NCFA Canada via the CFA Institute | Posted on August 27, 2013

James Allen, CFA, head of capital markets policy at CFA Institute, interviews researcher Douglas Cumming, CFA, on whether companies listed on venture exchanges have greater reporting problems, instances of fraud, and other issues when compared with companies listed on more established securities exchanges.

Market Integrity and Advocacy Webcast (click to play)

Policy Perspectives
Source: CFA Institute
James Allen, CFA | Douglas Cumming, PhD, CFA

NCFA Canada has summarized key points of the interview below.

James Allen (JA): In part 3 of this discussion with Douglas Cumming about venture exchanges, we discuss the JOBS Act (Jumpstart Our Business Startup Act), which was passed in the United States in 2012.  There are a number of provisions within the act that were designed for small companies to access the capital markets more easily, especially after the Tech bubble of early 2000's. In Europe, there is also a fairly significant push from the European Commission  to address financing for small companies in hopes to jump-start their national economies as well. What kind of policy lessons did you take from this study that would be applicable for small and medium sized companies?

Douglas Cumming (DC): Great question. To address this, I'll first note some interesting facts about UK, where we find similar rates of fraud relative to Canada. In particular, fraud accounts for:

• 0.4% of senior lending exchange listings
• 0.1% of AIM listings (smaller alternative market or venture exchange)

We are surprised about these results because they don't have the same fragmented regulatory structure as we do in Canada. The difference between the rates may be due to nominated advisors, who provide additional governance associated with companies going public. Other provisions to the JOBS Act that are widely discussed are efforts to allow crowdfunding, which is very different from traditional securities regulation. Equity crowdfunding (or investment crowdfunding) essentially allows issuers to raise capital without many of the normal disclosures associated with financing. The implications of this are quite significant - there may be tremendous benefits for companies that might otherwise have difficulty accessing capital markets.

Our observations in this paper shows that if these types of provisions for crowdfunding are allowed, there should be cost-effective governance standards put in place (as much as possible) on these companies to minimize any potential adverse consequences associated with crowdfunding.  In certain European countries as well as Australia, equity crowdfunding is permitted, which has provided a significant source of data for our other works. (Doug has done other work in the area of crowdfunding, one of the most known being a research paper on demand-driven securities regulation and crowdfunding)

JA: Can you briefly summarize how these other equity crowdfunding efforts in Europe and Australia work? What kinds of investors are drawn to these types of funding mechanisms, and were you able to track how these companies performed once they have accessed these financial markets?

DC: Yes, we have recent data from an equity (investment) crowdfunding portal in Australia in which we look at the disclosures made by issuing companies, which are effectively voluntary in crowdfunding. The interesting thing we see is that the company's success in terms of money they were able to raise and speed with which they were able to raise money a second time is very much correlated with the disclosures they make. Investors are showing some discernment; people are paying attention and companies whose disclosures which provide some level of comfort are able to raise much more money and much more quickly than companies that don't make such disclosures.

JA: What kinds of information are we talking about with these disclosures? Are these regular updates of financial information or just general corporate information?

DC: Financial information is certainly part of it, such as financial disclosures and forecasts. We see that the use of disclaimers on forecasts or no financial forecasts at all may negatively impact a company's ability to raise money. We also observe that companies who are selling too much equity (such as with founders who aren't keeping their "skin in the game"),  can be interpreted very negatively so investors are less likely to get involved, which is quite intuitive.

The other important thing we see is that if the issuing company has substantial or reputable board members, it significantly helpful for its efforts in is raising money. Also a route to liquidity, such as projected IPO exit dates, also likewise helps them raise more money in the future. Again, this is based on evidence from areas where equity crowdfunding platforms are permitted.

Another thing we saw is that if a company has a patent and it is disclosed, this type of signal does not necessarily help a company to raise more money or raise money quicker with crowdfunding. This is interesting, and we believe the reason for this is that if you are a startup with a patent, then you are likely to raise money in another way, such as venture capital financing. Raising money through crowdfunding may be a signal to investors that your startup was unable to attract funding through venture capital, so it doesn't help you in a crowdfunding context.

Source: CFA Institute