From a securities perspective crowdfunding is the raising of small amounts of money from a large number of people primarily over the internet to fund a business. It's a means of raising capital for start-ups and small and medium-sized enterprises without going through the costs of preparing and filing a prospectus, costs which are prohibitive for all but large companies.
Only Saskatchewan currently allows crowdfunding but that appears to be changing.
Earlier this month the Canadian Securities Administrators issued for comment its proposed new crowdfunding exemption which will allow Canadian companies to raise a relatively small amount from an individual.
Generally a person will be able to invest up to $2,500 in a single investment and no more than $10,000 in a calendar year. A company will be able to raise up to $1.5 million in a 12-month period.
A crowdfunding exemption will be very positive for small businesses that need capital but have run out of close friends and family members to tap for money under the existing family, friends and business associates prospectus exemption.
Not every type of business will be able to use crowdfunding. Real estate companies that are not reporting issuers are specifically excluded. So are investment funds. Also excluded are blind pools, which means a company can't raise money using crowdfunding unless it has a specific purpose in mind set out in a written business plan.
Investors should recognize that start-ups and small businesses that need capital can be risky and have a high failure rate. Indeed investors who were active in the mid-1990s will remember professionally managed labour-sponsored investment funds that invested in venture situations and as a group had disappointing performance.
The $2,500 investment limit should in fact keep potential losses affordable and not risk anyone's standard of living too badly.
In fact, in my opinion, potential buyers should look at each crowdfunding opportunity as something analogous to a lottery ticket with a price tag of up to $2,500, with one important difference. Losses from a crowdfunding investment that turns sour can be used to offset capital gains for tax purposes.
The regulators are concerned about investor protection and are proposing substantial safeguards. These include, requiring companies to be incorporated and have a Canadian head office. Furthermore, a majority of the directors must be Canadian residents, reflecting the regulators' view that this may reduce risks to investors.
Also, the regulators will prohibit companies from using crowdfunding if they have previously raised money and have failed to meet their ongoing disclosure obligations.
The on-line portal through which crowdfunding securities will be offered must be registered as a restricted dealer. It will be required to "take reasonable steps to establish that the business of the issuer will be conducted with integrity and in the best interests of the security holders of the issuer based on the information contained in the issuer's application and the results of background checks. This obligation includes considering the past conduct of the issuer and any of the issuer's executive officers, directors, promoters or control persons. The portal must also conduct background checks on the issuer and its directors, executive officers, promoters and control persons."
This puts the onus on the portal operator to keep the rogues from using the crowdfunding exemption to scam the public. Also, the portal, the issuers and their directors and officers are prohibited from lending money to or arranging loans for potential investors.
Investors are required to sign a risk acknowledgement for confirming among other things that they could lose all of their money and understand the specified risks set out in the form.
The offering document will be on the portal website, and in fact that is the only place that marketing material can appear. The document will include basic information only, but there must be a business plan.
No unique or complex securities can be used. Just common shares, non-convertible preferred shares, non-convertible debt securities linked to a fixed or floating rate, flow-through shares and limited partnership units can be offered.
The exemption will be limited to distributions of an issuer's own securities. It cannot be used by the issuer's shareholders as a means of getting rid of their holdings. Also, the $1.5-million limit applies to the issuer and any affiliates or other entity involved in the enterprise. This will of course prevent the same business from going to the trough more than once in the 12-month period.
Also, any failed distributions made by any issuer in an issuer group must be disclosed.
A key element in my opinion is the requirement that an issuer's on-line offering document state the minimum amount of money being raised. If the issuer fails to raise that amount the offering will not be completed. That way a handful of investors won't end up in an undercapitalized business that will likely founder.
The window for a crowdfunding exercise is 90 days, which should be long enough to raise the required capital if there is investor interest. Anything beyond 90 days would likely mean that the offering information will be stale.
The principals of an issuer don't have to invest their own money in the venture, but if they have securities they must disclose what they have and the price they paid, as well as any hold period. This lets investors see what they are getting relative to what the principals are keeping and make an informed decision.
It will be interesting to see what kinds of ventures will use crowdfunding to raise funds when it is allowed, and what their success ratio will be over the next several years.
