"Significant deficiencies" in exempt market should cool Crowdfunding hype

News report: Ontario Securities Commission finds ‘significant deficiencies’ in exempt market

As the OSC sifts through the responses to its “Considerations for New Capital Raising Prospectus Exemptions” consultation paper, it shouldn’t lose sight of its own recent findings in the exempt market.

According to the Globe and Mail report:

The OSC warned it has found a range of deficiencies at other firms, primarily around selling securities to investors who did not qualify as “accredited” or wealthy investors eligible to buy exempt market products, and around sales of securities that were not appropriate for investors’ situations under what are known as know-your-client rules.

“Know-your-client and suitability determinations are fundamental obligations owed by registrants to their clients,” OSC chairman Howard Wetston said in a statement.

“Enhancing compliance among portfolio managers and exempt market dealers is critically important and we are taking appropriate regulatory action where we identified significant compliance issues.”

And here’s the irony. It seems as though the OSC is being stampeded into legally sanctioning whatever “crowdfunding” is, while, at the same time, coming down hard on the “exempt market”. Can someone explain the difference to me? Each draws inestment capital from the same pool of fish.

Two weeks ago, the Osler legal team, led by Montreal’s Shahir Guindi, published an excellent summary of the OSC’s considerations and the public comment on the consultation paper. Here’s an excerpt:

1. Would a crowdfunding exemption be useful for issuers, particularly small and medium-sized enterprises (SMEs), in raising capital? It would increase the availability of capital for investment in SMEs. Stakeholders identified a gap in funding for projects in the $1 to $2 million range. A crowdfunding exemption would address this concern by growing the available capital pool – one stakeholder’s estimates this would be 20 times the size of existing institutional venture capital.

By committing funds to a project, the crowd may also bring market validation for a product, a benefit that goes beyond what a venture capital firm could provide.

Sourcing capital through crowdfunding may be more efficient than relying on informal networks of contacts, and would allow entrepreneurs to focus on developing their ideas.

Issuers may be wary of saddling themselves with a difficult governance structure at such an early stage in the company. Equity crowdfunding can result in thousands of shareholders, each with fractional interests in the company. This could complicate conducting routine corporate business and arranging for future financings. Even if equity investors are given non-voting shares, corporate law gives shareholders the right to vote in respect of certain fundamental changes. Commentators said that one solution would be to use a trust model and have investors who wish to participate in profits hold units rather than shares. Debt crowdfunding poses fewer problems from a corporate governance perspective.

The U.S. government gave the thumbs up to crowdfunding in 2012 for political reasons. Part of the impetus was driven by stagnent job growth; who can forget that the U.S. economy and financial system suffered far worse than Canada’s over the past 5 years? Some Canadian entrepreneurs and ecosystem thought-leaders are looking to Ontario’s key Securities Regulator to jump aboard the train. And yet, the American public is notoriously far more open to risk and certainly more accepting of failure than their Nothern cousins.

Just think about the challenge this poses. To play in the exempt market, you need an annual salary of $200k or net assets in excess of $1 million (last time I checked). On the one hand, the OSC Chairman is concerned about the suitability of certain private company investments being sold by agents in the exempt market to folks who are relatively well off. He’s also observing that these Exempt Market agents are often failing the “know your client” test prior to selling private stock to high net worth individuals.

Assuming these concerns are legitimate, how then could the OSC ever approve of the underpinnings of Crowdfunding?

Let’s say you thought you knew how to turn water into energy without a turbine, or replace Avastin; based upon a certain cocktail of widely-available, low cost ingredients. That’d be a big market and would definitely attract investor interest.

If you wanted to raise $1 million for your seed round, 2,000 retail investors investing $500 each, or 200 investors at $5k per would do the trick via Crowdfunding. Put up a home page and the money flows in via PalPay. Talk about not-knowing-your-client.

And then there’s the governance challenge. Once the round has closed, who is going to speak for the “Crowd” at the Board level? Every Company Director is supposed to, of course; but the types of Directors a nacent startup are bound to attract are usually there at the behest of personal relationships of the CEO. At least in an Angel deal, the connection between the seed capital raised and the Director (assuming the Angel takes a Board seat) is very clear to the Company CEO, the independent Company Directors, as well as any future institutional investors. Why the Angel’s replaced by a leaderless Crowd, the saaviness is gone.

Issues such as budgets, capex, size of the option pool, founders shares, valuation, governance, liquidity rights are tough issues at the best of times. With 2,000 “bosses”, I’m not sure anyone is really in charge. At least with a public venture capital pool company you’ve got the TSXV officials looking over the Founder’s shoulder.

That’s not to say the fine tradition of the “Friends and Family” round can’t work, with or without Angels. It often does, and we recently closed a $8 million Canadian-based financing where the company had succeeded entirely without a venture capital round prior to our financing. The point isn’t that individual investors can’t be enough; but the disclipline and transparency that comes from raising capital from your Aunt or highschool chum falls away when there’s no chance you’ll ever see your investors face-to-face if things take a turn for the worse.

Which is the risk of faceless fundraising. The OSC can’t grouse about the Exempt Market, where at least someone is checking the business plan who has to answer to the Regulators, and then turn around and bless the Crowdfunding model merely because it is doing “God’s Work.”

MRM