When Palmer Luckey needed money to develop his virtual reality headset, the Oculus Rift, he turned to crowdfunding. Over a month-long Kickstarter campaign in 2012, 9,000 backers put up US$2.4 million; a year and a half later, Oculus VR was acquired by Facebook Inc. (Nasdaq: FB) for US$2 billion. If the US$300 many of those online supporters pledged had bought them equity instead of an early version of the Rift, they would have netted a $43,500 payout, by some estimates.
Equity crowdfunding, the offering of shares of (typically startup) companies on crowdfunding platforms akin to Kickstarter, has been legal in Europe, Australia and Israel going back as far as 2010, but it’s only now catching on in North America. Saskatchewan was the first province to formally recognize this web-enabled alternative to traditional venture capital or private equity fundraising in 2013. Regulatory changes set to take effect on Jan. 25, 2016, will legitimize equity crowdfunding in Ontario, Manitoba, Quebec, New Brunswick and Nova Scotia. Accredited investors will be able to invest up to $25,000 per company (up to a $50,000 yearly total), while non-accredited investors will be restricted to $2,500 per investment (and a $10,000 cap in Ontario). British Columbia adopted rules in May capping individual investments at $1,500. The provinces restrict the kinds of companies that can seek funding and how much they can raise. Those looking to set up online portals where issuing companies can list their offerings will also be required to register with regulators and fulfil certain gatekeeper functions, like doing background checks on issuers and reviewing disclosures.
For retail investors, crowdfunding offers a way to diversify one’s portfolio into private equity, normally the preserve of institutional investors and high-net-worth individuals, says Don McDonald, president of Waverley Corporate Financial Services. “I think most people are probably underweighted in private equity,” he adds. Waverley licenses the SeedUps and InvestX platforms in Canada, which allow users to invest in fledgling and established private companies, respectively. (The company uses existing memorandum and accredited investor exemptions, and McDonald says it is unlikely to make heavy use of the new equity crowdfunding regulations.) Since private company valuations are not strongly correlated to the swings in public equity markets, crowd holdings can provide diversification to investors who already have conventional stock and bond portfolios, he says. “You could even view it as a bit of a hedge.”
Still, it’s a high-risk asset class. Investors would be wise to approach crowdfunding campaigns the same way they do the long-standing market for exempt securities. Most companies seeking funding are in the startup stage, and the failure rate of such enterprises, statistically speaking, ranges between 75% and 90%. “If you’re thinking about investing in crowdfunding, limit your exposure to something that you’re comfortable losing,” says Michael Pieciak, chairman of the corporate finance section committee of the North American Securities Administrators Association. The asset class also has limited liquidity. “There’s no secondary market for trading in crowdfunding,” notes Pieciak. “If you need to access the cash in an immediate way, then you are in sort of a bind. You can’t go to the stock exchange and trade the shares in for dollars.”
Another issue is the lack of transparency. Notwithstanding regulators’ intrusion into the market, the requirements for financial and governance disclosure are nothing like those for publicly traded companies. You can’t expect to find third-party analysis of the venture, and your financial adviser likely won’t be much help either. McDonald suggests sticking to companies in sectors you understand well.
If the experience of the U.K., which legalized equity crowdfunding in 2011, is any guide, Canadian investors might want to wait for the market to mature. “What happened over here is platforms started erring on the side of the companies rather than the investor,” explains Luke Davis, CEO of London-based IW Capital. “Lots of companies—and maybe they did this to encourage business to the platforms rather than traditional private equity houses—were overvalued.” Platforms tend to base their business models on commissions, so they are motivated to attract listings and maintain high volumes, not protect investors’ interests. But Davis—also a founding partner at Crowdfinders, which organizes events for crowdfunding platforms—says the market is undergoing a process of Darwinian selection, washing out platforms with poor due diligence track records and whose executives lack financial services credentials.
The offerings have also evolved, with more established companies that would previously have gone to a private equity firm raising their Series B rounds online. Although replacing venture capitalists or private equity investors in this manner comes with its own set of concerns—such backers traditionally bring expertise and connections in addition to funds—waiting for a later stage may make better financial sense. Plus, seed-stage investments can become diluted by later rounds, says Pieciak. In the best-case scenario, where the company you’ve invested in starts growing exponentially, say, or is acquired for a nine-figure sum, your piece of it may not be as big as it was at the startup stage.
Even with all these risks, equity crowdfunding’s potential payoff remains alluring. Just recognize that the market will be tumultuous in its early stages and that picking the right platform may be just as important as picking the right companies. “This may turn out to be the best investment you’ve ever made in your life,” says Pieciak, “but that doesn’t help you if your car breaks down and you need $5,000 right now.”
This article was originally published on Canadian Business.