By Senior Associate Matt Vitins and Lawyer Cameron Winnett.
As you read this, the Melbourne-based makers of 'LazerBlade: the affordable laser cutter / engraver' are probably exchanging high-fives. Their Kickstarter project, seeking $45,000, has raised almost ten times that much. Soon, the project's backers hope to receive their LazerBlades – their pledges were effectively a pre-purchase of the product itself, a common model on crowdfunding platforms.
Meanwhile, southern-style food truck business 'Breaking Bread' appears to be struggling for support.
Pre-purchase and other 'patronage' models of crowdfunding are more useful to some businesses than others. In this case, we'd probably rather spend our $15 on lunch today rather than pre-purchasing online the possibility of lunch in November.
A recent report by the Corporations and Markets Advisory Committee (CAMAC) explores regulatory issues involved in allowing slow-cookers like Breaking Bread to take advantage of crowdfunding platforms in a different way: by offering equity to investors, as a means of raising capital. This would be an attractive prospect for many small companies for whom the costs of fundraising, given the onerous disclosure requirements under the Corporations Act 2001 (Cth), might normally be prohibitive.
In this article, we discuss CAMAC's proposals on equity crowdfunding and how these compare to developments in other jurisdictions. Perhaps more so than proposals in other jurisdictions, CAMAC's report seems to achieve a reasonable balance between two competing interests: the interest of companies (particularly smaller ones) in easily raising capital, and the public interest in protecting investors from fraud and questionable investments, and thereby providing for confidence in capital markets.
Providing access to crowdfunding platforms could contribute to the efficient and effective allocation of capital in the financial system, which is a major focus of the Financial System Inquiry (FSI) currently taking place. David Murray, the chair of the FSI, has noted in a recent speech that innovations such as crowdfunding and peer-to-peer lending are 'an area we need to assess closely – especially when we consider the rapid growth of some of these innovations globally'. It may be that the FSI will recommend changes to the regulatory settings to allow equity crowdfunding within a framework of appropriate consumer protections. We hope that issues in the CAMAC report are taken up in the FSI's interim report, due to be issued on 15 July 2014.
CAMAC's report, Crowd Sourced Equity Funding (the Report), provides a detailed review of the regulation of equity crowdfunding in Australia. It draws upon developments in other jurisdictions including the USA, Canada, New Zealand and the UK, all of which are also considering what adjustments should be made to their regulatory regimes to take advantage of crowdfunding.
Broadly, the Report proposes a new regulatory scheme made up of:
- a new corporate form better suited to the types of companies seeking crowdfunding;
- a cap on the total amount that can be raised by companies through equity crowdfunding, and a cap on crowdfunding investment by individuals;
- obligations on companies issuing equity through crowdfunding platforms (issuers), and
- obligations on equity crowdfunding intermediaries (platforms).
In the Report, CAMAC takes the view that existing company structures in Australia are inappropriate for companies engaged in equity crowdfunding. Proprietary companies can have no more than 50 non-employee shareholders and are generally prohibited from making public equity offers, while public companies are subject to significant compliance requirements. CAMAC recommends creating a new corporate form: the 'exempt public company'.
Exempt public companies would be exempt from obligations including continuous disclosure, the need to hold AGMs, and auditing of annual reports. Their exemption status would expire after a period of time or once certain financial measures are met.
CAMAC proposes that exempt public companies should be prohibited from raising more than $2 million through equity crowdfunding in any 12 month period. This compares to proposed thresholds of $1 million in the US and $2 million in New Zealand. In Canada, there are two proposed models in the works, which contemplate different types of companies – a 'Start-Up Crowdfunding Exemption' would cap investment at $150,000 per offering, whereas a 'Crowdfunding Exemption' modelled on Ontario's past proposals anticipates bigger investments within a cap of $1.5 million.
Consistent with these other jurisdictions, CAMAC would also cap the amount that can be invested by an individual through equity crowdfunding in 12 months – $10,000 in total, or $2,500 in any one exempt public company – though there is no sanction proposed for any breach.
These caps largely match up with the crowdfunding experience to date. Kickstarter stats show that of over 63,000 successfully funded projects, only 70 have raised more than $1 million, whereas more than half have raised between $1,000 and $10,000.1 On Pozible, the average amount raised is $6,177 and the average pledge is $86.2
Setting appropriate caps nevertheless involves some guesswork. How will equity crowdfunding compare to patronage crowdfunding in terms of number of investors, or the size of their investments? Arguably equity-funded projects are likely to require larger investments from tens of people – maybe of more than $2,500 – rather than smaller pledges from hundreds.3 Acknowledging that any figure chosen is somewhat arbitrary, CAMAC says the cap could be adjusted from time to time based on experience with equity crowdfunding.
The tricky balance referred to earlier comes to a head on the issue of disclosure, as CAMAC recognises:
A general comment in submissions was that, in designing issuer disclosure requirements, a balance needs to be struck between the need to provide reliable and useful information to the crowd investor and the need to ensure that the disclosure obligations are not so burdensome as to discourage bona fide start-up and other enterprises from seeking equity funds through [crowdfunding]4.
CAMAC suggests issuers disclose the offer size and pricing of shares, the amounts invested by founders, a business plan, information on any prior crowdfunding offers, and details of the intended use of the proceeds – particularly whether any amounts will go directly to people involved in or connected with the issuer.
Departing from the US position, CAMAC's proposed disclosure obligations do not include an obligation to disclose financial statements (but still require companies to publish annual financial reports online). In the US, the Jumpstart Our Business Startups Act (the JOBS Act),5 signed into law in 2012, will require issuers to disclose a tax return for the previous year, and financial statements – which must be reviewed by an independent accountant if the total amount raised is between $100,000 and $500,000, or audited if the amount is over $500,000. The two Canadian models also differ from each other in this respect: the 'Start-Up' model does not require disclosure of financial statements, whereas the Ontario model is closer to the JOBS Act.
An important lesson from the US is that reasonable disclosure obligations, taken on aggregate, can become onerous, particularly in the hands of regulators. The JOBS Act left to the Securities and Exchange Commission (SEC) the tasks of implementing the new equity crowdfunding exemption and prescribing rules. The SEC Rule Proposal, issued in October 2013 for public comment, proposes a prescriptive set of disclosure (and other) rules. The rules would require issuers to disclose the business experience of directors and officers during the past three years and the terms of any indebtedness by the issuing company, and to discuss the material factors that make the investment speculative or risky.
CAMAC has similarly flagged a role for ASIC in designing a disclosure template. The challenge will be to retain the right balance, and perhaps to avoid producing a document like the telephone-book SEC Rule Proposal.
For platforms that want to host equity crowdfunding,6 the regulatory burden of doing so will be an important consideration.
Submissions to CAMAC were divided on the extent to which equity crowdfunding platforms should be required to conduct background checks on issuers and their management. CAMAC ultimately concluded that 'left to themselves, crowd investors would have little capacity to distinguish between genuine and questionable issuers'.7 Therefore, platforms would be required to conduct limited due diligence on issuers and their management, with a view to preventing fraud.
Should platforms be required to consider the issuer's business itself? In Canada, under the Ontario model, they would – at least in order to form a reasonable belief that information provided by issuers adequately describes the structure, features and risks of the issued security. CAMAC doesn't quite form a view on this question, though notes that it may involve a complex and technical exercise.
As per the proposals in other jurisdictions, CAMAC suggests that platforms would be responsible for providing the generic risk disclosure statement to investors, monitoring compliance with investor caps and acting as a means of communication between issuers and investors. People involved with the platforms would be subject to a number of restrictions in regard to investing in, or lending to issuers, and providing advice to investors. All platforms would require a licence from ASIC in order to operate a crowdfunding website.
And finally, maybe the most important question for equity crowdfunding platforms: their liability. Under the JOBS Act, platforms could be liable for false or misleading information by the issuer. By contrast, CAMAC suggests platforms that comply with the requirements in a due diligence template should not be liable, except where they had actual knowledge of fraud or wrongdoing by the issuer. Wronged investors would generally be left chasing the food truck.
Has CAMAC's report found a good balance? Probably only experience will tell, though at the very least CAMAC has shown excellent awareness of the competing interests at play and has supported its conclusions by detailed reference to developments overseas. We should hope that the influence of the Report isn't diminished by the Federal Government's decision to take the LazerBlade to CAMAC in the recent Federal Budget. An important indicator will be whether the conclusions in the Report are advanced by the Financial System Inquiry when it issues its interim report on 15 July 2014.
- Kickstarter, Stats (2014).
- Pozible, The Handbook (2014).
- Paul Niederer, 'For many Startups there is no “Crowd” in Equity Crowdfunding' (5 June 2014).
- The Report, page 69.
- Public Law No 112-106, 126 Stat 306 (2012).
Some existing platforms may not. Kickstarter, for example, has indicated that it won't switch to an equity-based model: it is a platform intended for people 'to support things because they like them, rather than finding things that produce a good return on investment' (see Jennifer Bogo, 'Q&A: Kickstarter Co-Founder Yancey Strickler' (7 May 2013).
- The Report, page 103.