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New money

Legal Report: Securities Law
|Written By Charlotte Santry
New money
Illustration: Pierre-Paul Pariseau

Small businesses and startups across Canada look set to gain much wider access to capital under proposals to permit equity crowdfunding. In recent months, securities regulators in Ontario, British Columbia, Saskatchewan, Manitoba, Quebec, New Brunswick, and Nova Scotia have all released plans that would allow businesses to raise cash in this way.

Unlike traditional crowdfunding models such as Kickstarter, which treat online contributions as donations or offer a tangible product in return for financial help, equity crowdfunding allows businesses to solicit cash in return for a stake in the company. “Social technology, the Internet, crowdfunding portals like Kickstarter and IndieGogo have demonstrated the efficiency and the power and the sexiness of looking to the crowd for capital to fund any number of initiatives,” says Eric Apps, a lawyer at Wildeboer Dellelce LLP.

In the United Kingdom, where equity crowdfunding is already allowed, Scottish beer-maker BrewDog raised £4.25 million (Cdn$7.85 million) over six months last year by offering 42,000 shares to investors via an equity crowdfunding platform. The United States plans to allow similar schemes through its Jumpstart Our Business Startups Act.

Canada suffers from a lack of investment in technology, says Apps. “The idea of encouraging any easier means through which people can get access to capital will be well-received in the startup community. The question becomes what’s the appropriate regulatory environment.”

The Canadian regulators’ proposed rule changes would allow businesses to raise capital through equity crowdfunding without having to issue a prospectus — the detailed and often costly legal document providing information to investors. Generally, securities cannot be sold without a prospectus. The Ontario Securities Commission released a consultation paper March 20 — the same day regulators in Saskatchewan, Manitoba, Quebec, and New Brunswick published similar proposals. The three latter provinces, in addition to British Columbia, are proposing a prospectus exemption for startups, aimed specifically at small and early-stage businesses, similar to Saskatchewan’s existing regime.

The consultation papers shed light on how regulators hope to balance the need to appeal to businesses while at the same time protecting inexperienced investors and avoiding scams. The OSC wants to cap the maximum amount that can be raised through a registered portal at $1.5 million a year. Investors would be given an “acknowledgement form” highlighting the key risks associated with the investment, and could contribute $2,500 per investment, to a maximum $10,000 per calendar year. They would receive limited disclosures at the point of sale and on an ongoing basis.

Crowdfunding portals must be registered only as a restricted dealer, conduct background checks on users, and not make recommendations or operate as a market or exchange.

Some think the $1.5-million threshold could be too low, due to the legal and accounting costs faced by issuers, which can amount to $250,000, says Shara Roy, of Lenczner Slaght Royce Smith Griffin LLP. “That’s quite a large cost compared to the potential upside,” she says.

Ted Maduri, a partner at Davis LLP, points out the lower the per-investor limits the higher the number of shareholders. Many startups are looking for $1 million, which under the current proposals would require 400 shareholders. Marudi therefore urges against the addition of further disclosure requirements, or reducing the limits to try to protect investors. “To have even more checks and balance puts an unbelievable burden on these companies that are trying to raise capital. I think there are sufficient checks and balances in the system, in particular [portal] registration and background checks [on issuers].”

The proposal under consultation in B.C. is more financially restrictive than Ontario’s, but does not require portal registration and is available to non-reporting issuers only. It would only allow businesses to raise $150,000 per offering, and would limit investments to $1,500 per person.

Businesses would have to provide investors with a “streamlined offering document,” and portals would still be subject to certain rules. For example, they would be banned from giving investment advice and would have to require investors to confirm they had read and understood the issuer’s document and risk warnings.

Alberta is yet to release any proposals and is taking a “wait-and-see” approach, says Marek Lorenc, of Davis LLP’s Calgary office. This may be simply due to a lack of demand. “There’s a growing number of startups in Alberta, but the demand for the exemptions is really driven by Ontario. There’s quite a strong startup community, a lot of small and medium enterprises, operating there,” he says.

The uniquely disparate nature of Canada’s provincially organized securities regime could create problems for businesses planning to use these new regulations. Many startups will be regionally based, but the appeal of crowdfunding is premised on reaching out to as many people as possible. The prospect of having different rules across the country “limits the appeal of the exemptions,” says Lorenc. “If you’re restricting those who can invest based on their provinces, you’re splitting up the potential investments that these companies can receive.”

Given Canada’s population distribution, perhaps companies will simply choose to comply with Ontario’s requirements, regardless of where they are based. Roy says it will be interesting to see where investors are coming from, and “whether companies will need to meet the Ontario requirements in order to raise more money, or whether they will gravitate towards their own regulator.”

Keeping the bar high on disclosures and screening, rather than dropping to the lowest common denominator to ensure uniformity, would go down well with many people in the field. Apps, for example, is concerned not enough discussion has centred on the need to protect and educate investors. Whereas securities investment has traditionally been “the playground of the rich,” the mooted changes would allow a broader group of people to participate in risky ventures, he says. “They may know very little about the business or the people behind the business, because most of these companies will be very little more than simply an idea,” Apps adds, encouraging the portals to take ownership of the issue.

If investors treat their contributions as akin to betting on horses or playing the lottery, their expectations may be aligned with reality, he says. But he warns without a sufficient understanding of what they are getting into, investors could end up feeling cheated and frustrated, which would backfire on issuers and portals in the long term.

The threat of fraud and money laundering is one of the main fears raised by opponents of equity crowdfunding, especially taking into account investors’ relative lack of sophistication. Investors will certainly need to be on their guard. Alixe Cormick, at Vancouver-based Venture Law Corp., says angel investors in B.C. normally mark down issues by up to two-thirds from the valuation provided by startups. “With crowdfunding, the price put up there is determined by an issuer and whoever their consultants/lawyers are,” she highlights.

Cormick agrees on the need for portals to make the risks clear to the public, but is less concerned about the danger of equity crowdfunding platforms being exploited by con artists. “The Internet has a long memory. That’s a really strong deterrent for doing anything crazy,” she says. Investors are very likely to check a business’ online footprint, which she feels significantly reduces the likelihood of large-scale fraud.

As the plans are all still out for consultation, it is hard to accurately gauge their impact on the startup community, or the amount of business the changes could generate for lawyers. “The size of it and where we play a role would ultimately depend on the exemptions adopted by the provinces,” says Lorenc. “If it’s usable, and people see it as being an effective way to raise capital, we could have quite a bit of work.”

It seems unlikely anything will be implemented before the end of the year. OSC vice chairman James Turner is reported to have told delegates at a National Crowdfunding Association of Canada event in April they should not expect to see any official rule changes until 2015.

There is a risk that, by the time these new regulations are adopted, they will already be outdated, says Roy. “Even though equity crowdfunding is a fairly new way to raise capital, I expect the technology will evolve, I expect investors’ wish to participate will evolve, and the regulators will need to evolve,” she says. “It’s a commendable process, but this has happened over two years almost already, so there will be a bit of catch-up to be had,” she adds.


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