Yesterday I had the distinct pleasure of being invited by the National Crowdfunding Association of Canada to be a panelist at their breakfast briefing “Igniting Entrepreneurship and Capital Flow in Ontario.”
The other distinguished panelists that I spoke alongside of were James Turner, vice chair of the Ontario Securities Commission, who gave an overview of the Ontario Securities Commission regulatory framework; John Wires of Wires Law who gave the legal overview; Jos Schmitt of Aequitas who spoke of structuring a portal and building an exchange for private securities and how that may be affected by crowdfunding; and yours truly, sharing my views as an investor. We spoke to a sold out audience led by Craig Asano, founder of NCFA and Murray McKercher, NCFA board advisor.
The timing of this briefing coincided to the “Introduction of Proposed Prospectus Exemptions and Proposed Reports of Exempt Distribution in Ontario” on March 20, 2014 and is open for comments for 90 days. This release of proposed amendments to ‘Prospectus and Registration Exemptions” include an Offering Memorandum (OM) Prospectus Exemption, a Family, Friends, and Business Associates Prospective Exemption (FFBA), a prospectus exemption for distributions by a reporting issuer to it’s existing shareholders and the Crowdfunding Prospectus Exemption and regulatory requirements applicable to a Crowdfunding Portal which we addressed in the presentation.
I would be the first to admit that two years ago I was skeptical of crowdfunding and did not feel that that it would provide a viable alternative for capital formation. Today I believe it is required for me and others to be part of the discussion so that entrepreneurs are well informed on crowdfunding and if they take advantage of this Prospectus Exemption they will continue to be positioned for future capital fundraising for their company. It is my view that crowdfunding will be introduced in most provincial jurisdictions in Canada later this year or early next year as both regulators and government would like to ensure the environment for capital formation for seed and early stage innovation is robust and the introduction of crowdfunding will have low budgetary impact for provincial governments.
My comments here within are divided among three distinct groups of investors, some concerns of regulators , the unintended consequences of crowdfunding and my attempt to be futuristic about how crowdfunding may be viewed several years after implementation.
The general market or ordinary investor perspective
Everyone is speaking of the democratization of investment opportunity in early and growth stage private companies. I see no evidence that most investors that currently invest in mutual funds, ETFs, GIC’s etc. are lining up to invest monies in equities of seed and early stage companies. These changes in prospectus exemptions will be no panacea for the investee companies. Currently less that 10% of Canadians hold equities on a direct basis. As a result of the introduction of crowdfunding I don’t see that number rising substantially in the coming years. Most investors that I speak to are concerned that the gestation period for an ROI (Return on Investment) from crowdfunded Investments will be long and they will take a wait and see approach.
Like it or not investment in early stage companies is a high risk investment. I commented in Money Sense Magazine in May of last year that this asset class should be considered part of an investor’s total portfolio where alternative investments including commodities, speculative ventures, derivatives, early stage companies, etc. should be no more that 5 to 10% of the investor’s portfolio. Any prudent financial adviser or portfolio manager would follow this theory.
During the Q&A I was specifically asked if RSP’s and Registered Savings Plan assets could be used to invest via the crowdfunding exemption in early stage companies. The legislative intention is that these savings plans be used for the longer term liabilities of retirement and therefore from a asset management perspective be matched with longer term assets. A equity investment in a high risk seed or early stage company does not align with the longer term nature of the assets of a registered savings plan.
The accredited investor perspective
Accredited investors who include our members at Maple Leaf Angels don’t require legislative change to invest in seed or early stage companies. This is the group that is most blase about crowdfunding as they already have the opportunity to invest in private companies. However, I believe it is this group that in the fullness of time will adopt to investing through portals such as Funders Club or Angel List.
It is accredited investors that will be investing the largest amounts as they adopt the technology and become comfortable with the investee companies. I believe in the early evolution of crowdfunding, cannibalization of investment from this group through private placement or offering memorandum will be disguised as crowdfunding to demonstrate the success and adoption rate of crowdfunding. It is generally understood that currently a Crowdfunding Campaign requires 30 per cent or more of the raise to be pre sold and with equity crowdfunding I don’t see that number changing substantially. It will be through traditional methods of pitch and present to accredited investors where this pre selling will occur.
Tech entrepreneur, business owner, knowledgeable individual etc. who is not an accredited investor
This investor currently is not permitted to invest due to not being an Accredited Investor. When referring to the democratization of investment opportunity it is this investor that is being most referred to. They will be the early adopters investing via a portal for both Offering Memorandum and Crowdfunding Exemptions. They are the friends and associates of the founders of the seed and early stage companies we speak of. They will most likely have exited their own startups and will have investable capital of between 200k and 1mm and come from the millennial generation. They understand the space, participate in the ecosystem, went to school with the founders and I believe will be the most active new investors under the Crowdfunding Exemption. However as a result of the Crowdfunding limits the Offering Memorandum Exemption may become the exemption of choice for this investor.
Investors from the perspective of the regulators
You can not expect that in this day and age that the regulators will give cause for a condition to exist where individual investors are not being protected. It is also highly unlikely that they will discharge this responsibility to a third party such as a SRO (self regulated Organization). Selling unsuitable investments to seniors is a significant concern for regulators as selling unsuitable investments represented >40% of IIROC’s disciplinary actions last year and too many of these actions had seniors as victims.
I feel that credit must be given to the OSC for the pace in which they brought these four Prospectus Exemptions to the marketplace. Having just attended the Angel Capital Association’s Annual Summit in Washington the buzz is, Canada is further advanced than the USA on it’s initiatives for capital formation for seed and early stage companies siteing such programs as Start-Up Visa, FEDDEV’s IBI program and Province of Ontario’s ANP (Angel Network Program) as examples.
The unintended consequences of crowdfunding
The cost of raising capital for private companies will increase. These increased costs will include but not limited to fees to portals, legal costs as a result of substantial increased number of shareholders, the requirement to use a back office service or transfer agent such as Boardsuite, Computershare, TSX etc., the use of accountants for increased information rights for shareholders etc. I estimate the cost of capital to rise from current levels for private placements of 8 to 10 pts to between 25 and 30 pts under a crowdfunding exemption.
Companies will have to hire dedicated staff or outsource the administrative burden to manage the rigour of these increased requirements of raising capital under crowdfunding.
There will be a significant # of deal promoters or agents that will become active in the marketplace all charging some sort of performance fee and making promises that are not deliverable. Keep in mind that to conduct this type of activity you must be a registrant of a provincial securities regulator and today that is often not the case.
The portals will find themselves in a position of educating and handholding tech entrepreneurs through this process. There will be many consultants offering this service and there will be a hodgepodge of misinformed advisors holding themselves out to be experts. This will initially be a buyer beware market.
There will be increased governance required by the companies raising capital. Companies will learn to understand they will have a responsibility to structure their company for continued financings and this will not be a simple task. I can speak from experience that in the majority of cases where I have lost or will loose invested money in early stage companies there was a distinct lack of governance and accountability on behalf of the directors and senior management of that enterprise. Having spoken to a number of entrepreneurs and participants in the crowdfunding space, they have given little thought to what a well structured and governed company looks like.
Potential developments of the future
Sophisticated investors and VC’s will be aware of the pitfalls, costs and concerns of raising capital under the crowdfunding exemption. I anticipate many companies will be orphaned from future financings as a result of complicated capitalization tables, not hiring a back office or a transfer agent to manage the process, not compliant with shareholder information rights, complicated or restrictive covenants in USA (unanimous shareholder agreement), setting a excessive valuation for a pre-commercialized company that does not hold up under future financings, etc.
I find the pace of change in Ontario and Canada to be exhilarating. The opportunity for seed and early stage companies is bountiful and the regulatory environment to raise capital here tells me that government is serious about growing innovation and jobs in this country and I am pleased in my small way to be part of this evolution.
By way of disclosure Jaguar Capital is a Governance, Financial Structuring and Financial Management advisory practice where I am Managing Director. In addition you can find many other presentations on Jaguar Capital’s Slideshare File on topics such as Valuation for Pre-Commercialized Companies, Forming an Advisory Board, Accessing Angel Capital, Understanding Investor Term Sheets, etc.