Equity Crowfunding – the selling of shares in new ventures to the general public – can give entrepreneurs access to a vast resource of new capital. While this will stimulate the creation of more companies and jobs, not everyone thinks that this is a good idea. Securities regulators are worried about investors losing out due to fraud or flaky deals – not to mention the high risk associated even with the best deals. This article puts forward some suggestions – for discussion purposes – on how we can make it work – right here in Canada.
Update – 11 July 2013
Saskatchewan announced (July) its version of an equity crowdfunding to enable companies to raise small amounts – up to $100K with a maximum of $1,000 per investor. Click [here] for details. Now, we’re getting closer to selling lottery tickets!
In December, 2012, it appeared that some regulators in Canada – notably in New Brunswick [click here] and Alberta [click here] are following some of the recommendations made herein. They are willing to remove the main barrier – the requirement for audited financial statements – but they’ve added an unrelated barrier: limit the amount per investor to $2,000. They also limit the total per company to $500,000 which is OK, but that means bringing in more than 250 investors – that makes no sense. Why? They should read the rest of this article!
Note: In B.C., Crowdfunding has existed for a long time. The Offering Memorandum exemption has been available for over 10 years – with NO restrictions (if audited statements are used) – the ONLY jurisdiction in North America that allows this. Yet, it is rarely used by entrepreneurs. Why? It’s largely because they don’t know about it and/or don’t understand it. They think that they will become “public” and have to report. That’s not true. They also think it’s very expensive. That’s also not quite true because a startup can get audited statements for around $2K. Other than that, it’s just the time and effort to write one – but it’s worth it and such a document is required by smart investors anyway!
Early in January, regulators appear to want to tighten up on some of the exemptions relating to the sale of shares according to a recent Vancouver Sun Article. This appears to run contary to crowdfunding intentions. It appears that the issue that regulators are wrestling with is who can sell shares (e.g. use of agents and their qualifications). The B.C. Securities Commission published BC Notice 2013/01. Similarly, the Ontario Securities Commission addresses this in its OSC Staff Notice 33-738. The B.C. Commission is looking for comment by Feb 4, 2013. If you don’t like it, comment!
On the positive side, the OSC issued (Jan 14) its Consultation Paper 45-710 to consider new capital raising exemptions (presumably crowdfunding).
In Canada, and similarly in the U.S., entrepreneurs are only allowed to sell shares in their companies to relatives, close friends or millionaires (referred to as accredited investors) unless they use a full-blown “Prospectus”. Presently, in some provinces (notably B.C. and notably not so in Ontario), companies can raise capital from any resident by using what is referred to as the “Offering Memorandum Exemption”, i.e. an exemption from the requirement to produce a Prospectus. The Offering Memorandum is a document (referred to as Form 45-106F2, available on the BCSC website).
Unlike what’s contemplated in the U.S., the Offering Memorandum exemption does not impose limits on how much an investor can risk (which is good). So why don’t entrepreneurs use this more often? In the words of BCSC’s CEO, Brenda Leong, “…we have heard concerns expressed about the overly burdensome financial statement requirements that businesses must deliver with an offering memorandum.” Even a startup has to produce audited financial statements (even if there is no financial history). Although not required, many entrepreneurs incur additional legal expenses in preparing the document.
The only other problem with the Offering Memorandum exemption is that it is not available Canada-wide. Some other provinces that do permit it, have adopted an “Enhanced OM” version that limits the investment amount to a maximum of $10,000.
A good discussion about the Offering Memorandum and provincial nuances can be found on Venture Law Corporations website.
Seed Offering Memorandum (“SOM”)
It would be good for Canada to have a standard, Canada-wide form of Offering Memorandum that would allow entrepreneurs anywhere in Canada to sell their shares to investors anywhere in Canada.
Rather that change the current Offering Memorandum form, it is suggested that a new exemption, e.g. a “Seed Offering Memorandum” be implemented that would specifically address the financing needs of new ventures. This might also have a better chance of getting national adoption rather than getting all of the provinces to accept an exemption that, up until now, they’ve rejected.
In the meantime, B.C. is in a good position to lead the country with a working solution – as outlined herein.
Seed Offering Memorandum (SOM) Features
The SOM would, at a minimum, be similar to the current Offering Memorandum but with the following attributes:
To be used by new ventures (i.e. start-ups seeking arms-length investors)
- Eliminate the requirement for audited financial statements*
(*this is the only aspect of the current form that would be eliminated)
- Retain and reinforce the “Risk Acknowledgement Form” (e.g. make investors
write-off their investment)
- Require an independent Board of Directors (minimum of two plus the founder)
- All directors must sign the SOM attesting to its completeness & accuracy
- More disclosure on capital structure naming principal shareholders
- More disclosure on principals – detailed resumes
- Include standard Term Sheet provisions (e.g. vesting provisions, voting, etc)
The sole subtraction from the current Offering Memorandum form is the need to include audited financial statements – something that makes little sense for a startup that has no history. Every other attribute that’s suggested is in addition to what’s already in place.
In the spirit of protecting investors – a primary concern of the regulators – the Seed Offering Memorandum (the “SOM”) would require that entrepreneurs have an independent board of directors (minimum 2 directors plus the founder) and that these directors sign off on the SOM.
For even greater investor protection, the SOM could require that a set of standard terms such as those used by angel investors or venture capitalists be addressed, e.g. a set of questions that are answered in the SOM. For example, will founders’ shares reverse-vest? If so, what are the terms and criteria? Is there a shareholders agreement? How will directors be appointed? In the case of a founder holding a majority of voting shares, how will shareholders’ interests be served? How will directors be appointed?
Valuation will, as it always is with start-ups, be a key concern. An SOM should provide the rationale for the venture’s pre-money valuation. Perhaps the SOM’s use should be restricted to start-ups valued below a certain threshold?
Most importantly, the SOM should clearly be defined as a tool for start-ups with low valuations and with modest funding needs (e.g. companies raising less than $1 million with valuations under $5M).
Bottom Line Footnote
To be clear – and this is an important message to regulators – I am NOT advocating that we make it easier for entrepreneurs to access crowd capital. I am suggesting that we make it cheaper. It’ll be cheaper because they won’t have to spend a lot of money on audit fees or legal expenses but it won’t be so easy because they need to get a board of directors and accept angel style term sheets! We need to improve the quality of deals while at the same time letting more investors access these deals.
Comments welcome! Please use the reply box or email mike (at) volker (dot) org. (An earlier commentary was posted in January 2012)