While exciting on the surface, issuing equity via crowdfunding could cause serious headaches later on
Crowdfunding has been all the rage for a while, and it’s popping up again as an area of interest among entrepreneurs. Startups have long been able to run crowdfunding campaigns to raise money, but they weren’t allowed to issue equity in their company for such contributions. Because of this restriction, crowdfunding has been more of a market validation or PR tool rather than a serious means of corporate financing.
But on May 14, the laws changed. Now, in B.C., startups can issue equity to the contributors of their crowdfunding campaigns. So, the big question: Should entrepreneurs now be considering crowdfunding as a serious option for financing their early- to growth-stage companies?
First, some fast facts about the new crowdfunding exemption.
- Startups can raise up to $250,000 per crowdfunding campaign, with up to two campaigns per year.
- The maximum contribution amount per investor is $1,500 per campaign.
- All of your investors must be residents of a participating jurisdiction in Canada (B.C., Saskatchewan, Manitoba, Quebec, New Brunswick or Nova Scotia). Ontario is not a participating jurisdiction at this time.
- The distribution must occur on a crowdfunding portal based in Canada that is equipped to facilitate distributions in compliance with the new laws (U.S. portals are off the table).
- Strict filing requirements must be met before and after the distribution.
Let’s say you raise $250,000 in contribution sizes that average around $1,000 each, and you offer shares to each one of those investors. You now have 250 shareholders on your cap table. For shareholder resolutions and shareholder agreements, that’s 250 signatures you need to track down. Even for the most avid lover of administrative work, that’s a nightmare.
There are certainly ways that your lawyer can assist you in managing this, whether through a unique share structure, shareholder rights (like a drag-along), voting trusts or even something as simple as amending your by-laws to allow votes via email. But even with all of this creativity, the fact remains that you still have a large number of shareholders on your cap table, and that will be a recurring issue that needs dealing with.
Crowdfunding equity will engage two types of legal fees: exemption-specific fees and standard equity financing fees.
- Exemption-specific fees: You don’t want to take chances when issuing securities. The consequences for getting it wrong are too great. With all the forms required under this new exemption, and the filing requirements, you’ll incur new legal fees unique to a crowdfunding campaign. You’ll also need to get creative on the legal side to structure the deal in a way that allows you to manage your new investors as efficiently as possible. Again, increased fees.
- Standard equity financing fees: Regardless of which exemption you use, when you issue equity, you’re going to incur legal fees for the subscription agreements, resolutions and other corporate maintenance work required to effect the transactions. And in a crowdfunding campaign, with a large number of investors, the fees might end up reflecting the added paperwork.
Forfeiting the private issuer exemption
Here’s an implication that’s been overlooked by most. If your campaign is successful and you bring in over 50 new shareholders, you will be disqualified from using the private issuer exemption in future financings. This is a big price to pay.
Under the private issuer exemption, you can raise money (without a cap on investment amount) from close friends, family, close business associates and accredited investors. It is easily the most flexible and attractive fundraising tool available to early- and growth-stage companies, and you’ll lose that the moment your crowdfunding campaign exceeds 50 contributors (or fewer if you’ve already got investors on the books).
I’m not charmed by the new crowdfunding exemption. On the surface, it’s exciting to see our securities laws evolve to accommodate innovations in the fundraising space. But as we dig deeper to evaluate the attractiveness of this option from a corporate financing perspective, the exemption falls short.
Companies relying on the crowdfunding exemption will face practical difficulties in managing the large number of shareholders on their cap table, increased legal fees and lost opportunities for future fundraising. If you want to crowdfund, pass on issuing equity in exchange for contributions, and try using more creative rewards.
Geoff Dittrich is a business and technology lawyer at Segev Homenick LLP, a boutique law firm in Vancouver with practice strengths in business and technology. This article is for informational purposes only and is not intended to be legal advice. The laws referenced in this article have been oversimplified. The commentary may not be applicable or advisable to your business based on your unique commercial realities. In any event, consult a lawyer before relying on any of the contents of this article. Special thanks to David McHugh for his contributions to this article.