By Dave Gauthier
The funding environment for start-ups has changed dramatically over the past decade, particularly for technology companies that require significant capital and time to commercialize a product. The bursting of the technology bubble in 2001-2002 essentially halted lucrative corporate takeovers and public market offerings for technology-based companies, resulting in a lack of liquidity opportunities for equity investors that had spent significant resources supporting early-stage development.
As a consequence, venture capital fund managers could not produce the return on investment expectations of their limited partners (often 25% per annum or more). Many funds were closed and those that survived refocused efforts on later stage investments that produce lower returns but are safer. The situation in Saskatchewan is no different. Our dominant provincial labour-sponsored funds now focus on funding growth and expansion opportunities, many in oil and gas and real estate, rather than risky pre-commercial technology start-ups. As a result, venture capital has essentially disappeared from our environment.
The importance of Angel investors in funding start-ups has become increasingly recognized over the past few decades. Angels are defined as “high net worth individuals or ‘accredited investors’ who typically invest and support start-up companies in their early stages of growth.”[i] Angels have existed for a long time, but the formation of Angel networks has made them more visible in the funding landscape, leading to a number of advantages for both Angels and companies looking for financing, such as:
>Allowing Angels to access steady deal flow (and companies to access a self-identified group of Angels)
>Allowing individual Angels to diversify an investment portfolio and invest in larger deals by partnering with others, partly filling the void of early stage venture capital
>Providing an opportunity to learn best practices in due diligence and become sophisticated investors
>Providing a known contact point for entrepreneurs to seek Angel capital instead of trying to find an Angel on their own
Around six years ago, the Saskatchewan Angel Investor Network of Saskatchewan (SAINT) was created as a first attempt to organize Angels in the Province. In 2011, the Saskatchewan Capital Network was created and several investors have already presented to this group of Angels. One element that would help to promote stronger participation in Angel networks in Saskatchewan is an Angel tax credit that would reduce some of the risk for Angel investors making investments in areas deemed to be important to the Province. Such programs exist in six other provinces and in many US States. Despite demonstrated impact of these programs, the Saskatchewan government has not yet implemented one here.
Due to the ever-expanding influence of social media on all aspects of our lives, a concept called crowdfunding has recently gained some traction. Based on the micro-credit model of KIVA.org and others, crowdfunding allows entrepreneurs to reach a large number of potential investors very quickly by listing their opportunity on a website. Rather than spending a lot of time and effort to find a few larger investors, a company may end up with hundreds or thousands of investors who invest much smaller amounts.
The concept sounds simple, but there are several issues with the model, primarily concerning securities regulations that exist to keep people from being “swindled.” Our securities laws require that companies raising investment broadly do so through the development and brokered marketing of a prospectus. A prospectus is created by an investment banker who does detailed due diligence on the opportunity and makes potential investors aware of all the risks involved—similar to the long list of side-effects we see on pharmaceutical advertisements. Development and marketing of a prospectus is expensive and time-consuming, making it a barrier for many young start-ups.
Exemptions exist that allow friends and family, registered entities like venture capital funds, banks and Angels who meet accredited investor definitions (i.e. high net worth measure like net income and liquid assets) to invest. The assumption is that people close to the entrepreneur will not be taken advantage of and that “sophisticated” investors are capable of doing their own due diligence and can afford to lose some or all of their investment if things go awry. However, the public at large could be susceptible to fraud, which is whya prospectus is required, and why the US feels that crowdfunding also requires regulation.[ii]
The general approach to crowdfunding in the US is to lessen risk by limiting the amount an individual can invest (the lesser of 5% of income or $2,000 for anyone making under $100,000 per year). It also places responsibility on the hosting websites to validate both investment opportunities and investors to prevent fraud. This latter requirement could be a problem for implementing true crowdfunding models, as legal responsibility will require web owners to do more detailed and costly due diligence, which could lead to increased costs for companies to list their opportunities. Consequently, we may end up with a situation that is not much different than today, with web hosts becoming more like investment bankers who develop an expensive web-based prospectus for only the most promising opportunities. Investors may also choose to invest in a group of companies listed on a particular website that are recommended by the site managers, similar to existing mutual funds.
In the end, nothing may change except for the use of social media in marketing a prospectus or selling investment portfolios based on fund manager assurances. The direct “connection” that previous crowdfunders had with the companies they were contributing to may be lost. It will be interesting to see how this model develops and whether or not it will lead to increased opportunities for Saskatchewan start-ups.
|Dr. David Gauthier is a member of the Ag-West Bio Board of Directors|