Last month in Part I of this series we introduced you to the new equity crowdfunding prospectus exemption and rules regarding Multilateral Instrument 45-108 (the Instrument). As you will no doubt recall, the Instrument provides a means for companies to raise capital from the general public in return for equity in the company without first issuing and certifying a prospectus. As a refresher, the Instrument came into effect on the 25th of January, 2016 and necessitates that numerous requirements must be filed by issuers, investors, and crowdfunding portals before an investment may properly be made under the exemption the Instrument introduces.
This week we will explore some of the risks that raising capital under the Instrument may pose to issuers, as well as some of the hazards potential investors should keep in mind when considering whether to invest in companies under the regime. Further, we will provide some tips for investors and/or acquirers targeting a company that has raised capital using the Instrument in the past.
Dangers to issuers
The main dangers to issuers attempting to raise funds under the exemption introduced by the Instrument stem from the myriad compliance responsibilities the Instrument places on issuers. For example, any issuer seeking to crowdfund capital in return for equity in Canada must:
- ensure that each investor contributes no more to the issuer than the limit the Instrument places on their particular class of investor;
- ensure that each investor does not surpass the yearly limit the instrument imposes for investments relying on the exemption;
- comply with strict advertising rules and makes certain representations and warranties to potential investors as required by the Instrument;
- make certain filings with the securities regulatory authority upon closing of the distribution (whether successful or not); and
- comply with certain ongoing disclosure, filing, and communication requirements imposed by the Instrument as well as several related instruments.
These are but a few of the requirements imposed on issuers who attempt to raise capital under the exemption introduced by the Instrument. Such issuers should keep in mind that failure to comply with requirements may expose the issuer as well as subsequent investors to potential liability. Further, traditional private equity funding is usually accompanied by access to guidance from experienced advisors as well as corporate governance mandates imposed as a condition of the investment. Regular, non-accredited investors are unlikely to offer such perks to the companies they invest in.
In addition to the risks mentioned above, issuers considering whether to issue securities through an equity crowdfunding offering as allowed by the Instrument should also consider the possible effects equity crowdfunding may have on subsequent attempts to raise capital. Publications including the Financial Times and CNBC have pointed out that a previous equity crowdfunding round may be a red flag to traditional venture capital investors. Generally, companies that participate in non-accredited investor equity crowdfunding, such as that introduced by the Instrument, may be perceived to be less desirable start-ups that were unable to raise funds by more conventional means. The Financial Times further states that since equity crowdfunding is so new, traditional investors see the associated risks as being "largely unquantified."
Dangers to investors
The most readily apparent risk to individuals considering whether to invest under the exemption introduced by the Instrument is that the company offering securities my fail. Conventional wisdom holds that up to nine out of ten start-ups fail (see also here), and it is quite likely that regular, unsophisticated investors will invest in a good number of that doomed 90%.
Further risks include outright fraud. The Washington Times, Gizmodo.com, and the Globe and Mail, have all published reports detailing the alarming rate at which fraudsters raise funds via traditional crowdfunding websites. Also, in the past few years, the Federal Trade Commission has fined dozens of crowdfunders it found to have defrauded investors. Websites such as NCFACanada.org and Crowdfrauds.com are largely dedicated to exposing and rooting out fraudulent crowdfunding campaigns. Potential investors should consult professional advice or, at least, familiarize themselves with common signs of fraudulent crowdfunding campaigns.
Finally, investors should be aware of the huge liquidity risk involved with buying equity in a start-up company. Traditionally, venture capitalists in such companies have been able to cash out when the start-up becomes a public company or is acquired by another, larger, investor or company. Barring such circumstances, regular investors who acquire shares through equity crowdfunding campaigns may find themselves unable to ever sell their stake.
The author would like to thank Bert Riviere, articling student, for his assistance in preparing this legal update.
About Norton Rose Fulbright Canada LLP
Norton Rose Fulbright is a global law firm. We provide the world's pre-eminent corporations and financial institutions with a full business law service. We have more than 3800 lawyers and other legal staff based in more than 50 cities across Europe, the United States, Canada, Latin America, Asia, Australia, Africa, the Middle East and Central Asia.
Recognized for our industry focus, we are strong across all the key industry sectors: financial institutions; energy; infrastructure, mining and commodities; transport; technology and innovation; and life sciences and healthcare.
Wherever we are, we operate in accordance with our global business principles of quality, unity and integrity. We aim to provide the highest possible standard of legal service in each of our offices and to maintain that level of quality at every point of contact.
For more information about Norton Rose Fulbright, see nortonrosefulbright.com/legal-notices.
Law around the world
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.