Equity Crowdfunding: A New Way To Invest For Main Street?

Equity crowdfunding is the hottest mania in finance. Jurisdictions all over the world are looking into it. Consideration is being given to removing time-proven investor protections to make way for this runaway freight train. Canada is not immune, with several provinces considering making regulatory exemptions to securities laws so Main Street can join in by investing in risky start-ups. In the U.S, the argument is that equity crowdfunding will give rise to many new companies and create millions of jobs.

Equity Crowdfunding 

Crowdfunding has been around for a while. In May 2013, a crowdfunding website successfully raised over $200,000 to pay organized crime in Toronto to acquire a video of Toronto mayor Rob Ford allegedly smoking crack cocaine. That fundraising exercise received global attention, partly because it raised numerous ethical, criminal, regulatory, money-laundering and investor- protection issues for crowdfunding.

Equity Crowdfunding is a subset related to raising capital. Equity crowdfunding is the offering of unregistered securities through a securities commission- registered funding web portal/platform to raise small amounts of money from a large pool of non-accredited and/or accredited investors. These securities may be common shares, non-convertible preferred shares, convertible preferred shares, non-convertible debt securities, convertible debt securities, limited partnership units, trust units, or flow-through shares. Portals will be required to register with the provincial regulator and conduct background checks on firms raising money. To qualify for this proposed exemption, a company must be incorporated or organized under Canadian laws and have its head office in Canada. The majority of the company's directors must also be resident in Canada.

Crowdfunding makes use of the easy accessibility of vast networks of people through social media leverage to drive traffic to their fundraising webpage. Crowdfunding portals thus have the potential to increase entrepreneurship by expanding the pool of investors from whom funds can be raised beyond the traditional circle of owners, relatives and venture capitalists. It is argued that crowdfunding can lead to a democratization of investing—the small investor gets a chance to invest in the next Google. It is aimed at investors who are not “Accredited Investors” under securities laws.

What Is A Crowdfunding Funding Portal?

A crowdfunding funding portal or platform is a dedicated website and intermediary that facilitates funding transactions between entrepreneurs (i.e., the creator of the business or start up) and investors. Entrepreneurs post all funding-related information, such as business goals, value proposition and use of proceeds on a funding campaign page on the funding portal’s website. Entrepreneurs and potential investors can post questions, answers and comments on the campaign page during the funding campaign. Funding portals also manage certain parts of the process like basic background checks, review of information provided by entrepreneurs for conformity to basic regulatory standards or portal requirements (but not merit, completeness or accuracy of information), receive and hold funds in trust, investor education, marketing tools and regulatory reporting obligations.

nyone who has ever watched the TV program ‘Dragons' Den’ can quickly see how many zany potential investments there are. Unlike the dragons, most small investors do not have the skillset, experience or time to effect proper due diligence. If a regulatory exemption is granted, these “investments” will not only cause losses for Canadians but will also divert much needed money away from more deserving companies. It is these high risk investments that are unable to find funding from traditional sources that will come looking to small investors and retirees for support. Of course, there are many other problems not to mention the high possibility of fraud. It seems to be incongruent that, even as governments are exploring ways of assisting people with their retirement, the crowdfunding initiative with its attendant ultra-high risks should be a priority of security commissions. Securities regulators have done an excellent job in warning investors about the fraud/ identity theft potentialities of the Internet yet their recent plans to grant Equity Crowdfunding an exemption opens citizens up to an even greater amount of potential fraud. The recent CRA identity theft fiasco is a case in point.

The Labour-Sponsored Investment Fund Mania

A previous attempt to allow investors to invest in early stage companies was, quite frankly, an unmitigated disaster. The 2007 paper The Failure of Labour Sponsored Funds http://www.fraserinstitute.org/research-news/ news/display.aspx?id=11941 points out the striking fact about labour-sponsored funds that their poor rates of return were consistently below those of risk-free investments. Even professional managers invested in companies further developed than start-ups were unable to generate reasonable rates of return for investors. The poor rate of return of labour-sponsored funds indicates they had not been successful at financing high-growth entrepreneurial businesses.

The paper concluded that ensuring that, while Canadian high-growth entrepreneurial firms have access to sufficient capital is critically important to the health of our economy, labour sponsored venture capital corporations were not the answer. Only a handful made any money at all, even over the eight-year holding period required to avoid repaying the tax credits. And many funds suspended redemptions after the 2008 stock market crash, leaving investors on the hook for an even longer period. Labour-sponsored funds flamed out once the provincial tax credits vanished. So the history is poor when unsophisticated investors get involved with start-ups and the intermediaries that surround them. Embracing equity crowdfunding for the masses is clearly another example of failing to learn the lessons of history. It would be far better if regulators urged Canadians to save more for their retirement.

Investor Protections

The regulators have imposed some very basic investor protections relevant to equity crowdfunding. These include limiting the dollar value of the raise, limiting the participation of individuals to a defined dollar amount per raise, setting a cap on the total dollar value for all raises an investor can make during the course of a calendar year, laying out some minimal criteria for the operation of crowd funding portals and requiring background checks on issuers. The company is required to produce and distribute streamlined disclosure—at its most basic, disclosure of the issuer's cash and annual financial statements—and to maintain accurate records regarding the use of capital raised. Following the campaign, issuers must provide ongoing continuous disclosure.

Investors must sign a “risk-acknowledgement form” that says they could lose all the money invested. There are no suitability requirements applicable so it's up to you to do all the homework unless you have an investment advisor. Depending on how individual provincial rules shake out, there may be access to OBSI or another third- party complaint-handling resource. Litigation for small amounts is not practical. Investor advocates argue that payment by credit card should not be permitted on the basis that it constitutes a form of leverage. Securities regulators are simply doing what they can to inject some investor protection into a fundraising tool that is being driven by a global mania. No country wants to appear to be an obstacle to “progress”.

The Risks Of Equity Crowdfunding 

Investor advocates have been constructively critical of Equity Crowdfunding. As the Ontario Securities Commission itself notes, crowdfunding may be a highly risky investment and investors may experience a high probability of loss, even if there is no fraud. Many startups and SMEs are expected to fail: Canadian data shows that only 72% of SMEs that entered the marketplace in 2007 survived for two years and only 51% of SMEs that entered the market place in 2005 survived for five years. The survival rate of issuers that rely on equity crowdfunding may be lower since there is the possibility of adverse selection. Businesses with good prospects may gravitate towards donation- or rewards-based crowdfunding or other cheaper sources of financing whereas less successful businesses may use securities-based crowdfunding because they are unable to raise funds from other sources.

Crowdfunding sounds good in theory but the socio- economic risks are enormous. If, as predicted by some, poor investments and fraud prevail, tens of millions or more dollars of Canadian savings could evaporate. In the end, it is taxpayers who may have to come to the rescue, not the portals.

Investments in small businesses and start-up companies are often risky. For example, if a company is new, its management may be unseasoned and investors will not be able to evaluate the company’s operating history. Small businesses may also depend heavily upon a single employee or supplier whose departure would seriously damage the company’s prospects. The demand for the company’s product may be impacted by the overall economy, alternative technologies, or other industry sector-specific risks. The company may also have a hard time competing against larger companies that may have economies of scale. Furthermore, a small business may not be able to mitigate risks from lawsuits, patent infringement claims, tougher governmental regulations, and multiple other impediments to growth.

Small investors will likely be unfamiliar with key startup investing principles (e.g. implied valuation, liquidation preferences, minority protections, information rights, tagalong provisions, first refusal rights, anti-liquidation, reverse vesting, to name just a few). This will set them up for failure at the outset. Small investors are unable to influence the management decisions that affect the profitability of the investment. New investors are often asked to pay a higher price for their shares than the company’s officers or principal owners (who may have contributed “sweat equity”). Furthermore, the value of the small investor’s ownership share in the company’s assets (the “tangible book value”) is difficult to assess and is almost always less than the amount paid for the shares. Even if a retail investor had the talent, resources and time to investigate the start-ups they would be faced with a large number of threats to capital. These include but are not limited to the regular investing risks. There is the likelihood that successive rounds of financing will dilute the holding to almost NIL for the original small investor. Breakdowns in corporate governance, unscrupulous insider trading and the fact that no regulator will have verified that the disclosure document is accurate or determined that it is adequate add to risks.

In addition to these general risks related to investing in start-ups, you should carefully consider the specific information and risks disclosed by the company issuing the securities. It may be difficult or impossible to recover your money if the investment does not perform as expected. Due to very limited regulatory oversight over crowdfunding offerings, small investors are highly vulnerable. Because of these risks, you should not invest any funds in a crowdfunding offering unless you can afford to lose your entire investment.

You also should not invest if you may have an immediate need for the return of your funds. The shares are illiquid. The company may restrict re-sales of its securities. Even after these restrictions are lifted, it may be difficult to resell these types of securities because they are not listed on any securities exchanges and a public trading market may never develop.

Money Laundering An Issue

Equity crowdfunding is particularly susceptible to money laundering and other financial crimes. Private placements pose a money laundering risk because they are often used to generate illicit assets through manipulation, insider trading and fraud. Unlawfully acquired cash can be used to purchase securities with proceeds of crime in order to resell them and create the appearance of legitimately sourced funds. The combined effect of crowdfunded securities being low-priced, placed in offerings that are exempt from registration and not subject to the filing review process of a registered offering, makes crowdfunding open to being used as a vehicle for money laundering and other financial crimes. http://www.lexology.com/library/detailaspx?g= 1749dfe8-8946-466c-9fe2-a920e7f83118

Freedom Of Choice For Equity Crowdfunding?

Despite the many concerns, there is an argument that Canadians should have freedom of choice. After all, they are permitted to buy cigarettes and thereby expose themselves to lung cancer; they buy alcohol and that could lead to many health problems; and they can spend their hard earned savings in casinos exposing themselves to many financial threats including addictions and much worse. Investor advocates have jokingly suggested that provincial Lottery and Gaming Corporations be in charge of regulating this new fundraising scheme. After all, they are used to people losing a lot of money and experiencing life-altering events. One additional benefit that crowd funding could provide, if its proceeds were considered lottery wins, is that proceeds would be tax-free, a big advantage for investors who have taken huge risks to make some returns. An important collateral benefit would be that it would keep securities regulators away from the inevitable scandals/debacles and thereby protect reputations. It would also steer media attention away from the idea that capital markets are flawed. A Win-Win all around, eh?

Conclusion

If the regulatory exemptions are approved, equity crowdfunding would become part of the roughly $100-billion exempt market, which has historically been subject to less regulatory scrutiny because it does not require companies to file detailed prospectus documents before selling securities to investors and investors are required to be accredited, meaning knowledgeable. Equity crowdfunding brings investor protection down a notch or two or maybe three.

There couldn’t be a worse time to expose small investors to more risk and speculation. Many people are still reeling from the 2008 global financial crisis, a crisis that has its root in a maniacal breakdown of regulatory oversight and abandonment of common sense. Canadians are now operating at the highest level of debt-to-income and there is a looming pension crisis. Investor advocates therefore argue against the adoption of this exemption to common sense rules that are designed to protect small, unsophisticated investors. If you want to learn more you might want to read TD Research Bulletin Crowdfunding: A Kickstarter for Startups raises some pros and cons. http://www.td.com/document/PDF/economics/special/ Crowdfunding.pdf

Remember, it's your money.

Ken Kivenko, PEng, President , Kenmar Associates, Etobicoke, ON (416) 244-5803, kenkiv@sympatico.ca, www.canadianfundwatch.com