Capital Prohibitions and Crowdfunding

Crowdfunding Gains Momentum

The U.S. Senate has passed legislation (March 2012) that will essentially legalize crowdfunding in startups by practically anyone. The “CROWDFUND Act” was passed earlier this month so that companies would be able to use SEC-approved crowdfunding platforms to raise money from “small-dollar investors. And, what are we doing here in Canada?

Regulations Limit Access to Capital

The BC Securities Commission (along with the Canadian Securities Administrators) is reviewing two regulations that permit entrepreneurs to raise money for their companies. These are the Accredited Investor exemption and the $150K Minimum Investment exemption.  Without using one of these exemptions, private companies cannot legally raise money from strangers unless they incur considerable expense to produce a prospectus (which also means going public) or an offering memorandum (quite onerous, especially for start up ventures).

“Exemption” means being exempt from having to use a prospectus in order to raise capital. It may explain why so many companies go public “too early” – it’s almost the only way they can tap into that vast sea of capital.

These regulations exist to protect the investing public by limiting how companies can raise money from arms-length investors. The rationale is that if someone is an Accredited Investor (the definition of this is someone who has more than $1 million to invest or has an annual income of $200K – in other words, a wealthy person), they can afford to speculate with their money or if someone is willling to gamble at least $150K, they too, can afford to gamble.

These are fairly high thresholds. In essence, the regulators are protecting the investing public by shutting out most investors and allowing only the wealthy to play. The current thinking is to make these hurdles even higher.

On the other hand, the B.C. Government openly encourages us to gamble on-line but does not allow us to gamble on a start-up. I have to wonder if provincial regulators have the right to limit citizens’ freedoms in this manner?

Accredited Investor Exemption

If an investor is a millionaire (has more than $1 million in liquid assets, excluding residential property) or a high income earner (>$200K/year alone of $300K/year family income), he can invest freely in a startup with no red tape whatsoever. Less than 2% of the population qualify as accredited investors. Some regulators are wondering if this million-dollar requirement should be raised (the USA pondered it as well but reversed its position – see below).

By the way – what happens in a market turndown? If you are an accredited investor on Monday and the market crashes on Tuesday (putting you under $1 million), you are suddenly disqualified from making additional investments as an accredited investor. Serves you right!

Minimum $150,000 Investment Exemption

If an investor is willing to invest a minimum of $150K in a company, he can do so easily. Supposedly this protects investors somehow or does it encourage someone willing to invest $100K to go for broke?

The question that’s being asked by the Regulator is: should this be changed, i.e. increased? My answer: It should be eliminated. If it is a “Minimum” it could – and I’ve seen this happen – encourage someone to risk more that they really want to. Someone willing to put $100K into a deal might top up the investment simply to not be left out altogether. Betting the farm is not my idea of providing protection. Is that right? Instead, it would be better to create a “maximum amount” exemption. This would certainly limit the amount that an investor might lose (while I prefer it, I still don’t like it). Minimum or maximum – there’s always the issue of what that number should be. I do not believe there is – or will ever be – universal consensus onwhat might be an appropriate amount in order to “protect” an investor. Better to provide protection with education. If the investment fails, that’s education – i.e. a “learning experience”. To its credit, the BCSC is doing this with its InvestRight.org website.

In B.C., there used to be a $25,000 minimum investment exemption. I’m not sure why this disappeared. It would be interesting to hear the arguments for its elimination with respect to investor protection.  By the way, investors and companies always find ways to get around these barriers. A few investors would pool their cash so they could rely on this exemption in order to invest while at the same time limiting their exposure rather than having to increase it.

When investors buy/sell in the public markets they can invest any amount easily and quickly. Are they protected somehow? Not really. Just because a (startup) company issued a prospectus and provides quarterly reports, that doesn’t protect investors because: a)the operators may still be dishonest, b)competition is fierce, c)failure rates of startups are very high in any event.

Other Exemptions

In addition to the Accredited Investor and Minimum Investment exemptions to a prospectus requirement, there are many other exemptions that companies can use although most do not apply to the typical tech startup. Most startups rely on the “Family, Friends, Relatives” and “Close Business Associates” exemptions when raising money from people they know. Another exemption that is available is known as the “Offering Memorandum” exemption. The regulators usually suggest this as an option for entrepreneurs. The problem with this one is that it can be expensive and cause delays, among other things. In reality, the B.C. Securities Commission reports that a very small percentage (around 3%) of financings rely on this exemption. The B.C. Offering Memorandum Form can be downloaded [click here] from their website. More information on exemptions is available from the BCSC’s web site [click here].

Ironically, the Offering Memorandum exemption has actually been used by scammers as a tool to help them with their fraud. Why? Because the O.M. looks very official, legalistic and has the appearance of being qualified. David Baines, a Vancouver Sun columnist, did a great job of showing how the O.M. served the purpose of scammers quite well.

What are other countries doing?

In the USA, on November 3rd, 2011, the House passed the “Entrepreneur Access to Capital Act” (HR 2930). The bill was a hit with  both parties and also received White House backing. It passed by a vote of 407 – 17. In March, 2012, the Senate passed the CROWDFUND Act by a vote of 73-26.

In summary, Bill HR2930 provides a crowd funding exemption from Securities and Exchange Commission registration of securities offerings, with certain limitations:

  • A $10,000 limit per investor (or 10 percent of annual income, whichever is less).
  • A cap on the amount a company can raise of $1 million per offering (and up to $2 million if audited financial statements are provided).
  • No limit on the number of accredited or unaccredited investors.

NO MATTER WHAT – entrepreneurs in Canada, should at least have the same, preferably BETTER, access to capital.

Other countries such as China have no regulations to protect investors – seems like quite an anomoly. Are we being more big brother-ish than China? I attended an angel investing conference in Shanghai in March, 2011 and I asked angels what is being done  there to protect investors. The answer: it’s up to investors to do their own due diligence. Most investors factor in the reality that some 20% of entrepreneurs are inherently dishonest (a North American study noted a similar figure). Hence, they have to do enough deals to mitigate against this reality.

The Brits are right on it: there’s already a web site set up to do the matchmaking between companies and investors: www.crowdcube.com. You can even invest using your credit card. Unlike the USA, it doesn’t look like the UK is limiting the per-investor amount to $10K. The UK also gives investors a 30% tax incentive. Also, from April 2012 people investing up to £100,000 per annum in a qualifying start-up business will be able to benefit from income tax relief of 50 per cent. Won’t that give innovative companies a shot in the arm?

Australia is often cited as an country that permits crowdfunding. The Australia Securities and Investments Commission (ASIC) has published guidance on crowdfunding. Raising equity capital (e.g. via crowdfunding) is a regulated activity in Australia and is not a free-for-all for anyone. However, hats off to the Aussies for making it work within existing regulations. For an example of an equity crowdfunding portal, check out the Australian Small Scale Offerings Board.

Forget about other Countries – what about other Provinces?

I was wondering why only two exemptions – The Minimum Investment and Accredited Investor exemptions – were being reviewed by the CSA (Cdn Securities Adminsitrators). Answer: these are the only ones on which there is national uniformity. For example, Ontario does not have an Offering Memorandum exemption. Does any Province make capital raising easy for startups? Well, Nova Scotia has the CEDIF – Community Economic Development Investment Funds.

There are now 47 CEDIFs in Nova Scotia that have successfully closed at least one offering. These Funds, through a total of 120 offerings, raised and invested $40 million in local enterprises. The capital of these Funds has been invested by 5616 individual Nova Scotians (some repeat investors reduce this number).

The Volker Rule

Paul Volcker, former US Fed Chairman is more recently known for the Volcker Rule: legislation to protect banks by restricting speculative investments.

Here’s a new idea: the (Mike) Volker Rule: Protect investors by setting higher corporate (investee) standards through good governance and stewardship.

If the idea is to protect investors, having them sign a risk acknowledgement will not protect them from scammers. If the idea is to protect against scammers, put the onus on the companies raising the capital. For example, set some corporate standards – such as requiring a board with a majority of external directors (i.e. not founders or employees) which have each qualified as directors and signed an acknowledgment of their responsibilities.

Instead of an Offering Memorandum, companies could be required to provide a simpler form of Information Memorandum (signed by the directors) which includes directors’ CVs and some basic information on the business of the Company – how much capital it is raising and what it intends to use it for. It would not require audited statements and could follow a standard format. Additionally, the company should state that it will provide quarterly financial reports to its shareholders. In the case of a failure due to fraud or misappropriation of assets, hold the directors accountable or at least bar them from acting as directors and/or bar them from trading in any securities for five years or more.

Additionally, such an action would also serve to improve the quality of companies in general. So, even those with impeccable ethics and standards would benefit from the Volker Rule: protect investors through good governance and stewardship. Currently, and surprisingly, such a standard does not exist for companies seeking to raise capital from arms-length investors.

We’ve got it backwards: we’re trying to protect investors by making them meet certain investment standards; we should protect them by making the investees meet certain standards!

In thinking about it, the existing Offering Memorandum (O.M.) exemption, is the closest thing to what’s needed. The main problem with an O.M. is that it requires a company’s financial statements to be audited (even if a startup) and hence can be expensive and cause delays. Legal expenses are often incurred with an O.M.  The minimum cost of preparing an O.M. is at least $10K (with a cheap audit, but likely closer to $35K) and takes at least 6 weeks to write. If an O.M. is used, companies also lose their “private issuer” status requiring them, in the future, to always have to report any sales of their shares to the Commission.

In fact, the Commission ALWAYS retorts that companies can use this exemption – i.e. whenever I complain to them about capital raising woes.  A modification to the O.M. requirements might be more palatable to the Commission and be met with less push-back.

I would suggest that, if companies want to ask people that they do not know for money, they should meet a certain standard. Astute angels demand this already. So if the Regulators really want to protect investors, they should require the companies – not the investors – to meet certain standards, wouldn’t you agree?

Three directors – i.e. the CEO & two others is not onerous. They can still use the current exemptions if they think this is too onerous. I’m just suggesting this as another option.

In essence – it’s really more like an O.M. but not as difficult as an O.M. and with more emphasis on stewardship. Consider this: eliminate the need for an O.M. to have audited statements, simplify the O.M. and put more emphasis on the Directors.

I believe that we can improve on the Americans’ crowdfunding exemption by using the Volker Rule so that a non-accredited investor need not be limited to $10,000. Note: investors in B.C. can use the 30% refundable provincial VCC tax credit and an RRSP so that when investing $10,000 they are at-risk only to the tune of around $3,000. Given this, why impose a $10K limit?

Oh, and one more idea: To make sure that investors understand that they will more likely than not lose 100% of their investment, make them write-down their investment and take an immediate capital loss (which, at the same time, gives them a tax break incentive).

By using a concept like the Volker Rule (with our without the extra tax break), I believe that the public will be better protected than it is now and companies will have not only better access to capital, but will benefit from better corporate governance.

While crowdfunding looks cool, it doesn’t go far enough – either to protect investors or allow companies to raise more then $10K from individuals. Indeed, there are concerns by the SEC about crowdfunding. Also, raising small amounts from many investors presents new challenges to companies in that they will have to pay attention to these investors. They will likely get more calls and questions from these investors that they have to respond to on a regular basis – especially when small investors need the cash and want to unwind their investment. Holding an investment for 10 years may not be right for such investors! Equity Crowdfunding, if not done properly, could make it tough for entrepreneurs to raise capital from angel investors or VCs because of unwieldy cap tables and voting issues.

I Suggest: a new exemption: SEED Financing Memorandum (similar, but simpler & better than current  Offering Memorandum exemption). Let’s do BETTER than the USA. We’re so close, let’s just do it!

Recommendation

So, enough rambling. What, exactly am I suggesting?

  • don’t change existing Accredited Investor Exemption
  • reduce Minimum $150K exemption
  • add a new exemption (Volker Rule): SEED Financing Memorandum* (improve current  Offering Memorandum exemption)

*The SEED Financing Memorandum would be a simple document signed off by the company’s board (a majority of which must be external) showing a “use of funds”, a proforma cap table and an undertaking to provide, at the minimum, quarterly basic financial statements to investors. Unlike the Offering Memorandum, companies would not require audited statements. A “risk acknowledgement” form for investors would still be required). Note: this would be superior to the USA crowdfunding model because the emphasis would be on making companies meet certain standards and it would not set arbitrary (and debatable) investment limits.

Taking Action

Let me know what you think. In B.C., through the BCTIA and nationally, via CATA [click here for more], we need to get the high tech sectors views about innovation and access to capital heard by policy-makers. There are numerous organizations and groups that believe changes are required to our regulations to give entrepreneurs better access to capital. A Canada-wide initiative is being undertaken by Alliance i-Canada with a recently formed group called Invest Crowdfund Canada.

[for current progress and updates on this matter, refer also to: http://mikevolker.com/equity-crowdfunding-doing-it-right-for-discussion/

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8 Responses to “Capital Prohibitions and Crowdfunding”

  1. Steven Forth says:

    I endorse this approach – put the onus on the company. I doubt that the Commission will ever support this though as it takes power away from them. The standard could include a standard way to report business results and financing to investors, and this could be done on-line.

  2. Al Werenko says:

    One of the reasons for often screwy regs is that there are bureaucrats and politicians who mean well or may mean well but are not entrepreneurs, not angels, never made an investment, not risk takers, … sort of like a priest dispensing rules for better sex!

    Who provides oversight to the bureaucrats? And what is the best way to create change?

  3. Joseph Bowes says:

    Insightful comments Mike … hopefully the regulators are listening … implementing such changes would help both investors and entrepreneurs dramatically more than anything that will come from the considerable efforts and investment presently being made on the new IFRS – ASPE GAAP requirements … for that matter, why not add to the mix the benefit of “flow-thru” tax credits – i.e. allow “tech companies” the same access to the considerable benefits of “flow-through share financings” that have been enjoyed for many years, by both public and private companies, in respect of ‘qualifing expenditures’ by early-stage, junior exploration firms.

  4. John Biehl says:

    As a new investor, in fact a first time self-directed investor, I wonder why there is any restriction at all as to who can be an ‘accredited investor’ on private investments. It is grossly unfair that there is a wealth restriction at all. I do like the idea of an ‘Information Memorandum’ as suggested to ensure responsible private corporate governance. The regulatory authorities (read governments)should be actively promoting greater numbers of people to become entrepreneurial investors. How else can Canada otherwise compete in R&D of new technologies?

  5. Jim Fletcher says:

    Great work Mike. In particular your point that anyone can put any amount into a TSX-V listed start-up, even tho’ the high Admin costs & distractions of being public – and the (usually) much higher valuations – and the lack of SH Agreement protections like pre-emptive rights – and the loss of SRED – all make most of these public ventures inherently much riskier for the early-stage investor. Instead, we should be simplifying the ability of bona fide quality start-ups to access retail capital efficiently & professionally.

  6. Roger Killen says:

    Yes!!! Common sense at last. Good governance and responsible stewardship are indeed the best investor protectors. Complex exemptions and oversight by the British Columbia Securities Commission do not offer investors any significant measure of protection and serve only to add to the cost of capital and the complexity and distraction of the capital-raising process.

    I want to supplement Mike’s excellent suggestions by adding another one: use the battle-tested Nominated Advisor (‘Nomad’) system. I have long admired the simplicity and effectiveness of the Nomad system used by the Alternative Investment Market (‘AIM’) which is part of the London Stock Exchange. In essence, each company seeking a listing on AIM must have, and must keep, a Nomad. The role of the Nomad is to ensure that the company’s actions are fair and reasonable for its shareholders. If we had a system of approving certain local individuals as BC Nomad equivalents and if each private BC business seeking to raise external capital was required to have such an individual as one of its independent directors, both the company and the investors would win. For more information on AIM and its Nomad system see:
    http://www.londonstockexchange.com/companies-and-advisors/aim/publications/documents/a-guide-to-aim.pdf

  7. John Sprague says:

    Ah yes…the “upside down rule”…

    Where “non-sophisticated” investors are forced to invest too much, while accredited “sophisticated” investors are allowed to invest as little as they wish.

    Truly backwards.

  8. I fully agree, to protect investors, the responsibility should rest on the CEO,his management and directors.

    As a public company officer and director also involved in private companies, our protection or performance standards include:

    - No frills financial,operations, and outlook reporting per quarter;

    - Advanced disclosure of strategic plan including milestone targets, variance reporting against targets as well as solutions under consideration for not meeting targets;

    - Involvement of non-executive independent advisors or directors.

    - Customer centric and value driven corporate culture or philosophy. We are only in business if we have customers who buy our products at a profit. We only have investors buying our shares (instead of selling) as long as we are creating value.

    - We also keep abreast of best practices to maintain competitiveness.

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