Equity crowdfunding: does it have a role to play in the financing of Canadian startups?

Crowdsourcing refers to the activity of an individual or group setting out to achieve a particular project or goal by appealing for contributions from members of a (usually online) community. Crowdfunding is merely an extension of the concept of crowdsourcing to the activity of sourcing funding for a particular project or goal. Crowdfunding projects or goals are often charitable or civic-minded, but they may also take the form of appeals by startup companies for a small financial contribution from members of an online community to help fund the development, production or marketing of an innovative product or service.

Theoretically, crowdfunding would appear to be a method of raising equity financing that would be especially well-suited to matching startups with retail investors. For the founders of a startup, selling small equity stakes in their business through crowdfunding can provide them with access to an attractive form of financing since a company generally has no legal obligation to repay the capital of its owners. For retail investors, crowdfunding can provide them with an opportunity to get in on the ground floor of a new and potentially highly lucrative business startup – an opportunity usually reserved for family and friends of a startup’s founders (angel investors) or deep-pocketed private equity funds (venture capitalists).

Creating a legal framework to realize the potential of crowdfunding as a method for raising equity financing for startups is, however, proving to be a challenge. In Canada, the obstacles to doing so are primarily conceptual and political in nature. Conceptually, offering small ownership interests in a startup through crowdfunding constitutes an offering of securities to the public which is subject to the very burdensome and expensive prospectus and registration requirements under Canadian securities legislation. Equity crowdfunding does not qualify under either the accredited investor or the private issuer exemptions that are currently the most commonly relied upon exemptions from such requirements. Politically, the Supreme Court of Canada’s 2011 decision in Reference re Securities Act affirmed that securities regulation is prima facie a matter that falls under the provinces’ constitutional authority over property and civil rights, which means that startups would have to comply with the securities regulations of all of the Canadian provinces in order to engage in an equity crowdfunding raise that would be open to Canadian investors nationwide.

Few, if any, startups would be able to justify the costs of complying with all of Canada’s provincial securities regulation regimes just to be able to legally accept what would be comparatively small equity investments from a pool of available investors that’s one-tenth the size of the investor pool in the United States, which further benefits from having a national securities regulator in the U.S. Securities and Exchange Commission. But even if the existing provincial opposition to a national securities regulator in Canada were to disappear tomorrow, the viability of equity crowdfunding as a method of raising financing for Canadian startups would depend on the content of the legislation that would be put into place to regulate it.

If the devil is in the details, for proponents of equity crowdfunding, the initial American experience cannot be especially encouraging. The Jumpstart Our Business Startups Act (the “JOBS Act”) that was ratified in the United States in April 2012 contained a new securities exemption and a proposed new regime that were specifically designed to regulate equity crowdfunding. While the crowdfunding provisions of the JOBS Act were initially embraced by entrepreneurs and business commentators based on their stated objectives, securities attorneys who’ve actually studied those provisions closely have been quick to point out that their many restrictions cumulatively pose serious compliance challenges that will likely eliminate equity crowdfunding as a viable financing option for most U.S. startups. Those restrictions include: significant disclosure and annual reporting requirements, a 12-month restriction on the resale of shares issued as part of a crowdfunding transaction, a prohibition on advertising, capital raises being limited to $1 million in any 12-month period, and crowdfunding share issuances and sales having to be conducted only through registered funding portals or registered broker dealers.

In other words, the proposed requirements to regulate equity crowdfunding in the United States appear to have focused heavily on the goal of protecting “Main Street” investors from fraud, while arguably failing to recognise that the social media origins of equity crowdfunding make it a unique form of investing that does not fit easily within existing investment paradigms. This is because consumers who decide to participate in a crowdfunding campaign typically tend to be motivated, to some greater or lesser degree, by the emotional conviction that a particular product or service that’s deserving of their financial support would make the world at least a marginally better place. Judging from the contents of Staff Consultation Paper 45-710: Considerations for New Capital Raising Prospectus Exemptions that was issued by the Ontario Securities Commission in December 2012, the JOBS Act’s approach to regulating equity crowdfunding is likely to have considerable influence on any equity crowdfunding exemption that may be adopted by Canadian securities regulators.

Given Canada’s comparative lack of scale and the daunting nature of the legislative and jurisdictional challenges described above, it’s doubtful that equity crowdfunding will play a significant role in the financing of Canadian startups for the foreseeable future. It’s more likely that the reward-based crowdfunding model popularised by websites such as Kickstarter, Rocket Hub and Indiegogo will remain the dominant and most viable crowdfunding model for Canadian startups. (Startups that use the reward-based crowdfunding model avoid the legal restrictions imposed by securities legislation by offering contributors perks of various sorts – usually in the form of a product or service – in return for their financial support, instead of an ownership interest in the startup.) In the for-profit sector, the reward-based model of crowdfunding has been, and will likely continue to be, most popular as a fundraising method for Canadian startups that are involved in creative and artistic fields such as the visual arts, software and video game development, consumer tech products and the production of independent music, documentaries and films. For-profit Canadian startups as well as small to medium sized enterprises that operate in mature industries that sell an established product or service with little or no “buzz” factor are unfortunately likely to continue to find themselves largely shut out from crowdfunding as an alternative source of financing.