Is the government’s innovation statement just a $1.1 billion cash-splash for votes? An in-depth look at equity crowdfunding reforms

This is the fourth article in a series where CapitalPitch co-founder Jeremy Liddle explores different aspects of the government’s innovation statement and the potential impact they will have. You can read his take on the tax incentives, the support for accelerators and incubators and global landing pads.

The innovation, startup and investment community rejoiced in December 2015 when our new Prime Minister chose to make the statement about innovation and science the first priority policy decision of his tenure.

Fast forward to May 2016, with an impending election; we must ask the question of our Government: “Are you investing public money based on sound decisions for the future prosperity of Australia or are you buying media opportunities and votes?”

At the time of writing this article, with the announcement of the double dissolution and federal election, there are no sitting dates scheduled for the Senate or House of Representatives to pass any legislation or rulings.

So we can now be sure of one thing: very little will change for the benefit of our ecosystem in the near future. The senators and ministers that had previously championed the Innovation Agenda are now fighting for their seats instead of implementing their much needed promises.

At least Labor & the Coalition are fighting to be the parties that are more innovative and supporting of startups, so let’s hope that the election will drive stronger support and better policies in the long run.

Equity crowdfunding

Let’s now look at crowdsourced equity funding. Legislation to implement CSEF was introduced into Parliament on December 3, 2015, so this initiative should have been rolling out shortly.

What is it? Innovation.gov.au states:

CSEF is a new fundraising approach that:

● allows entrepreneurs to raise funds—up to $5 million per year—from a large number of individuals in return for equity in their company
● will give companies, that become a public unlisted company, access to CSEF that includes a five year exemption from the reporting and disclosure requirements that normally apply to public companies.

Who is eligible?

• CSEF will be available to Australian public unlisted companies with annual turnover and gross assets of less than $5 million.
• Individuals seeking to invest using the CSEF platform can contribute up to $10,000 per company, per year

However there are challenges to making the CSEF a successful regime, given some of the requirements:

• CSEF Offers will require the preparation of a specific CSEF Offer document, the contents of which will be prescribed by the regulations and somewhat similar to a prospectus. Producing a document such as this can be onerous and often an extremely expensive process for a Startup. We consistently see Startups wasting $20k – $100k producing Information Memorandums and Prospectuses who then fail to raise the capital they require
• Eligible companies raising capital through CSEF may have slightly lower compliance costs than other public companies for up to 5 years, such as exemptions from disclosing entity rules and the requirement to hold an Annual General Meeting
• However, these exemptions are void as soon as the company raises over $1m with a CSEF Offer. The compliance burden on great companies that can, and will, raise larger rounds will therefore immediately become expensive and onerous
• Each CSEF offer must be made through a single platform operated by a CSEF intermediary. CSEF intermediaries must hold an Australian Financial Services Licence (AFSL) that authorises the provision of a ‘crowd-funding service’. There is currently no such authorisation available from ASIC, so even if the changes come into effect, platforms are not yet able to operate
• CSEF intermediaries will have appropriate and lengthy diligence obligations under the proposed framework including checks on company identity, directors, officers, company CSEF eligibility and the validity of the CSEF Offer document. Intermediaries can also be liable for any losses or damages caused by an offer of securities under a defective CSEF Offer document where the CSEF intermediary knew that it was defective

A failure by the CSEF intermediary to comply with its obligations will be an offence punishable by fines and a jail sentence of up to five years.

The fundraising system for startups is broken.

Great startups are being killed by failing to raise capital and investors struggle to find great deal flow. The implementation of the CSEF regime in its current proposed state perpetuates a broken system instead of truly innovating a solution to give Startups and Investors an efficient and effective way to connect and grow together.

At CapitalPitch, in order to be compliant with Australian law, we have had to operate as a Business Introductory Service under the ASIC Class Order. We are now moving to Regulated Unregistered Offers under an AFSL which will restrict us to working with Sophisticated & Professional investors.

We believe very strongly that investors in startups should only ever be smart and strategic individuals or organisations that can add significant value to the business, and help the founders.

There is a clear and present danger under the proposed CSEF regime that startups will attract investors that do not understand the business and therefore cause distraction and damage both to the business and to the reputation of startups as an asset class.

Our recommendation to Treasury in 2015 was to allow platforms to advertise to a relaxed definition of sophisticated investor, so that the definition is closer to those of the US or the EU’s accredited investor. This could have been implemented very quickly and would have had a dramatic and immediate impact.

The CSEF regime as it currently stands is at significant risk of failure.

Platforms will need to do an extremely good job of screening and selecting only the best Startups, ensuring that the investors add value and that they receive positive returns across a portfolio of investments.

The last thing Australia needs is for more inexperienced “mum and dad” investors to get involved in risky ventures when they are neither able to add value to the ecosystem or entrepreneur, nor can they absorb some of the potential losses that can result from such investments, which would cause the devaluing of startups as an asset class by the market.

What we do not need is more regulation and red tape to address this potential eventuality: we need platforms and startups with a significantly higher standard of rigour, diligence, valuation, revenue and investor protections baked in.

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