Even angel investors need a devil’s advocate, so here I am.

There’s a lot of buzz about the push by the Canadian Advanced Technology Alliance and other parties to get equity crowdfunding legalized in this country.

Christine Wong, staff writer, ITBusiness.ca

They fear Canada’s tech startups will lag behind those in nations where it’s already legal – the U.S., U.K. and Australia – if they don’t gain better access to capital through this new combination of social media and investing.

Removing red tape would obviously make it easier for Canadian startups to tap into this type of funding. That’s a good thing.

But what are the risks? Without trying to be a negative Nelly (or a critical Christine?), I think it’s worth taking a sober second look at the potential risks or downsides of crowdfunding.

One is that, at least in the way the U.S. JOBS Act has made it legal, crowdfunding is by its very nature subject to less rigorous oversight and regulation than traditional equity investment in larger companies. Startups planning to raise less than $1 million via crowdfunding within 12 months don’t have to file a prospectus.

For startup founders still in their twenties or early thirties, this doesn’t seem like a big deal. I’m old enough to remember Enron, though. And WorldCom. And closer to home here in Canada, Bre-X. After all of those scandals – massive frauds that collectively bilked thousands of investors out of billions of dollars in the late 90s and early 2000s – the Sarbanes-Oxley Act in the U.S. and Bill C-198 in Canada were brought in to tighten up regulations around companies offering equity shares to investors.

Obviously one startup taking small amounts of money each from hundreds or even thousands of individual investors could never add up to a multi-billion dollar fraud like the Enron scam. In fact, the U.S. JOBS Act actually caps the amount an investor can invest through crowdfunding: if your annual income or net worth is less than $100,000, you can only invest up to $2,000 per startup. Still, there’s nothing in that law that prevents individual Joe Investor from investing $2,000 each in 50 startups, which would increase his exposure to potential losses overall.

And what about the risk that a startup, which may have no revenue, just goes under as quickly as it appeared, or simply takes investors’ money and runs, with no real intention of building a company? Under the U.S. law, startups looking to raise less than $100,000 must have their CEO certify that their financial statements are correct. Startups that want to raise between $100,000 and $500,000 must have their financial statements reviewed by a public accountant. Doesn’t sound too bad.

But while companies that trade on U.S. markets after a traditional IPO filing must file public financial statements quarterly, startups governed by the crowdfunding law only have to provide that information to investors annually – that’s right, once a year. A heck of a lot can change with a startup’s financial position in 12 months.

Can something as risky and complicated as equity investing just be made too easy? I hope not. I’m counting on the fact that as Canadians who typically tend to be more cautious and reserved about anything to do with money, our regulators will find a way to open up capital access for startups without putting investors at undue risk. Our bank regulators were credited with being the voice of reason while other financial systems melted down around the world. Perhaps our securities regulators can do the same with crowdfunding.

While we’re all waiting for the provinces to pass crowdfunding legislation (securities law is a provincial responsibility, not Ottawa’s), investors should bear two things in mind when mulling over whether to invest their cash via crowdfunding in the future.

First: statistically, most startups fail (30 to 40 per cent liquidate their assets and lose all or most of their investors’ money; 70 to 80 per cent fail to attain their projected return on investment). So when you invest in one, know the risk is higher than with a larger, more established company.

Second: everything new is accompanied by lots of hype. There will be great startups raising money for legitimately viable, innovative stuff through crowdfunding. There will inevitably be many that are kind of weak and not worth investing in. Similarly, there will be huge expectations about what crowdfunding can do, especially for Canadian startups. After the initial hype settles down, will it gain longterm traction? Perhaps, but in a quieter, more realistic way than what we’re hearing about now.

So be prepared, be vigilant and be cautious. That shouldn’t be hard. We’re Canadian.

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  • The jobs act states: “Investors with an annual income or net worth of less than $100,000 will only be permitted to invest the greater of $2,000 or 5% of their annual income or net worth in any 12 month period. Investors with an annual income or net worth greater than $100,000 will be permitted to invest the greater of $100,000 or 10% of their annual income or net worth. Investors are limited to investing $100,000 in crowdfunding issues in a 12 month period.”

    So the sentence ” Still, there’s nothing in that law that prevents individual Joe Investor from investing $2,000 each in 50 startups, which would increase his exposure to potential losses overall.” is not really accurate and the overall risk is smaller if the individual diversifies.

  • All investing is about risk and reward. The greater the risk the more reward (mostly). But, the smart investor will mitigate those risks as best they can by doing a little homework on the companies they invest in (crowdfund). It is what accredited investor or professional investors do to limit their risk.
    While the Act does limit investment per person – no one will (have the ability) to monitor what each person actually invests – thus, they could invest $2,000 in 50 startups – just might have to do it through 50 different platforms or under different names.