By Hessie Jones
Altitude Accelerator, Innovations Manager
The time for startups to rethink venture capital alternatives has been gaining momentum. 2023 and the looming, or some would argue the current, recession creates opportunities outside the current investing norm. Enter Equity Crowdfunding (ECF). This is an emerging capital raise option that not only increases opportunities for early-stage startups but also democratizes the investment ability for more people. This notion, now more than ever, opens opportunities for all investors (including non-accredited) to capitalize on tech investment opportunities previously available only to high-net-worth angels (accredited), venture capital or institutional investors.
As Tech Crunch reported recently, more than $215 million in equity crowdfunding has been invested in startups from January to May 2022, up from $200 million the same period the year previous.
“…equity crowdfunding has shed much of the stigma that used to imply that only companies that weren’t good enough for VC raised this way. Some traditional VCs have even scouted on the platforms or encouraged their portfolio companies to pursue the process.”
Is this the moment for Equity Crowdfunding (ECF) to emerge and become a viable alternative for startups? For startups domiciled in Canada vs the United States, jurisdiction and laws vary when it comes to choosing equity crowdfunding platforms. Qualification, campaign execution and benefits can also be different. What should you consider when getting ready to do your first capital raise?
I reached out to two ECF platforms: Jonny Price, VP of Fundraising at Wefunder (US) and Alexander Morsink, Managing Partner at Equivesto (Canada) to understand these disparities but also demystify the many stereotypes associated with this emerging fundraising alternative.
State of Equity Crowdfunding in Canada and the US in 2022
Jonny Price pointed out in the US 2022, Wefunder was ‘flat’ and was less driven by macroeconomic events, compared to VC community. However, the company was impacted by the March 2021 changes driven by the SEC to improve regulation in crowdfunding, given the massive growth in the overall crowdfunding category. What was clear was a whole new class of startup was now eligible for this type of fundraising:
“The sweet spot for Wefunder are the startups with a large audience of customers or community members who love them. It can be a tech startup like Replit or Levels, a soccer team like Chattanooga FC, or a distillery like Cleveland Whiskey. Ideally, venture capital would lead the round and set the investment terms, then the startup’s community can follow on those same terms, but this is not a requirement. We’ve had companies use Wefunder to raise $5M as part of a $120M Series B round on a billion-dollar valuation. But I think Wefunder can also be a great fit for a friends and family round.”
The clear benefit, as per Price, is the efficiency his platform affords when it comes to accredited vs. non-accredited investors. In addition, startups can publicly promote, and leverage the Wefunder investor base – all rolled into one SPV (Special Purpose Vehicle) on the founder’s cap table.
In Canada, 2022 was the first calendar year after the new Canada-wide ECF rules, as Alexander Morsink explained, NI 45-110 Startup Crowdfunding.
“These were the first standardized rules that allowed ECF in every province and territory in Canada. Since securities law is regulated on a province-by-province basis, prior to the introduction of these rules, there were different ECF rules in each province, and it was not even legal in all provinces. It’s important to note, securities laws apply based on where the investor lives – so if a company in Ontario wants to raise from a BC investor, they need to follow BC securities laws and use a platform licensed in BC. “
What ensued was a considerable growth in the number of successful and Canada-wide ECF campaigns in 2022. For Equivesto, 2022 was their second full year of operations and they experienced a 10X year over year increase in total capital raised with support from the platform to $21MM in 2022. The company expanded its Exempt Market Dealer (EMD) license to all provinces and territories and is currently the only EMD operated equity crowdfunding portal licensed in every jurisdiction in Canada. Most capital raises included both angel and private friends and family rounds.
Morsink introduces the Equivesto services that will appeal to investors including comprehensive due diligence, and one combined platform for investors to review deals, transact and sign documents. In addition, the option for Canadian investors to invest via a tax deferred or exempt retirements account (TFSA/RRSP) can be attractive. This versatility has become attractive to companies , at different stages. He refers to some client raises: Scott McGillivray, large scale raise for private fund of $14.5MM via Offering Memorandum round; Naborino, private friends and family round; Coredelia’s Locket and AwardPool, equity crowdfunding rounds for a new restaurant launch and a tech startup seed raise respectively. Morsink underscores the importance of a strong community and network of investors to influence campaign success:
“The platform is not the source of the vast amount of capital companies want to raise, but instead is more of a processing location. Companies that plan to attract the majority or all the raise through their own efforts and network are typically well positioned for success.”
The Legal Differences between Canada and the US
Morsink illustrates that the publicly known concept of equity crowd funding is an umbrella term used to describe different ways private companies can raise capital in Canada. Private companies raising capital in Canada use prospectus exemptions, which are legal doorways that any company raising must bring their potential shareholders through. The first national ECF rules (NI 45-110 Startup Crowdfunding) introduced in 2021 now allow companies raising capital to do so via an online investment platform. He notes that 45-110 is similar to Regulation Crowdfunding (US); the Offering Memorandum exemption (part of NI 45-106) “which is similar to the Regulation A (US) still allows the company to raise from the general public in Canada, but at no maximum raise limit.” In Canada, this option requires private companies to have ongoing audited financial statements and annual reports filed to regulators where 45-110 does not.
In addition, the “Accredited Investor” exemption allows high net worth individuals (HNW) to invest in private companies with no regulatory reporting. Morsink explains:
“Equivesto uses multiple prospectus exemptions at the same time for one issuer, so while a deal on the platform will be listed as an ECF deal open to the public, Angel investors will use the ‘Accredited Investor’ exemption, not the NI45-110 ‘Startup Crowdfunding’ exemption, as the legal doorway to make the investment.”
Can ECF steal funding share from VCs in 2023?
It’s apparent that so far this year, investors are less bullish about current investment opportunities. While there are still investments to be made, many startups intending to raise money feel less confident about their prospects. This, coupled with skyrocketing interest rates and lenders leerier of approving startup loans, leaves a lot to be desired. The more recent demise of Silicon Valley Bank and its spillover effects on the startup and banking community globally will compound the funding challenges.
Price of Wefunder says it’s going to be harder for founders to raise capital and on favorable terms in the coming year vs 2020-21,
“So, then founders should be looking to cut burn, to extend runway and reduce the capital they need to raise to make it to profitability; and also, be on the look-out for alternative ways to raise additional capital if/when they can get it.”
Morsink emphasizes that we do not yet know the full trickling effect of the Silicon Valley Bank, however, the support of both Canadian and US governments to protect depositors will help minimize any direct immediate impact to companies’ successes and their ability to raise capital. In Canada, the success of an equity crowdfunding campaign is really driven by the extended community of the company, so those individuals are not always connected into the overall venture capital space. He adds that private companies looking to raise put themselves in the best possible position by putting fewer limitations on those who may be interested in investing. Early-stage companies are less affected by the current valuation crisis that pervades much of the tech sector. The key for these companies is to be able to successfully raise at their earlier stages to create momentum and be on the radar for investors who may be interested in later investing rounds.
Myth or Fact? VC’s Don’t Invest in Companies with Messy Cap Tables Associated with ECF
A few VCs I spoke with, are less comfortable with companies who have gone through ECF, pointing to having a messy cap table, and therefore would not be an attractive investment. Will a company be doing themselves a disservice towards later Series A funding if they’ve raised through ECF at a pre-seed or seed stage?
Price agrees the “messy cap table” argument was an issue when Regulation Crowdfunding (Reg CF) first went into effect in 2016, but nowadays the new rules have addressed this: “The SEC allowed for Special Purpose Vehicles (SPVs) to be used for Regulation Crowdfunding as part of the March 2021 rule changes, which allows us to roll investors to one line on the cap table and now fixes this problem.”
In Canada, however Canadian regulators do not allow SPV investing for ECF campaigns. Companies raising on Equivesto are encouraged to offer a new class of non-voting common shares, and have all crowdfunding investors sign a voting trust. Morsink says,
“The combination of these two items means that the new investors have no say in the management of the business, which makes corporate governance easier. This simplifies the cap table; the main page of the cap table would simply include the ECF share class as one line item and have a separate tab with all the ECF investors.”
Morsink adds that having spoken to dozens of VCs in Canada, all are comfortable with this structure. In fact, private companies have gone on to raise successful rounds afterwards from VCs.
True or False? Raising money via ECF is a way for the entrepreneur to raise funds his/her own way
Raising via VC usually means raising largely on the terms and valuation of the investor, While ECF often means raising from many smaller investors without one combined voice. Does ECF really put the founder in the driver’s seat?
Price responds this is mostly false because an entrepreneur cannot set their own terms for raising capital. They may be able to get slightly better terms e.g. higher valuation if they raise $1M from 1000 customers investing at $1000 each vs. one VC investing $1M.
“We’ve seen many examples of companies struggling on Wefunder because their valuations were too high. One of our clients who raised on Wefunder decided to do a community round instead of doing a VC raise because VCs would have constrained his optionality. He said, ‘you become part of their business model.’ What he meant is that VCs need you to be the power law winner that returns their whole fund, and so they encourage / pressure you to grow at breakneck speed which, at least for this founder, was not necessarily the path he wanted to commit to, at least not yet.”
Morsink’s response: Yes and no. When it comes to valuation or deal terms, he concurs that this is false. Licensed as an Exempt Market Dealer (EMD), Equivesto is obligated to complete a due diligence process for companies before they raise. This includes working with companies to help them understand the current investor landscape, market expectations and their opinion the current valuation:
“Equivesto is not a simple listing site, where companies can choose any valuation and throw up a deal based on a pitch deck. We work with companies to help them understand the implications of choosing different valuations. While a sky-high valuation might sound nice, if you proceed to a VC raise for subsequent rounds and the VCs disagree, companies could be forced to raise a down round (raising lower than the previous round’s valuation). And if the round raised on Equivesto was mostly from friends, family, supporters, and customers, those individuals will see their investments tank in value because of that future down round. Essentially, don’t punish your first backers and supporters by asking for an unrealistic valuation that could hurt both them and you in the long term.”
Morsink acknowledges that setting higher valuations can lead to successful campaigns, however, investors will not participate if they feel the terms are unrealistic. He adds that while Equity Crowdfunding gives founders more control and flexibility when it comes to the company’s future, many VCs are bound by their investors. Typical VC funds may promise returns to limited partners in 5-8 years, so they need to ensure the underlying investments have large exits within that timeframe. Morsink also emphasizes,
“VC funded companies sometimes need to continue raising subsequent rounds to fuel high growth objectives that may not always benefit the company’s long-term future. VC investment can be, and often is, extremely valuable to companies, but it can mean choosing to put the company on a path that some founders do not want.”
Differences between US and Canadian ECF requirements and process:
Transparency is an obvious difference between crowdfunding and VC
I’ve seen campaigns where pitch decks, traction, performance are on display for all the investors. The same thread is shared with prospective investors too. Is that a risk to founders especially where competition and IP is concerned?
Price notes that the US SEC requires certain things to be publicly shared for Reg CF raises. This includes CPA-audited GAAP financials for the last 2 years for raises of $1.235M or higher (or going back to the incorporation date). This is not required in Reg D (for VCs/Accredited investors only). While there are certain aspects of the company strategy like IP, the founder is under no obligation to share. Community rounds are a very public way to fundraise and Price notes this can be uncomfortable for the founder, and if that’s the case, this may not be the best fit for them.
In Canada, the process is more rigid. Morsink points out disclosure to investors depends on the type of campaign being run. NI 45-110 Startup Crowdfunding requires providing a 45-110 F1 Offering Document to investors, which includes details on the business, capital raised previously, use of funds and risks associated with the investment, etc. This does not require financial statements. Conversely, the 45-106 Offering Memorandum section of NI 45-106 (Similar to Reg A in the US) requires much more disclosure including the Offering Memorandum itself as well as the audited financial statements.
Morsink agrees with Price that founders are not obligated to share any private company IP or secret sauce, however, ECF is a publicly visible campaign, and so information on your campaign page and pitch deck will be visible to the public.
“Companies raising private rounds on Equivesto can enable discretionary access to their private pages. For angel rounds, Equivesto can also assist in setting up and managing an additional data room for companies, so once an investor has signed an NDA additional documentation can be provided.”
Comparing VC vs. ECF, Morsink agrees that the pitch deck and more details are much more public with ECF. VC due diligence is also comprehensive so once an NDA is signed, considerable information is being shared with potential investors. For the EMD, executing due diligence for private companies on an ECF platform mandates the same comprehensive effort, which may actually result in higher access restrictions.
What are the requirements for those who wish to invest?
Jonny Price points out there are very few restrictions in the US. The SEC typically sets limits on how much investors can invest across Reg CF each year. Everyone can invest $2,500 per year. Any amount above this is based on your income and current assets. Similar to Regulation D, Accredited Investors can invest an unlimited amount in Reg CF offerings.
In Canada, securities law is regulated based on where the investor lives. Unlike the US, there is no federal securities body that governs capital markets in Canada. This is done at the provincial level. Morsink signals that Equivesto cannot take American investors because it not licensed in the USA. Wefunder, similarly, cannot take Canadian investors because Wefunder is not licensed in Canada. Equivesto needs to be licensed in each province in order to accept investors from that province. Morsink adds,
“Different prospectus exemptions also have further rules. Under 45-110, investors over the age of majority (18) can invest up to $2,500 per year, or up to $10,000 per year with advice from an Exempt Market Dealer (EMD). Accredited Investor rules do not set maximum investment limits for investors, and The Offering Memorandum rules set different maximum annual limits based on investor eligibility.”
Private companies who wish to raise capital on Equivesto will go through a due diligence process called Know your Product. Investors undergo a Know your Client (KYC) process and a suitability assessment before they can invest. This includes review of net worth, income, investing experience, risk profile etc. to set personalized investment limits for investors. Morsink explains,
“So even if someone is only looking to invest $100 into a startup, Equivesto must still collect all that information and provide individualized investment limits for them and their personal scenario. Even though the rules may allow investments in ECF up to $2,500 per year, if someone signs up on Equivesto with only $2,500 to their name, we will not allow them to invest their entire net worth into one high risk, low liquidity investment. We do everything we can to at least provide limits of $100 so that people have an opportunity to participate. Investors looking for higher limits will also need to provide further personal documentation to support their disclosed income or net worth. Simply saying you have $10MM will not result in high limits for investors.”
What is the time and investment commitment for a founder?
Jonny Price says it depends on investor demand. Depending on the size of your customer community base he says it’s entirely possible to raise $5M in a few hours but for most founders, it is more of a “grind”. He believes that through Reg D, which governs private placement exemptions and allows companies to raise capital through the sale of equity without registering those securities with the SEC, fundraising through Equity Crowdfunding can be easier:
“First, you can now raise from unaccredited investors, as well as accredited investors. It’s definitely an AND, not an OR as accredited investors account for 50% of investment volume on Wefunder). Secondly, you can market your raise on the internet. Thirdly, you can get in front of Wefunder’s investor base (1.5 million people), which typically accounts for about 30% of your raise. There’s also the time investment to set up the page for getting your financial review and audit completed with the CPA etc. The amount of time and cost will vary depending on the complexity and how completion of the financials.”
Alexander Morsink agrees, and the process of raise capital on Equivisto is time intensive. He compares this to raising a large angel round, inviting both angels and the extended community to invest.
“Founders should budget considerable time for the investor readiness and review process that they go through with Equivesto before launch, as well as the planning and deployment of an often-considerable marketing strategy for their raise. While founders often can get help, and many will hire a third-party marketing firms to assist, any capital raising activity takes work and ECF is no exception.”
Areas like social media are ideally suited for ECF because they offer wide reach, scalability, convenience, and ease of record-keeping. But these very features also make it easy for scammers to set up dubious ventures to attract ECF from naive or first-time investors. How do Wefunder and Equivesto mitigate this risk and protect the investor?
Price noted the number of rigorous fraud checks, which are taken very seriously by Wefunder.
“The protection of retail investors is one of the reasons why the SEC requires a higher level of financial disclosures requirements for Regulation Crowdfunding (Reg CF) vs. Regulation D – e.g., companies raising exclusively from accredited investors don’t need audited financials to raise $5M. One of the product features we’ve rolled out over the la
st couple of years is ‘Lead Investors’, meaning a lead investor writing a larger check (typically around 5% of the round) is prominently featured on the page. It’s one example of how we’re trying to help investors with “signals” that can help them assess investment opportunities.”
As explained previously, in Canada the Exempt Market Dealer (EMD) is a licensed securities dealer that allows them to help connect companies in the exempt market (private companies looking to raise capital from all manner of Canadian investors). Equivesto must comply with numerous regulatory requirements to protect both the companies and investors beyond the platform.
For private companies, Equivesto must first complete a process called “Know your product”, gathering a detailed understanding of the product before it’s put on the platform and made available to investors. All companies that want to raise capital must have a minimum viable product/service (MVP) or current revenue from operations. Equivesto will verify this information to ensure the company has created a unique IP. In addition, Equivesto will do the following:
- ID verification of founders and company
- Background and criminal checks on directors
- Full review of legal documents
- Full review of documents (pitch decks, strategy) pertaining to the raise
- Companies will certify information is truthful and valid before it is made available to investors – with further review from Equivesto for validation
Morsink notes that companies raising via 45-110 Startup crowdfunding must prepare an offering document, outlining all pertinent information, including detailed risks to investors.
“Companies raising via the Offering Memorandum exemption must provide more detailed disclosure compared to the 45-110, including financial statements. In the case of any material changes to the company or the offering, the company is legally obligated to inform Equivesto. We will, in turn, provide the appropriate campaign update and duly notify the investors.”
Morsink notes that there is a 48-hour backout window for participating investors, essentially giving them the option to request a full refund, no questions asked. This can also apply to any material change to the offering.
Unlike the US, soliciting investments outside of the prospectus or prospectus exemptions rules is illegal in Canada. Therefore, companies who raise capital via ECF can post about it on social media but are subject to strict guidelines regarding what can and cannot be posted. Clients planning to use social media, press releases, ads, billboards, videos, email blasts, etc. must first provide the materials to Equivesto for a compliance review. He highlights,
“Companies cannot publish detailed terms of the investments on those platforms, and cannot make promissory statements like XXX return guaranteed, or zero risk etc.”
Morsink reiterates the importance of the onboarding process and the KYC and suitability review for investors, which clearly disclose the riskiness of the investments, and set maximum limits for each investor based on their personal financial position and risk profile.
Assuming there are many investors in one equity crowdfund, how does a startup founder manage the deluge of investors?
For founders raising on Wefunder, the lead investor will sign on behalf of the thousands of investors within the SPV. Therefore, only one signature is required. The founders have a legal obligation to provide one annual report. Price suggests the importance of more frequent updates to keep investors engaged. They’ve complemented their offering with a product feature called “Lead Investor”, which prominently features investors who write checks typically ~5% per round, that can be a signal to other investors when assessing investment opportunities.
In Canada, the process is much different. NI45-110 specifically will not allow investments into companies via SPV, which means that every investor does need to go directly onto the cap table. Equivesto simplifies this process by recommending companies raise by issuing a new class of non-voting shares and requiring investors to sign a voting trust agreement. Now, investors are essentially silent partners. On the capitalization table, the new share class will be represented as one line item, with the full details of the individual investors accessible if required.
With the non-voting shares, voting trust and cap table setup, Morsink notes that both founders and VCs have confirmed they are comfortable with the structure and does not affect the company’s ability to be managed or to raise future capital. At some point in the future should the company attract a lead investor, Equivesto can structure the voting trust to provide the voting control to the lead, depending on the agreement between the lead and the VC.
Equivesto also recommends companies provide quarterly investor updates:
“Founders often find that having many smaller investors can actually be a sizable benefit. The company now has a large list of believers and supporters, who can be asked for help to grow the company, like introducing potential sales leads of a certain type, testing out a beta version of a product, or giving feedback on general public marketing etc.”
What are cost considerations for founders who are considering Equity Crowdfunding?
Wefunder charges 7.5% success fee on the amount of capital raised. This is not paid upfront but subtracted from the funds disbursed to the startup upon a successful close. Price indicates that for founders using standard SAFE/Convertible Note templates, they don’t incur upfront legal fees. If they are raising on a priced round, their lawyer will typically draft the subscription agreement. As per price,
“Usually, the only upfront cost for founders is for the CPA review/audit. If they are raising between $124K and $1.235M, founders need a CPA review. If they are raising from $1.235M up to $5M, they need a CPA audit.”
In addition, startups will spend money to advertise/market the raise. For those raising on community rounds, especially those with large audiences, marketing costs can be quite low. Replit and Mercury, who raised $5M on Wefunder in one day from their customers spent $0.
For Equivesto, there are 3 costs related to an ECF campaign:
a. Platform itself (Equivesto fees) – Equivesto charges CAD $3,000 + tax up front, and 7% of the total amount raised (no warrants). Other Canadian platforms charge other fees and may take warrants.
b. Legal fees – For a standard campaign, Equivesto can connect companies to our partner law firms that can provide a fixed price for legal support ~CAD $5,000 assuming standard needs. This includes amending articles of incorporation to add non-voting share class; review and edit of the 45-110 Offering document; report filing of Exempt Distribution with securities regulators; and assistance with legal paperwork with respect to issuance of shares post raise.
c. Marketing expenses – This component will depend on the size of the community, like what price outlined. Morsink noted that some companies can spend up to 10-20% of their targeted raise on marketing and advises that companies should target gathering up to 30% their targeted raise on the pre-campaign waitlist before they go live.
Will we see more companies going this route? And is this how ECF disrupts the VC space especially now that this lowers the investing threshold and opens opportunities for those who had not traditionally invested before?
Price agrees with this principle of democratization to allow angel investors to invest smaller amounts and adds it allows investors to not only access early opportunities, but also to diversify their risk and invest in more companies. Price notes that the playing field is not level just yet.
“The vast majority of startups
in the US are still raising through Regulation D and retail investors don’t have access to invest in them. Over time, we hope more and more startups open access to let their fans invest, on the same terms as VCs.”
Morsink agrees that more investors have access to early stage investing through ECF but also believes that ECF and venture capital can work alongside each other rather than replacing the other,
“Venture capital firms typically can provide much larger amounts of capital than can be raised via ECF, and while some VC firms participate at the earlier stage with smaller checks, most operate at Series A and beyond. ECF via 45-110 is limited to a maximum raise of 1.5MM per company per rolling 12 months, where most VCs invest in deals raising 5MM plus.”
He notes that VCs investing alongside angels on the same terms provide valuable advice and the provision of capital for faster growth for companies.
What’s clear is there is fertile ground to introduce and attract a new type of investor especially as innovation is poised for some critical disruption in the coming decade. And with the once-exclusive investment access to many cool technologies, Equity Crowdfunding could be just the solution to level the playing field and increase capital raising opportunities for entrepreneurs.
This post originated on Forbes.