova Scotia Securities Commission indicates that there are two crowdfunding portals operating in that province, but there isn’t have any data on the use of the exemption so far. (Nor is there any data on crowdfunding use in Quebec.)

However, crowdfunding is new territory for companies, investors and regulators alike, and there doesn’t seem to be any clear consensus on the best way to cultivate this emerging capital-raising space. So, regulators are taking a variety of approaches.

Crowdfunding exemptions – which are being introduced in four of the provinces that already have the startup exemption (plus Ontario) – are fundamentally different from the existing startup exemption in several important ways.

For example, the crowdfunding exemption allows companies to raise more money than the startup exemption does and also provides greater protection for investors. Companies would be able to raise up to $1.5 million per year from ordinary investors via crowdfunding, vs the $500,000 limit that applies under the startup exemption.

The crowdfunding exemption also provides a variety of investor protections that may help to encourage more participation in these offerings. For example, the online portals that match issuers and investors will have to be registered as restricted dealers, and have to vet prospective issuers.

In addition, the crowdfunding exemption limits ordinary investors to $2,500 per investment (vs $1,500 under the startup exemption). And in Ontario, investors also will be restricted to a total of $10,000 in investments per year under the exemption; no such limit applies in the other provinces.

The crowdfunding exemption also restricts the type of securities that can be issued, imposes disclosure requirements and mandates rescission rights.

Conversely, the proposed crowdfunding exemption in Alberta and Nunavut sets a $1-million lifetime limit on the financing an issuer can raise. And a $1,500 annual limit per investor will be imposed (although investors can risk up to $5,000 if they get advice from a registered dealer).

The SEC’s new exemption has its own twist. The SEC proposes a US$1-million annual limit on the amount a company can raise via crowdfunding, and a US$2,000 annual limit for small investors (although higher limits apply to wealthier investors). The SEC also would require portals to register with the commission and become a member of the Financial Industry Regulatory Authority self-regulatory organization. And the SEC’s proposal imposes some initial and ongoing disclosure requirements on issuers.

With all of these various regulatory approaches to crowdfunding in play, or on the way, regulators effectively are carrying out a real-world experiment that should reveal whether a concept that sprang from the power of the Internet to connect disparate groups of people has any practical application in the investment world.

FAIR Canada certainly doesn’t believe that it does.

“Crowdfunding isn’t going to foster real or sustainable growth of capital markets,” Gross says. “Instead, it will lure a lot of unsophisticated people into making unrealistic, impulsive, low-percentage bets. Basically, it’s a ‘pig in a poke’ – not really investing at all.”

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