The Trouble with the OSC’s Crowd
By: Sandi Gilbert
With Equity Crowdfunding gaining momentum across the globe, the Ontario Securities Commission (OSC) took the bold step to formulate proposed regulations to allow the Crowd to invest in Canada’s small to emerging companies that are notoriously starved for growth capital. It made sense after all. The model was proving itself in the UK and other jurisdictions; the SEC was getting closer to implementing the long ago Congress-passed JOBS Act; and Canada’s regulators were sitting on the sidelines watching it happen.
Although the rest of Canada allows non-accredited investors (the other 97%) to invest in private capital through an Offering Memorandum (OM) exemption, the citizens of Ontario are currently left out. If you live in Ontario and you aren’t a millionaire you cannot invest in private companies – period! So, the OSC decided to join the ranks of the rest of Canada, by introducing their own version of the OM exemption – a welcomed addition – yet they went a step further, and introduced another exemption for the Crowd.
What the OSC is proposing
The proposed Crowdfunding Exemption (CFE) is quite complex, but the basics are quite simple.
- $1.5 million capital raise per year
- Light disclosure – the OSC has proposed a “Crowdfund Offering Document”
- Audited financials required only at certain company milestones
- $2,500 per investor (regardless of qualification of the investor) – maximum $10,000 per year
- Securities offered through a “Restricted Dealer” on a platform
- No dual registration – an EMD cannot also be a Restricted Dealer therefore an EMD cannot distribute a CFE offering
- Platform is not required to perform suitability of theinvestment
- Certain types of companies are not permitted to use the exemption
- Certain types of securities are not allowed to be issued under the exemption
As a long-time advocate for Equity Crowdfunding in Canada, you would think I’d applaud this step – and I am encouraged that they recognize the need to free up some capital for Canada’s young businesses. But not so fast. Here’s The Trouble with the OSC’s Crowd.
The Typical Private Capital Raise
Any company that has been through a capital raise knows there is a process to raising private capital. Whether online or offline, investors can be defined in three specific segments:
- Management’s network
- The Network’s network
- The Crowd
The first investors are key to a successful capital raise. Everyone wants to see someone else lead the way and typically, those lead investors are close to the company and its management or are advocates or customers of the company and have watched the development of the business to this stage – management’s network. Once these investments have been secured, the new investors share their investment story and create further interest in the company at dinner with friends, while watching a soccer or hockey game, at the nail salon – wherever. They also introduce the company to Business Angels and other sources of large capital - their network’s, network. Then finally, interested and engaged investors learn about the deal, request information about it and ultimately get involved - the Crowd.
It is a process that has replicated itself many times over, across board rooms and coffee shops throughout Canada for years. It’s just that the Crowd is not really a Crowd, as these opportunities rarely get into the hands of the ordinary investor. The Company is restricted by its ability to find and engage the Crowd in its capital raise.
Investors - Where they Come from
- Management's Network: 25%
- The Network's Network Sophisticated Investors: 40%
- "The Crowd" Ordinary Investor: 35%
The equity crowdfunding model
The premise of Equity Crowdfunding is to replicate this model in an efficient online environment that can harness the power (and capital) of the true Crowd. Crowdfunding platforms give the company access to thousands of potential investors in an online investment community. Instead of running from board room to coffee shop to pitch the Company’s story, management post’s their opportunity on an investment platform where their network, their network’s network and the Crowd can review and evaluate the investment opportunity. The Crowd can monitor the process of the capital raise and engage in dialogue with other investors and the Company’s management. As the investment dollars come in – the Company thermometer moves toward the target raise. They learn more about the investment, become more engaged in the opportunity and may ultimately invest.
Sounds like a perfect environment to execute a capital raise, right? Unfortunately, the proposed Crowdfunding Exemptions do not follow the proven path of a capital raise because they have restricted the investment in a Crowdfunding Exemption to a maximum of $2,500, regardless of the investor’s connection to the Company or their ability to invest more.
Sure, the Crowd can now invest, but what about the other two investor segments? What about their engagement and their ability to write bigger cheques? They have been removed from this process completely. The Company is supposed to engage the Crowd – the group furthest removed from their network – and raise $1.5 million at a maximum of $2,500 per investor. These young companies will have to secure investment from a minimum of 600 investors and more likely well over 1,000. The numbers just don’t add up.
The OSC has made it clear that companies offering securities under the CFE can conduct concurrent offerings under other exemptions, however a Restricted Dealer cannot market other exempt offerings, therefore the Company would have to engage an EMD or go offline to attract larger investments. This ultimately increases the cost of capital for the Company and creates undue complexities in the execution of the capital raise.
The OSC’s CFE is intended to facilitate capital raising for small to emerging companies at different stages in their growth and business cycles. At the same time the regulators must ensure that any proposed exemption maintains an appropriate level of investor protection and regulatory oversight. I think both of these can be accomplished with small but significant changes to the exemption as proposed by the OSC.
Option One – Implement the CFE | Restricted Dealer model
The OSC is proposing that a CFE offering only be distributed through a platform registered as a Restricted Dealer due to its intent that the platform not provide investment advice or suitability to the investor as is currently the practice for EMDs. If this model stands, it is imperative that the platform must be able to accept investment from all classes of investor and accept that investment without limit from those that qualify. Since the platform is not required to conduct suitability and the Company is providing limited disclosure, it is reasonable to expect that the investor be subject to investment caps based on defined investor qualifications. With investment caps, comes relief of suitability. The US JOBS Act Title III is proposing caps as a percentage of an investor’s income, however, I would propose caps based on the existing defined investor categories as follows:
- Ordinary investor – $5,000 per investment & $10,000 per year on platform
- Eligible investor – $15,000 per investment & $30,000 per year on platform
- Accredited investor – unlimited
In a CFE offering, the investor is making his own decision and conducting his own due diligence and therefore will invest what he is comfortable investing. Each investor will be required to sign and certify that he can lose his entire investment. Without accommodating investment from other investor types, the model is simply flawed. It is highly unlikely and impractical to think that a company will successfully raise $1.5 million of capital $1,000 at a time.
The Restricted Dealer would not be able to distribute securities under any other prospectus exemption, however the ability to attract all classes of investor will increase the probability of companies using this exemption and transacting a successful capital raise.
Option Two – Forget about it! | Focus on the OM Exemption
If the CFE is not broadened to include all investors, the OSC should concentrate on the OM Exemption. If I was a company looking to raise $1.5 million, I’d probably go the OM Exemption route so that I could engage investors from all classes. To be fair, the proposed CFE document is not that dissimilar to the current OM document. I would venture to say, my probability of success would be better with the OM. The proposed regulations as they stand are not unreasonable however I would encourage the regulators to look at a couple of things:
- The OM Document – I understand that Phase II of this review is tackling the unwieldy document that has grown more prospectus like each year. Keep it simple, so investors can and will read the document to understand the business, the management team and the obvious risks inherent in illiquid securities.
- Incorporate the Alberta Blanket 45-512 – do not have two exemptions. Companies raising under $500,000 in capital should have disclosure relief as provided in the blanket order.
- The Investment Caps – as I have mentioned earlier in this article, investment caps are not necessary when securities are distributed through an EMD. If the regulators feel there are flaws in the current suitability practices, they should provide clear guidance and mandate compliance. We either believe in the suitability process, or we don’t. To me, it’s one or the other. But, I’ll leave that for another article!