Equity Crowdfunding: The Future of Impact Investing
An Impact(ful) Investing Trend
In recent years, there has been a far-reaching shift towards sustainable finance and long-term value creation in business. This is evident in the broader adoption of Environment, Social, and Governance (ESG) factors, a measurement system that scores investments on environmental, social, and governance criteria to determine their overall societal impact. The broader ESG market is forecasted to reach $45 trillion in assets under management (AUM) in 2020 and ESG-specific funds now account for over $1 trillion of global funds under management.
The Canadian government has recognized the potential of impact investing as a tool to enact social and political change. In 2018, the government developed the Social Finance Fund (SFF) which includes over C$755 million that will be deployed to Social Purpose Organizations (SPOs) over the next decade. SPOs, which include nonprofits, foundations, and social enterprises, use these funds to help grow their businesses while solving complex social and environmental issues. It was estimated that the Social Finance Fund will ultimately generate C$2 billion in economic activity, increase private market capital flows, and create 100,000 jobs over 10 years. In addition, the government has allocated C$50 million through its newly-created Investment Readiness Program which specifically aims to help small and medium-sized SPOs participate in the social finance market. However, while considerable progress has been made in terms of government support, regulatory gaps still exist that continue to hinder the growth of Canadian impact investing.
Past critiques of impact investing have resulted in improvements in impact measurement, management practices, and the proliferation of industry research. Despite these improvements, there remain opportunities for refinement. In the Canadian impact investing space, the biggest obstacles facing the industry are the capital gap for small- and medium-sized SPOs, and a lack of ready-made impact investing opportunities.
The Capital Gap
While public ESG investments are more popular than ever, the private impact investing market for early-stage ventures is severely underfunded. Currently, impact investors focus on organizations in the scaling stage: lower-risk ventures with semi-proven business models that are looking to grow. Conversely, only eight percent of early-stage venture capital investors adopt active ESG management into their allocation strategies. This leaves early-stage ventures lacking the capital needed to turn their research and development efforts into a proof of concept. This capital gap appears on a global scale—it is estimated that only a few hundred million dollars globally are earmarked to serve these emerging ventures.
In addition to the capital gap, one of the most significant barriers to widespread adoption of impact investing is the inaccessibility of existing investment opportunities. It can be difficult to find prospective early-stage ESG investments that meet investors’ social and financial return preferences given the lack of information available for these companies. Hence, while impact investing overall is on the rise, connectivity gaps have made it difficult for capital to be effectively distributed, especially to early-stage ventures.
There is also an underserved market of retail investors, particularly Millennials. Though over 86 percent of Millennials are interested in sustainable investing, they lack meaningful opportunities to participate beyond public market retail ESG investments. Consequently, although gaps exist between current investors and early-stage ventures, there is a broad group of interested potential investors that want to participate in impact investing. There needs to be a solution that supports companies at various stages of maturity, works in tandem with other financing mechanisms, and increases access to opportunities for both investors and entrepreneurs.
Letting the Crowd In: What is Equity Crowdfunding?
One nascent solution to the capital gap and other structural barriers is equity crowdfunding. The traditional crowdfunding market, including platforms like Kickstarter or Indiegogo, allows the public to contribute to the development of new products. Similarly, equity crowdfunding platforms like FrontFundr and Vested would enable companies to sell equity to a broad range of smaller investors.
While Canada has made significant improvements in establishing and regulating equity crowdfunding from a legislative perspective, the market is still underdeveloped. As a result, there remain significant market barriers for both investors and entrepreneurs. Other countries such as the U.K. and U.S. have found great success in using these models to catalyze capital fundraising for small-to-medium enterprises (SMEs), including underserved early-stage social impact ventures. In Canada, supporting SMEs is especially important because they make up 41.7 percent of national GDP. The capital gap shows that there are high potential businesses that require capital but have few means of accessing that capital from the private market. Equity crowdfunding would help bridge this gap while providing additional opportunities to retail investors, who care for social impact investments.
Making an Impact for Dummies: Three Key Steps
There have been several legislative changes that support equity crowdfunding in provinces like Ontario and British Columbia. However, significant challenges still inhibit investor participation, including the high costs of due diligence, transaction and investment limits, and lack of market liquidity. The Canadian government should work to implement tax incentives, regulatory changes, and support the broader ecosystem. With these recommendations, it can increase investor participation, solve the capital gap, and create wider support for organizations looking to raise capital.
To support the equity crowdfunding market and improve accessibility for both ESG investors and SPO entrepreneurs, the Canadian government must address structural and financial barriers to raising capital. Capital raising costs on equity crowdfunding platforms are affordable for established revenue-generating companies, but pose a significant constraint for cash-starved early-stage businesses because a considerable portion of raised capital will be lost to fees. Government tax credits or rebates can cover these expenses for SPOs, which would enable them to more easily solicit funding from potential investors.
Another tax credit should be available to retail investors who invest in SPOs. The success of equity crowdfunding in the U.K. was largely driven by the Enterprise Investment Scheme, Seed Enterprise Investment Scheme and Social Investment Tax Relief. These are tax incentives that allow investors to claim 30 percent of the amount invested against their income tax for up to £300,000. Investors can also sell shares in small businesses without capital gains tax. Tax credits such as these would effectively reduce the cost and risk of early-stage investing, which in turn would increase the funds available to these businesses.
More Investors, No Problems
Currently, retail investors in Ontario can invest no more than C$2,500 into a single investment through crowdfunding, for a total of C$10,000 annually. The amount available to invest increases for accredited investors—those meeting a minimum requirement of C$1 million in net worth or C$200,000 in annual income in the last two years. Accredited investors can invest up to C$25,000 per single offering with a maximum amount of C$50,000 annually.
The definition of an accredited investor is significantly less flexible in Canada than in other countries like the U.K. and U.S. While investor risk and safety are important, easing regulations would increase the amount that investors are able to allocate, allowing entrepreneurs the ability to raise much-needed capital. Furthermore, various countries have begun looking at other criteria for accredited investors, such as professional designations. Allowing those with professional designations that demonstrate knowledge of the financial and their risks—such as Chartered Financial Analysts—would allow more investors to access the market without endangering unknowledgeable investors. More importantly, relaxing strict restrictions democratizes access to early-stage impact investments, allowing everyday investors to participate in the space and invest in meaningful causes.
Supporting the ECosystem
Besides regulatory barriers, it is also important for equity crowdfunding platforms to accurately represent the environmental or social impact that aspiring ventures are seeking to make. There is an opportunity for these platforms to improve sourcing and visibility for SPOs that meet certain due diligence and impact measurement criteria. Doing so may require hiring additional human capital and investing in impact tracking methodology, but it has the potential to attract the underserved impact investor pool. This will in turn grow the equity crowdfunding market as increased transparency and the potential for higher returns will draw more capital towards the ESG early-stage ventures.
Above all, equity crowdfunding can unlock capital from the private sector and develop much-needed infrastructure for the impact investing space. Rather than replacing other investing channels, it complements the pre-existing private market by helping more organizations reach the growth capital stage. As this channel matures, it will be able to spur secondary markets and encourage more people to invest, resulting in a virtuous cycle for ESG investments. At this critical time, support for ESG investments not only enables innovation and entrepreneurship, but also helps organizations advocate for social and environmental change.