Regulators ponder crowdfunding

In addition to these events, the Ontario Securities Commission (OSC) has also promised to publish a consultation paper examining a range of issues in the exempt market, including crowdfunding; that paper is expected to be published early next year.

Utilizing the reach of the Internet to finance fledgling ventures that aren’t likely to have access to capital through traditional channels is not new. Microfinancing websites, such as Kiva (www.kiva.org), have been using the web for several years to raise small amounts of money from large groups of people to finance micro-loans to entrepreneurs in developing countries. More recently, Kickstarter (www.kickstarter.com) has used a similar model to fund creative projects, such as writing a book, recording music or developing a video game.

Thus far, this collective approach has proved to be fruitful. Kiva reports that almost US$370 million has been loaned by more than 840,000 people through its website since it started up in 2005. And Kickstarter reports that more than US$350 million has been pledged by more than 2.5 million people to projects that appear on its website, which launched in 2009.

Given the success of collecting money for loans and donations using this approach, it’s not a big jump to the idea that startup companies might be able to raise equity financing this way. Indeed, earlier this year, Alpha Trading Systems LP (before it was subsumed into TMX Group Ltd.) published a white paper on the problems with the venture-capital funding environment in Canada, which recommended that crowdfunding be permitted as a way to help fledgling firms find financing: “With crowdfunding as part of the mix, Canadian startups would have a brand new and highly democratic avenue to raise adequate amounts of capital.”

The Alpha Trading paper argues that even though so-called “accredited investors” (defined as those with $1 million in assets or $200,000 in annual income) can invest in private firms via the exempt market, small investors cannot.

Soon, U.S. firms are going to have the opportunity to raise money this way. Earlier this year, U.S. legislators passed a bill mandating the U.S. Securities and Exchange Commission (SEC) to come up with rules to allow equity crowdfunding in the U.S. (See sidebar, below.)

Just how effective this could be at addressing the venture-capital shortage is unclear.

Meanwhile, in Britain, Crowdcube (www.crowdcube.com), which claims to be the first equity crowdfunding platform, reports that 29 companies have been funded successfully, to the tune of £4.25 million ($6.77 million) since it began operations in February 2011. The median investment is £2,323 ($3,698).

For Canadian companies to get on the bandwagon, securities regulators will have to be brought on board. Although there is no specific rule against equity crowdfunding in Canada, a funding portal would probably be required to register, according to a report from Fraser Milner Casgrain LLP (FMC). That report adds that firms that use the portal also might need to be registered – all of which makes the proposition uneconomical: “Not surprising, many key players in the startup ecosystem have no interest in becoming registrants, and few registrants are interested in the low-fee, high-liability stakes of raising funds for startups.”

Although crowdfunding may not be practical under current securities rules, the idea is finding its way onto the regulatory agenda as regulators turn their attention to the availability of startup capital.

According to the Alpha Trading paper: “Canadian regulators should build a structure that allows Canadian retail investors the opportunity to invest in high-growth firms while, at the same time, protecting them from inappropriate or unknown risks and fraud.”

Furthermore, that paper suggests some possible parameters for a Canadian crowdfunding solution that may assuage the investor-protection concerns that accompany a model based on unsophisticated investors buying into risky startups with minimal disclosure. For instance, it suggests the crowdfunding mechanism could be housed within a registered exchange and that retail investments be limited to $25,000 or 10% of annual income. The paper also suggests these investments be eligible for RRSPs.

Still, at this point, it’s hard to say just how receptive Canadian regulators may be to the idea of crowdfunding.

“Crowdfunding is a very new concept in Canada, and quite different from our existing regime,” says Andrea Johnson, a partner with FMC in Ottawa who participates in Invest Crowdfund Canada, a voluntary advocacy committee, and who is also a member of the OSC’s new exempt-market advisory committee. “I think the regulators still need to think carefully about how crowdfunding might work in this market.”

The whole debate also is complicated by the provincial nature of securities regulation. In provinces in which the shortage of startup capital is perceived as more acute, or where regulators see a greater need to help foster capital formation, a new form of venture financing may seem particularly appealing. Conversely, jurisdictions with a more intense focus on investor protection may be more leery of exposing the crowd to risky startups with little oversight.

Indeed, there are already meaningful differences among the provinces in their approach to the exempt markets. And yet, given the borderless nature of the Internet, this would appear to be a case in which a national policy is required.

In British Columbia, which has a heavily venture-oriented market and a history of trying to tailor regulation to support it, regulators nevertheless appear cautious regarding the concept of crowdfunding.

In a recent speech to the Vancouver Board of Trade regarding crowdfunding, BCSC chairwoman and CEO Brenda Leong noted: “There is a fear that Canada will be left behind in the race for scarce capital for startups. In my view, those fears are unfounded.”

Paul Bourque, executive director of the BCSC, points out that in B.C., companies can already raise money from “as many people as [they] want” under an offering memorandum (OM).

However, for some firms, even complying with the OM rules can be burdensome. FMC’s report points out that OMs require audited financial statements, which can cost upward of $25,000 to produce – and are required even of firms with no operating history.

With that in mind, regulators may yet ease that requirement in order to facilitate fundraising through that well-established route. “We are looking at the OM requirement for audited financials,” Bourque says, “which might not be necessary for newly launched companies.”

There are other problems with the OM exemption. For one, it’s not available in Ontario. Moreover, the FMC paper states, even in the provinces that use the OM, the requirements aren’t uniform, and the information it presents may not be easy for unsophisticated investors to understand.IE

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