Equity Crowdfunding – Doing it Right (for discussion)

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 March, 2013, CATA, the Canadian Advanced Technology Association, prepared a thorough response to the OSC after consultations with many stakeholders. That letter can be found [here.]

Background Inforation

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)


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13 Responses to “Equity Crowdfunding – Doing it Right (for discussion)”

  1. Mike,

    As always, some valuable suggestions for nudging the existing system along. I think Brad’s thrust is to take into account the fact that the past is no longer prologue for the economies of the USA and Canada and our capital markets need to be redesigned with that as a point of departure.

    The reality is that:
    1. 60% of angel deals lose all capital;
    2. widows and orphans are also greedy; and
    3. secuities commissioners and their staff are criticised for any failure to make money, well almost, and hence cannot permit the level of early stage investment needed by our economy to compete.

    Why do we not try to solve their problem by removing the grounds for criticism while letting those of us who want to do this type of funding do it at our own peril without the “protection” of those who have been unable to strike the balance needed between growth and protection despite their mandate.


  2. Hi Mike,
    By coincidence, Paul Niederer, our colleague CEO of Australian Small Scale Offering Board (ASSOB)has also asked my comments on investor protection. I like to comment on investor protection because it is the fear of investor fraud that essentially delays our securities regulator from legitimizing equity based crowdfunding.

    I agree with all your points. In addition, here are some of my thoughts on investor protection:

    1. Equity based platform are better managed by public venture capitalists or merchant bankers like us who are accustomed to running public companies and associated best practices in corporate governance.

    2. If one agrees with point 1, then the protection of investors should be a joint responsibility of the merchant banker and investees/ clients.

    3. Healthy Crowfunder will co-manage its investees’ private companies just like any public company without the frills costs.

    4. To avoid playing Russian roulette with their investments, I encourage investors and the related securities regulators to initiate investor education curicula connected to the industry an investor is putting his money in. Thus, he becomes more aware of the risks associated with that industry. Buying shares of a company private, or public, is the same as buying into a business. The only difference is that, one becomes a passive investor instead of an active operator. [I have contacted the British Columbia Institute of Technology where I taught corporate finance to consider offering industry related investment courses. Given it takes time to put things into action in a government backed and unionized educational institution, I have also contacted the BC Securities Commission director of education to offer the same with the backing of private schools.]


  3. John Arnott says:

    Mike, Peter,

    Some good thoughts that deserve consideration but I think we are missing a couple of points;

    All calls for regulation and restrictions ‘to ‘protect the public’ are seriously misplaced. A recent article by the CfPA shows that the occurrence of fraud is close to non-existent, for a variety of reasons. (I shall attach a link.) It seems that the concern about fraud is mostly spread by those most likely to lose control, and that the emphasis should be on rapid detection rather than prevention: The threat to entrepreneurship and job creation is far more a threat than the individual ‘small scale’ investments.

    My second point is that in this discussion there is too little distinction between crowd ‘equity’ funding as proposed in the US JOBS legislation, and in the benefit crowdfunding as used in KickStarter and others. As an industrial design entrepreneur, the latter model provides an escape from the tyranny of the largely failed venture capital markets and other seed sources. The legalisation of this form of funding without major restrictions, would enable many entrepreneurs to achieve capital accumulation without the horrendous expense of a prospectus that can only pretend to lead to success.

    I believe that this form of funding could lead to truly ‘free’ markets and allow entrepreneurs to access global markets that the web truly presents. We should work toward a framework that will enable it, not strangle it. There are over 450 crowdfunding sites in existence today. Surely the demand has been demonstrated.


    • admin says:

      John – to be clear – my suggestions pertain ONLY to EQUITY CROWDFUNDING. The other forms of crowdfunding are great, too!

  4. Mike,

    Great blog post to start the discussion on equity crowdfunding and move things along in Canada. I read the comments above and appreciated how thoughtful they all were. One thing in particular resonated with me – Tony’s point #4 about the need for investor education. That’s essential – for both investors and entrepreneurs.


  5. Daryl Hatton says:

    Mike, you have laid some excellent groundwork for making the OM an effective and efficient vehicle for helping businesses raise capital through private placements. Getting securities regulators to see the value of this approach has to be our number one goal. This will entail the hard work of helping them understand and agree that the definition of accredited investor be expanded to allow less wealthy individuals to take risks and participate in wealth creation investments and supporting entrepreneurial businesses in Canada. It’s a big challenge but not insurmountable.

    At the same time we need to ensure that public solicitation of potential investors is not disallowed. In the BCSC report from earlier this year (http://www.bcsc.bc.ca/uploadedFiles/news/publications/2012-2015_BCSC_service_plan.pdf) there is language that indicates they want to increase their oversight of social media and internet solicitation. Oversight is good but we know that, in their zeal to be protective, regulators tend to stifle legitimate activities. Our second goal must be to ensure the companies can legally promote their investment opportunity on their own web site and on public portals.

    Finally, to truly implement the vision of crowdfunding, we need to get the regulators to allow funding portals to broker transactions on behalf of the expanded pool of accredited investors from step # 1. This step will likely have to follow the first two as it is the biggest leap for the model and has the highest risk to the public.

    While this third step is a major ‘feature’ of the US JOBS act, it is the component that is encountering the most resistance from the regulators and the established industry bodies. It appears that this may slow down if not completely stall the crowdfunding initiative in the US as the regulators grind through a consultation and evaluation process. If we focus on a ‘made in Canada’ solution of an OM with social media solicitation of investors (but not yet pitch for transaction portals) we can accomplish the goal of helping entrepreneurs raise the money they need for their businesses from a larger potential investor base, improve our chances of success and still keep the risk level manageable.

    In the interests of full disclosure, I’m the CEO of the largest crowdfunding (gifts and rewards) portal based in Canada. We don’t believe that crowdfunding equity via a transactional portal will be legal any time soon in Canada. In fact, given the risks of fraud, we prefer that the regulatory environment for crowdfunding equity be well established before any portals (FundRazr included) are allowed to enter this space.

    Let’s make sure we focus on the main goal, helping entrepreneurs raise the capital they need, and not on the form. Mike’s proposal for the OM is a great one and deserves our support.

    • admin says:

      Thanks for the support, Daryl. Indeed, crowdfunding won’t work if solicitation isn’t permitted. And, that’s a tougher issue for regulators. My Seed OM Proposal doesn’t address the broader crowdfinding challenge of promotion and awareness. I believe that getting a new exemption that entrepreneurs can use immediately is a good first step because it’s not a major step – just a little one to help entrepreneurs now.

  6. Greg Smith says:

    Mike, as you know I am not sure the problem in our eco-system is “access” to early stage capital. I think there is enough – in fact the stats would suggest there is too much. Canada funds on pro-rata basis 3x the number of start-ups than the US.

    IMHO, the problem lies in:
    1. We don’t build companies that scale – I place this responsibility on the management, investors and board members to make sure the vision and strategy can lead the company down a path to providing compelling value for their solution – not a feature of the solution. We, as investors, should be working on our companies to focus on big-picture problems and find ways to consolidate and build kick-ass companies.

    2. We need exits for the angel investors – I think we would all take a 5x return in 5 years than wait 10 years for 20x. I think crowd funding of secondary offerings make more sense where there are real metrics to base valuations on AND a higher likelihood of the smaller investors will make money. Turning the cash, makes the ecosystem work better. I would like to see some of the VCs allocate portions of their investment to buying ownership of the scalings companies from the angels. They will in turn, fund the next set of startups.

    • admin says:

      Thanks, Greg – what I’m trying to address is the situation in which an investor, is not allowed to invest because she isn’t accredited. I regularly see entrepreneurs having to turn away investors just because they are not millionaires.

  7. Great conversations all. I agree with the OM ‘lite’ argument. We need to ensure that start-ups and second stage companies have the governance and investment readiness required to reach out to a larger pool of investors. This pool has to include non-accredited investors, hence the requirements for additional regs changes to allow for the ‘crowd’ to invest in these companies.

    Canada may do a good job of funding start-ups, but many of those may fail, not because they aren’t well run, but because they can’t access second stage funding – that between friends and family and VC’s or more traditional money. It’s the $500K to $1.5M that is especially hard to come by.

    OM lite (a less expensive process) – and allowing for a broader investment pool will help. Accredited investors account for 1% of the population. Give our entrepreneurs access to the next 20%. Not EASY money, but CHEAPER money as Mike says.

  8. ASSOB’s business in Australia is built around a document similar to the “Offering memorandum” Mike talks about. We call it an Offer Document. It does not have to be lodged with the authorities but it has legislation prescribed warnings that these type of investments are high risk and investor beware. We have caps of $2 million if the entrepreneur raises the money themselves or $5 million if they operate through an intermediary. The authorities have nothing to do with these raises unless of course they go wrong.

    Our own rules have been added to strengthen these offerings. They are similar to what Mike has suggested for the Seed Offering Memorandum. Risk acknowledgement by the investor is essential as is the founders taking full responsibility for everything communicated about the offering.

    We dont use term sheets etc as that complicates things. A standard Australian company registered under the Corporations Act with ordinary shares issued for the capital raising does the trick.

    I believe the path Mike suggests is the same that should be taken in Australia. Existing legislation is modernised for the emergence of so called crowdfund investing. I can see that this Canadian legislation is an excellent place to start. The American implementation is rapidly heading towards broker/dealer involvement and an up front fees cost of $20,000 minimum and over 10% success fees. This will stifle the very thing they are trying to achieve. Upfront costs need to be under $5000 and no filing with authorities, and both the investor and promoter need to clearly acknowledge their responsibilities.

  9. I think Canadian regulators should take a hard look at the statistics of equity based Crowdfunding in other countries which have been doing this form of capital raise for years.

    Facts from a comprehensive May 2012 study by Crowdsourcing.org entitled CROWDFUNDING INDUSTRY REPORT: Market Trends, Composition and Crowdfunding Platforms provide an excellent roundup on equity Crowdfunding and its acceptance and its evolution in recent months. Some key findings:
    • Companies using equity Crowdfunding in 2011 raised $103.5 million, showing this method of capital raising has significant potential.
    • 18% of all Crowdfunding included in the study came from equity Crowdfunding, instead of donation-based, lending-based and rewards-based Crowdfunding. Again, this is a significant number, since in many geographical markets including the key US market, equity Crowdfunding is illegal. Most “equity Crowdfunding” companies are still in a preparation rather than active implementation stage.
    • Equity-based platforms grew from 2009 through 2011 at a rate of 114%, primarily including those based in Europe.
    • Equity-based Crowdfunding is most effective for digital goods such as applications or computer games, films, music, or literature. It also raises the largest sums of money per campaign. More than 80% of the campaigns in this category raised above $25,000.
    • 21% of the funds raised by equity-based platforms were raised for projects that drew $250,000 or more in funding.

    While equity Crowdfunding is active in Europe, Australia,South Africa and elsewhere there has been no published reports of fraud in all of these years of operation. This strongly suggests that these platforms and processes have employed the correct checks and balances to deal with such corrupt activities.

    What can we learn from those who are doing it today? It is working – something must be right.

    The elephant in the room for Canadian regulators, in not accepting equity based Crowdfunding, is the crippling fear of adopting something new. We know most equity based investors have gone upstream in their investing activities leaving start-up and emerging companies gasping for cash. This is probably why Canada’s Innovation Ranking has declined two more indices in the 2012 World Economic Forum Report, ranking below Romania.

    How can SMB’s be an engine of growth when the investment available to them comes from a scant 1% of so called accredited investors and they are not even interested in investing?

    The answer is so evident when we look at what other countries have been able to achieve. So it’s time our regulators face their fears and get on with making equity based Crowdfunding work here in Canada.

  10. Colin Lyons says:

    There has been an increasing level of discussion surrounding this topic lately in Canada with the focus often in the wrong areas. Many people have been looking to model our progression with our legislation after the recent drafting of the JOBS act in the U.S. and lately conversations have arisen about using CrowdCube – a UK crowdinvestment site – as a model for future Canadian sites.

    As a Canadian, I believe we should be comparing our actions to the U.S. when the U.S. is already behind so many other countries that have an active crowdinvestment industry developing. Who knows how long the U.S. will postpone the creation of regulations, and how they will end up turning out. We need to look to other countries, particularly the UK that have embraced this new form of financing.

    That said, CrowdCube is not an ideal company to model Canadian platforms after. CrowdCube goes around financial regulations through a loop-hole, that is not regulator approved and has not been tested in court. Their model does not have them acting as a trustee for the investor and investors are left with non-voting shares. On the other hand, Seedrs is another UK crowdinvesting platform that has been regulator approved, acts as a trustee on behalf of investors and in fact takes a portion of its commission from the profit made by investors. Therefore, Seedrs is aligned with its investors over the long-run and as a trustee can act on behalf of the shareholders to protect their interests.

    The main risks are fraudulent entries, the natural high failure rate of start-ups and the risk early shareholders will be diluted by later investments. All three of these risks can be significantly reduced by the platform, depending on how prudent they are with their guidelines and internal processes. The first risk would require identity checks, criminal background checks, credit checks, etc.. The second risk involving the high failure rate of start-ups can be mitigated by having an individual only investing a small portion of their financial portfolio in start-ups, but also by having a diverse start-up portfolio through many small investments over a large number of start-up companies. Many regulators see a larger minimum investment as a means of filtering investments for higher net worth individuals, but really the best way of reducing risk is by reducing the minimum investment criteria. Lastly, the risk of dilution can be overlooked by unwary first-time investors, but it is the most predominant risk. Angel investors and venture capitalists normally protect themselves with an anti-dilution clause, but the crowd-investors may not gain such a luxury if the platform dictating the terms does not protect their investors. It is especially due to this risk that I will only crowdinvest with a platform that has its interests aligned with the investors, and that does not merely generate all of its commission the moment it brokers the initial deal.

    We have every ability to create a world-class crowdinvesting industry today in Canada. We are a wealthy country with a massive entrepreneurial brain drain. I am a young entrepreneur myself, but I will be one of the first to invest in others here in Vancouver.

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