Welcome to the Age of Crowdfunding

Businesses and individuals are catching onto crowdfunding faster than regulators can keep up.

By Carolyn Camilleri

In October 2016, Markham resident Chris Prendergast spent a lot of time at ventureLAB, Markham’s regional innovation centre, attending business workshops and looking for guidance on how to proceed with his brainchild: JamStack, a guitar amplifier that attaches to a smartphone.

Chris Cory, senior analyst in venture services at ventureLAB, directed Prendergast to Cortex Design to get a prototype made. To pay for the prototype, Prendergast crowdfunded on Kickstarter, which brought in more than $80,000 in 30 days, as well as a following and publicity.

After making some adjustments to his approach, a second campaign, this time on Indiegogo, raised US$200,000 in 30 days, and pre-orders on InDemand – for people who missed the campaigns – brought in almost another US$200,000.

Then, in November 2017, Prendergast pitched JamStack on Dragon’s Den and got what he wanted: $200,000 at 20 percent equity.

Other than a small business-plan loan, Prendergast never even tried getting funding from a conventional bank. “People told me there’s no way,” he says.

And that is why more people are turning to crowdfunding.

“Small businesses and startups face significant fundraising challenges,” says Cory. “In the absence of positive operations history, banks are usually reluctant to lend to startups without personal guarantees. As a result, personal savings and investment from friends and family are the most common source of funds in the early days of the technology companies we see at ventureLAB.”

Another option is to find investors, but that has challenges, too.

“Many companies seeking expansion capital approach angel investors or small venture capitalists who typically demand some evidence that their product is attractive to customers at the price suggested in their business model,” says Cory.

When Prendergast pitched to the Dragons, he had that evidence — the support he gained through crowdfunding.

 

How the crowd grows

As its name suggests, crowdfunding gathers small amounts of capital from a crowd of supporters. It was first used most successfully by non-profits. Campaigns are conducted entirely online using dedicated platforms that provide project web pages and serve as intermediaries between the crowd and the projects.

Two of the most popular platforms are Indiegogo and Kickstarter. But they are just two of many. The number of niche platforms has increased to serve people looking for funding for specific purposes and to gain access to specific crowds. For example, PubLaunch is a Toronto platform for people who want to publish books.

“Authors were often being forced to choose between affordability and a good quality book, and PubLaunch allows them to do both,” says Meghan Behse, PubLaunch president. With successful crowdfunding, authors can cover editing and production costs and test the market for interest, promote their book, and gain a following.

But that’s just one type of crowdfunding.

Crowdfunding models

Crowdfunding is loosely categorized into models: donation, reward, lending, and equity. Donation-based crowdfunding is used by non-profits to support causes. Reward-based crowdfunding offers something (products, services, discounts) in exchange.

“The most popular kind of crowdfunding — and the one most people will recognize — is reward-based crowdfunding, where new products, such as the Pebble watch — $30 million raised — or the game “Exploding Kittens” — $9 million raised — can be pre-sold to consumers,” says Cory.

For technology companies developing consumer products, reward-based crowdfunding presents an opportunity to validate products with consumers.

“You get all kinds of good things when your product is out there crowdfunding,” Cory says. “Investors always want to know: will the dog eat the dog food? This is proof positive that your product has some traction.”

Like JamStack’s success with the Dragons, companies can leverage that traction into successful angel or venture capital funding. “There’s a very short line now often between a successful crowdfunding campaign and follow-on funding. That’s the big deal,” says Cory.

And with reward-based crowdfunding, you don’t have to file a prospectus, which is expensive for a young company.

By comparison, the other lending and equity crowdfunding models are more complicated and far, far less developed here.

“In Canada, equity and lending crowdfunding remain in their infancy due to regulatory constraints that limit the participation of small investors,” says Cory. “This is not the case for large or accredited investors, however, who can invest in the shares or debt of companies listed on several crowdfunding platforms such as AngelList and Crowdmatrix.”

The lending model, which provides opportunities to borrow and lend money at attractive interest rates, must follow all the same regulations and underwriting guidelines as their bank and lender counterparts that govern financial transactions with consumers and may also be subject to rules and regulations governing banks and other lenders.1

Meanwhile, in Europe, Cory says crowd lending is the biggest area of growth. “If you look at the U.K., crowd lending is a wonderful thing for businesses because they’re able to crowd source loans at better rates, and it’s a very efficient system. They do a better job often than banks are able to do.”

The equity model, which means company shares are given in exchange for investment, is mostly available only to “accredited investors” — basically, people with a lot of money. And therein lies one of the key reasons Canada is behind with equity and lending crowdfunding.

“The delay in the US and in Canada with crowdfunding has been the focus of the regulators, not on big investors, but on the mom-and-pops, on the small investors,” says Cory. “The regulators have a difficult job, because they always have to be seen to be protecting the small investor. It’s a bit of a tug of war between momentum in the marketplace that wants more crowdfunding, and the tug of regulators trying to ensure people are protected.”

And there is risk: “Investment in either the equity or products of early-stage companies is always risky,” says Cory. “Kickstarter reports that only 36 percent of projects were successful in meeting their fundraising targets. Only 20 percent of technology projects met their targets, and only 18 percent of all funded campaigns raised more than $20,000.”

However, there are also some impressive success stories.

Chris Charlesworth, an advisor for the National Crowdfunding Association of Canada and the CEO and co-founder of HiveWire, says the regulators’ protective role has become more challenging because, over the past five years, there are so many examples in other markets of activity that has been safe for consumers.

Moreover, the regulatory focus on risk at an individual level is creating delays with implications on a much larger scale. “One of the primary hindrances we have is that we do not have a national securities regulator in Canada that has overarching authority for all of our different provincial jurisdictions,” says Charlesworth.

Instead, minor regulation amendments have been made on a province-by-province basis. For example, Ontario’s Multilateral Instrument 45-108 Crowdfunding, which came into effect January 14, 2016, introduces a crowdfunding prospectus exemption for issuers as well as a registration framework for funding portals.2

Charlesworth says that while securities administrators are working to harmonize regulations, there are significant differences. “Instead of it being a Canadian capital-raising marketplace harmonized across the entire country, we have a fractured environment where there are differing rules and a lack of clarity as to exactly how people can raise money within the Canadian marketplace.”

The pressure on regulators is magnified by the emergence of even newer technology that hasn’t yet been approved, such as crypto currency.

Meanwhile, capital is becoming increasingly mobile, and because it doesn’t matter which jurisdiction your website is based in, it is making less and less sense to base capital-raising activities — and the technologies that unlock that capital — in the Canadian marketplace when you can access global investors by being based in another jurisdiction.

“At the core of this is the fear that the regulators in our market and those setting the rules don’t understand the magnitude of the technological changes,” says Charlesworth.

That fear is very tangible within the startup and crowdfunding community, he adds.

Charlesworth, who grew up in Markham, calls it “a hyper-local issue.” “There is a lot of great innovation in Markham,” he says. “There are great companies and incubator spaces and the regional innovation centre. Those companies in Markham need a good way to raise money to attract risk capital from their local community.”

And, of course, the local communities in Markham have international roots.

“Having a regulated way for our local startups to get the capital they need — right here in their backyard and then have those roots extend internationally — has a meaningful impact on the kinds of business that happens: the startups that will allow us to have good Canadian jobs and to have those companies scale and grow.”

“It matters at the local level, because that’s where the businesses are,” he says.

(References)

1 National Crowdfunding Association of Canada: NCFA 2016 Alternative Finance Crowdfunding in Canada, page 32.

2 Ontario Securities Commission. Multilateral Instrument 45-108 Crowdfunding. http://www.osc.gov.on.ca/en/SecuritiesLaw_45-108.htm