Financial Post  |  John Wires and Craig Asano, Special to Financial Post | 13/08/29 | Last Updated: 13/08/30 11:59 AM ET

How do we justify the unqualified crowds who invest in penny stocks?

Crowdfunding refers to raising small amounts of capital from a large number of people by leveraging the internet and social media. It is becoming all the rage largely because the venture capital industry is broken. In fact, in 2011, the Business Development Bank of Canada retained McKinsey & Company to draft a report which concluded just that.

According to Industry Canada, in 2011 there were only 176 venture capital financings under $1-million, of which the bulk were made with government funds, making them the largest gatekeeper to accessing capital and spurring economic development.

Aside from friends and family, the only other real hope for raising equity financing is to turn to public markets. But with our existing securities laws, even raising small amounts of capital is a complex and costly process. As a result, small businesses are often precluded from raising equity financing to expand.

For entrepreneurs, equity crowdfunding provides a real chance at financing their business from a new source of capital investors – “the crowd.” However, for Bay Street securities lawyers, crowdfunding represents a shift towards deregulation of the securities market and an open door for investors to lose their shirts.

Critics argue that ill-witted crowds aren’t qualified to assess investment opportunities properly. That is, reviewing investment opportunities requires the skill and expertise of a venture capitalist (VC) with well-polished shoes, and even they get it wrong the majority of the time. The irony is that VC’s are paid to figure out whether a market (read crowd) would actually buy the product or service offering being pitched. With crowdfunding, the argument goes that if thousands of people are willing to invest in a product or service, they in turn validate a demand for it and increase the prospect of a successful product offering. While this by no means suggests that all crowdfunded companies will attract success, it certainly gives them an advantage out of the gate.

Like VC’s, online crowdfunding portals offering securities have an interest in making sure that unqualified companies aren’t listed. The more companies that list and fail to raise money, or worse, raise money and then fail, the fewer prospects the portal has at surviving. For this reason, portals like CircleUp in the U.S. and Seedrs or Crowdcube in the UK report rejection rates between 80% and 98% of all issuer applications, of which only a fraction actually get funded.

In Canada, some have called for existing incubator and accelerator programs like MaRs, the Ryerson Digital Media Zone and Incubes to be involved in the weeding out process. Others have suggested incubators get involved in running portals and have successful issuers be required to work with them to properly grow their business. More importantly, under Ontario’s proposed framework, regulators will also be involved in regulating crowdfunding portals and not just the issuers.

But regardless of whether the crowd is qualified or not, the real question is what justifies limiting the crowd’s opportunity to invest in start-ups? If being “qualified” or “smart enough” to invest in a startup is the bar to entry, how do we justify all the unqualified crowds who continue to invest in penny stocks, the TSX Venture Exchange, junior mining companies and even the Nortel’s of the world?

Resources and Links:
Canada’s most comprehensive Crowdfunding Directory
NCFA Canada active Polls – Vote Today!

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The National Crowdfunding Association of Canada (NCFA Canada) is a cross-Canada crowdfunding hub providing education, advocacy and networking opportunities in the rapidly evolving crowdfunding industry. NCFA Canada is a community-based, membership-driven entity that was formed at the grass roots level to fill a national need in the market place. Join our growing network of industry stakeholders, fundraisers and investors. Increase your organization’s profile and gain access to a dynamic group of industry front runners. Learn more eBrochure |Prezi or contact us at casano@ncfacanada.org.