Area of Law: Business Law
Answer Number: 223
CrowdfundingRegion: Ontario Answer Number: 223
The use of crowdfunding has grown immensely within the startup community. Although crowdfunding can be a useful method for startups to acquire the capital they need, it does have some disadvantages. It is important to understand the different types of crowdfunding to evaluate what type, if any, is right for your business.
What is crowdfunding?
Crowdfunding is a way to raise capital (money) by asking for relatively small amounts from a large number of individuals (referred to as funders). In exchange, the people who give money generally receive some kind of value in return. The value can be a reward, presale of the product being developed, interest payments, or equity in the startup.
Benefits of crowdfunding
There are a number of general benefits of crowdfunding. Often, it is difficult for startups to be approved by institutional investors (such as banks), venture capitalists, and other typical financing sources. Crowdfunding, therefore, can be used:
- as a means to raise the necessary capital to get started,
- in conjunction with other ways of raising capital,
- to provide your business with quick cash (such as for bridge financing),
- as a means to reach a wider range of potential investors with a lower investment level per investor,
- to presell your product (in the case of presale crowdfunding), and/or
- to bring market awareness to your product.
Although crowdfunding has many benefits, initiating and managing a crowdfunding campaign takes time and money, and it is difficult to predict whether it will be successful.
Types of crowd funding
Before initiating a crowdfunding campaign, every business should consider which type of crowdfunding may help it achieve its goals. Each type comes with its own specific benefits and disadvantages. There are five basic types of crowdfunding based on the form it takes and what the funder receives (if anything) in exchange for their money.
- Donation crowdfunding occurs when individuals, charities, or other entities (such as for-profit corporations) ask for donations online. In this type of crowdfunding, the funders have no expectation of receiving anything in return. Their payment is considered a donation, although the organization may not be a registered charity and therefore, the funder will not receive a charitable tax receipt.
- Rewards-based crowdfunding involves the use of rewards to encourage people to contribute funds. For example, a startup that needs funds to create a product may offer branded merchandise, or complimentary tickets in exchange for contributions. In some cases, the business will return the money back to funders if the business does not reach its fundraising target within the specified time.
- Presale crowdfunding occurs when a startup asks for funding by pre-selling a product or service before it has actually been produced. This allows the funders to be first in line for a new product, while giving the business the money it needs to complete the development of the product or service. Presales are also useful to gauge demand for the product, so that the business does not spend time and money creating something that does not sell.
- Debt crowdfunding, also referred to as “crowd lending”, is basically the business borrowing a small amount of money from a large number of funders. In exchange, the business promises to repay the funders their principal plus interest. There may be variations to the basic loan terms, such as forgivable loans, whereby the money is only repaid if the business starts generating revenue. In addition, debt crowdfunding can also take the form of convertible debt, either to common or non-convertible preference shares, which are considered equity. Each business determines its own specific lending terms. Debt crowdfunding is particularly useful if a startup needs funding but wants to maintain control and equity ownership of its business. As with other types of debt financing, debt crowdfunding can be seen as less risky for funders than equity crowdfunding, since they are generally promised the return of their principal plus interest, as opposed to equity crowdfunding, which makes no such promises. However, given the lower risk and steady return, the payout for funders of debt crowdfunding can be smaller than with equity crowdfunding.
- Equity crowdfunding, in equity crowdfunding, funders receive securities in exchange for their payment. Securities can be shares (common or preferred), debentures, partnership units, and other forms of non-derivative securities. Businesses selling crowdfunded securities are regulated by their provincial securities commissions and must comply with their provincial Securities Act.
Startup equity crowdfunding exemption
Since the introduction of crowdfunding in Canada, several securities exemptions have been introduced for equity crowdfunding that eliminate the need to prepare an expensive and lengthy prospectus. Canada does not have one, national crowdfunding exemption; but rather, the exemptions are provincially based. A business can rely on more than one exemption where applicable.
1. Start-up Crowdfunding Registration and Prospectus Exemptions
In order for startups to rely on this exemption, they must adhere to the following requirements:
- the startup can only offer a maximum of two crowdfunded distributions per year,
- the amount raised is capped at a maximum of $250,000 in each distribution,
- investors (funders) are limited to investing up-to $1,500 per distribution,
- although the startups are not required to prepare a prospectus, they must still prepare an offering document, which provides (i) basic information about the company, (ii) explains how the company will use the money raised, and (iii) states the minimum amount required to achieve these goals, and
- the investors (funders) must understand and acknowledge the risk warnings presented in the offering document.
British Columbia can rely on the Start-up Crowdfunding Registration and Prospectus Exemptions.
Saskatchewan, Manitoba, Quebec, New Brunswick, and Nova Scotia may also rely on Start-up Crowdfunding Registration and Prospectus Exemptions; however, in these provinces:
- the exemption cannot be relied on if the company is a reporting issuer, or an investment fund,
- the company’s head office must be located in the jurisdiction (province).
2. Crowdfunding Exemption
Manitoba, New Brunswick, Nova Scotia, Ontario, and Quebec may rely on the Crowdfunding Exemption, which came into force in 2016. Under this exemption, the business may raise a maximum of $1,500,000 per year.
Equity crowdfunding challenges
Managing equity crowdfunding can be challenging to the business for a number of reasons, including:
- a startup cannot control who purchases the shares, and may acquire a large number of shareholders,
- depending on the type of shares issued, these new shareholders may receive voting rights, require annual meetings, and share in future profits,
- funders are generally invested for the long-term, since the shares may remain illiquid for some time until the startup has become more developed,
- the business must be accountable to the shareholders,
- the shareholders will be less likely to offer the same valuable advice, mentorship, and management expertise to the startup that other types of equity investors might, such as angel investors or venture capitalists.
If over 50 shareholders
If, after completing an equity crowdfunding campaign, the startup has acquired over 50 unique shareholders (excluding current and former employees) it will be required to meet ongoing securities compliance requirements and filings in each jurisdiction in which the company has sold securities and that of its head office. In addition, certain filings must be filed within a set timeline after completing the financing. The business must also send a confirmation notice to each participating investor within 30 days of closing the distribution.
Before launching an equity crowdfunding campaign, it is a good idea to consider:
- whether other sources of funding may be more appropriate,
- whether you will be able to spare the time and energy needed to run a crowdfunding campaign,
- whether you have the capacity to handle the needs of shareholders and securities regulators going forward, and
- the amount of money you want to raise, and
- the number and types of shares you want to issue.
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