Crowdfunding in Canada

It’s a fact. All businesses need money to survive. Some, however, find it easier to access than others.

Money is usually raised in the form of debt or equity. In Canada, equity investments are governed by securities laws, which differ from province to province. The general rule is that raising money by selling equity (including shares) to the public is prohibited unless you go through the very expensive process of filing a prospectus, or fit within one of several limited exemptions. Until recently, the most commonly used exemption related to accredited investors. An accredited investor is one considered sophisticated enough not to require financial advice before making an investment, and financially resilient enough to be able to absorb the loss of a bad investment.

In the spring of this year, six Canadian provinces introduced a crowdfunding exemption for start up businesses. Additional amendments to securities legislation are expected later this year, and will introduce a broader crowdfunding exemption. The introduction of the exemption has generated a lot of interest, but the implications of crowdfunding aren’t always carefully considered.

Wikipedia defines crowdfunding as the “practice of funding a project or venture by raising many small amounts of money from a large number of people, typically via the Internet”. There are two broad categories of crowdfunding – those that may result in financial returns and those that will not. Equity crowdfunding, of course, falls within the first group.

Capital always has a cost which must be balanced against investor protection. Crowdfunding investors must recognise that there is, at this time, no secondary market in which they can sell their investments. Notwithstanding this, the crowdfunding movement is huge. The widely quoted 2015 Crowdfunding Industry Report from Massolution states that crowdfunding raised US$16.2bn worldwide in 2014, and that the number is expected to increase to US$34.4bn in 2015. A successful campaign can result in crowd validation of the business or product.

Crowdfunding allows access to a lot of new investors. Accredited investors account for only a very small percentage of Canada’s population. Equity crowdfunding campaigns in Canada must be run through online platforms which are open to the general public. Previously, this was illegal unless a prospectus was filed. But this also means that there is no opportunity to screen the investors, and you will be in business with each and every one of them. There will be ongoing securities and reporting obligations. A shareholders agreement is essential, and some consideration should be given to offering nonvoting shares. Investors must be aware that there is at this time no secondary market in which their investments can be sold.

The rules governing crowdfunding campaigns are very stringent. The start up exemption allows a maximum investment of $1500 per person and a 48 hour cooling off period within which the investment is refundable. Each round (known as a distribution) can last no longer than 90 days and can raise no more than $150,000. No more than two distributions per year are permitted. The anticipated non-start up amendments will allow larger investments.

Crowdfunding campaigns are exercises in marketing, and they are a lot of work. For every successful campaign, there are thousands that fail. The process from inception to success is long, and it shifts the businesses focus. Managing shareholder expectations after investment also requires a lot of work.

A good sales pitch is required in order to persuade investors to part with their money. It is necessary to disclose enough information to capture their attention; however, businesses must be careful not to disclose too much as there are no nondisclosure agreements in effect. At the start up stage, many businesses either lack or are unwilling to spend the money necessary to conduct the recommended due diligence. They often fail to conduct trademark or patent searches or get freedom to operate opinions, thereby exposing themselves to the risk of claims of intellectual property infringement. Litigation has already been commenced in the US. Some businesses may try to deal with such claims by changing their product offering, but that would lead to claims of misrepresentation from investors.

The disclosure may also jeopardise the availability of intellectual property protection, and may give competitors a head start or insight into the product or business. Failure to ensure trademark protection could jeopardise the brand. Equally, disclosure may jeopardise patentability or trade secret protection. Further, the field of crowdfunding is very new and, as a result, there is uncertainty with respect to the tax treatment of certain types of investment. Revenue Canada has been looking at this with interest. There is, at present, little certainty to be offered in that regard. We will watch with interest as Revenue Canada reaches its conclusions.

Crowdfunding offers remarkable opportunities to access capital from previously inaccessible sources; but like everything else, with opportunity comes risk. Businesses must carefully weigh the resources and risks associated with a crowdfunding campaign against the possible benefits. The conclusion will not always be clear.

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