Access to startup funding and growth capital is essential to developing Canadian businesses and promoting entrepreneurialism, but small and medium-sized enterprises in Canada face legal and practical challenges raising capital at early stages of their business cycle.
Recognizing this, the Ontario Securities Commission has proposed enabling SMEs to raise equity in the exempt market through the use of crowdfunding portals. The OSC’s crowdfunding exemption signals a positive trend in Canadian equity financing: SMEs will be able to access capital with relative ease and minimal costs and Canadian investors will be able to invest in SMEs that may otherwise be inaccessible. With proper mechanisms in place to protect Canadian investors from unscrupulous fraudsters, the crowdfunding exemption has potential to start a groundswell of activity and equity-based growth amongst SMEs.
Crowdfunding is a method of funding a project or business venture through small amounts of money raised from a large number of people via an Internet portal intermediary. Crowdfunding originated with fundraisers seeking to raise money by soliciting small donations from the general public intended to assist the fundraiser in developing a product or launching a venture without providing any specific return to the donor. As the public recognized the success of crowdfunding and competition for contributions increased, fundraisers responded by offering perks in exchange for contributions. Inevitably the crowdfunding model evolved and is now increasingly used to facilitate other financings such as micro-loans.
Crowdfunding has more recently been used as a mechanism for SMEs to raise equity in exchange for securities of the issuer. Equity crowdfunding is already active in the United Kingdom and the Securities and Exchange Commission is currently assessing a proposed crowdfunding prospectus exemption for issuers in the United States.
Responding to the popularity of crowdfunding and interest among Canadian SMEs to access the exempt market through a low-cost prospectus exemption, the OSC initiated consultation in December 2012 seeking feedback regarding the possibility of a new prospectus exemption to facilitate raising equity through crowdfunding portals.
The OSC is attempting to create a system balancing protection for investors and fostering fair and efficient capital markets. Because equity crowdfunding is targeted toward SMEs operating on shoestring budgets and retail investors who may have little or no sophistication regarding capital markets, securities regulators must establish a regulatory framework that protects investors’ interests while keeping issuers’ compliance costs low.
The crowdfunding exemption closely resembles the framework published during the consultation and includes the following key elements:
Limits on the types of issuer, size of offering, and types of securities
Consistent with the policy promoting capital raising by SMEs, the OSC has imposed restrictions on the crowdfunding exemption to reduce risk and encourage simple offerings.
First, only Canadian reporting issuers and non-reporting issuers that are not investment funds, real estate issuers, or blind pools may access the crowdfunding exemption.
Second, issuers will be permitted to raise only up to $1.5 million total in any 12-month period. There is no limit to how often an issuer utilizes the crowdfunding exemption in any 12-month period, provided the issuer does not exceed the aggregate limit.
Third, issuers may only offer prescribed securities — for example, common shares or preference shares that are relatively simple.
Limits on amount investors can invest
Consistent with the policy of minimizing risk, investors will not be permitted to invest more than $2,500 per offering and more than $10,000 total in a calendar year. The SEC’s approach links the maximum permitted annual investment amount to the investor’s net income, enabling investors to invest more money and undertake more risk commensurate with the investor’s net income.
The OSC adopted specific maximums because it is easier to administer and avoids concerns that investors may be unwilling to share tax information with the issuers.
Initial and continuous disclosure requirements
Issuers must provide prescribed point-of-sale and continuous disclosure to investors who acquire securities under the crowdfunding exemption. To minimize costs to issuers, the initial offering document has few prescribed requirements, but it must include a warning to investors and certain facts about the financing, the issuer, and the registered funding portal.
The required continuous disclosure depends on the issuer’s status as reporting or non-reporting. Reporting issuers must comply with existing continuous disclosure obligations prescribed by National Instrument 51-102 Continuous Disclosure Obligations. Non-reporting issuers must comply with the continuous disclosure obligations prescribed by the crowdfunding exemption, including the preparation and delivery of annual financial statements to investors within 120 days of the issuer’s financial year-end.
Regulation of funding portals
Funding portals must be registered as a restricted dealer under the Ontario Securities Act and will be permitted to act only as an intermediary to an offering; among other restrictions, funding portals will not be permitted to provide recommendations or advice, solicit purchases or sales of securities, or handle investor funds.
Funding portals are the gatekeepers of the crowdfunding exemption and must conduct due diligence on both issuers and investors. For issuers, this includes background checks on issuers, directors, executives, and other representatives; confirmation of existence; valid business registration and solvency.
For investors, this includes taking reasonable steps to ensure investors understand the risks of investing and obtaining written certification from investors of compliance with the annual investment limit.
Inclusion of non-securities rewards
Traditional crowdfunding models typically reward contributors with some form of perk. Recognizing the importance of these perks to contributors and to keep the crowdfunding exemption connected to the grassroots of crowdfunding, the OSC permits issuers to offer non-securities rewards to investors concurrently with the securities offering.
Pairing the opportunity to be an early adopter of an SME’s product or service with the ability to invest and share in the growth of the SME creates compelling and attractive incentives for investors and SMEs to utilize the crowdfunding exemption.
The OSC is accepting written comments regarding the crowdfunding exemption until June 18. For more information or to submit written comments, please visit the OSC web site.
Graham King is a partner and Kyle Denomme is a student-at-law with Borden Ladner Gervais LLP.
The views expressed here are solely the authors’ and should not be attributed to Borden Ladner Gervais LLP or its clients. The author makes no claims, promises or guarantees about the accuracy, completeness or adequacy of any information referred to or contained herein. No person should act or refrain from acting in reliance on any information found herein without first obtaining appropriate professional advice. The following is presented for informational purposes only and does not constitute legal or other professional advice and does not create a solicitor-client relationship between you and the authors.