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olaf herschbach/Getty Images/iStockphoto

Securities regulators in Canada and the United States are considering endorsing crowd-funding, an unsettling prospect to anyone who thinks crowds are more inclined to generate popular lunacies than collective wisdom.

Crowd-funding has arisen as a possible alternative form of raising funds in Canada for companies forsaken by venture capital.

Websites such as Kickstarter that solicit online donations to meet fundraising goals for specific projects are not currently allowed to issue equity. The Ontario Securities Commission said last month it was weighing an exemption to change that in Ontario. Equity crowd-funding would give emerging companies access to a new source of capital and investors the chance to bet on small private companies and start-ups.

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The rationale behind raising capital from several small supporters relies on the judgment of the masses – a project or company is legitimized by the support of many ordinary investors. "That's the power behind these platforms," said John Wires, an adviser to the National Crowdfunding Association of Canada (NCFA Canada).

But Mr. Wires is also cognizant of the inherent risks of equity crowd-funding. "There is a lot to be said for the argument that the crowd is not wise enough. There is large exposure to the prospect of fraud."

Nonetheless, there exists the need for something new. "There's a gaping hole in Canada in terms of access to capital for small and medium-sized companies," said Darrin Hopkins, a vice-president at Macquarie Private Wealth in Calgary, who, despite his opposition to crowd-funding, acknowledges the severity of the funding gap. "Right now, the public venture capital market in Canada is completely broken."

NCFA Canada points out that investment in Canadian start-ups by venture capitalists, which hit almost $6-billion in 2000, fell 80 per cent over the following decade. Meanwhile, the costs of tapping public markets are prohibitive in Canada, where even a boilerplate prospectus costs six figures.

The U.S. Congress was an uncharacteristic catalyst for change when, last year, it mandated the Securities and Exchange Commission to legalize the issuance of equity without a prospectus to non-accredited investors. This legislation was to usher in a new way to connect entrepreneurs and investors – a model of raising capital for the digital age, its supporters claimed.

Critics foresee only the opportunity for investors to get fleeced. As it is, issuing equity requires meeting a demanding and expensive set of disclosure requirements, giving investors access to reams of information with which to weigh a company's investment potential. And still they get it wrong, Mr. Hopkins said. Sophisticated investors lose money all the time. Even outright fraud can escape the scrutiny of investors, analysts and auditors.

"If you move to the other extreme where you have a private company raising money on one of these portals, you've got an unregulated administrator, a private company with no disclosure, and you're selling it to the least sophisticated investor there is," Mr. Hopkins said. "It's naive to think you're not going to have a ton of problems."

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But the mere absence of a prospectus does not automatically increase the risk of abuse, said Anita Anand, a law professor at the University of Toronto. In fact, she cited one study of funded Kickstarter projects that found a lower incidence of fraud than among traditional IPOs. Of course, the risks can never be eliminated, she said. "But it's not the case that all capital markets activity has to stop until we figure out what to do about fraud."

It's possible to mitigate the risks, Prof. Anand said, through the right regulatory regime: minimum disclosure requirements, regulation of the crowd-funding portals and at least a temporary cap on the amount a single investor is allowed to commit per year.

The challenge for Canadian securities regulators is in striking the right balance between investor protection and ease of issuance, Mr. Wires said. "If we have similar regulations in crowd-funding that requires [issuers] to go to accountants and lawyers and spend thousands of dollars just for the opportunity, then crowd-funding will be dead on arrival."

Meanwhile, the U.S. crowd-funding initiative remains in limbo. The SEC long missed its January, 2013, deadline. Proposed rules are expected this fall, but a final framework might not come until the end of next year.

"The SEC is clearly worried about opening the floodgates to fraud," said Ermanno Pascutto, executive director of the Canadian Foundation for Advancement of Investor Rights. And with good reason, he said. "It rejects the whole way we've been raising money and developing our capital markets for the last 100 years."

Mr. Pascutto acknowledges the need for new ways to raise capital for small and medium-sized enterprises. "But just throwing the dart at crowd-funding because it's a fad of the moment is not the way to go about it."

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