0912/2015

Crowdfunding - a new wave of disruption in private capital

 

Crowdfunding is a major catalyst for economic and social transformation - it represents the democratisation of access to private capital, a grand experiment in the wisdom and folly of the crowd. The world is only just waking up to the impact that crowdfunding will have on entrepreneurship, investment and economic growth in the 21st century.

 

“By 2016 the crowdfunding industry is on track to account for more funding than venture capital, according to research firm Massolution’s annual report. With an estimated market value of $34 billion in 2015, crowdfunding has come a long way since its valuation of $880 million in 2010.”[1]

 

The recent introduction of Securities and Exchange Commission (SEC) rules in the USA allows investment in private projects by a larger portion of the American public. It is likely to propel the interest and use of crowdfunded finance to new heights. However, the USA appears to be moving much more slowly than the UK towards an integrated regulatory and tax regime for investment in start-ups and SME’s, holding back its full potential. The European Union is moving even more slowly.

 

Crowdfunding covers a wide range of behaviour including business and consumer peer to peer (P2P) lending and equity investment and invoice trading. It allows project and enterprise fundraising from a much wider range of sources and at more diverse levels of investment. Many entrepreneurs will have already realised the difficulty in accessing bank and private equity finance for their start-up or early stage projects. The ability to get direct access to the ‘crowd’ should not be underestimated as a force for social change and engagement.

 

At its best crowdfunding surfs the wave of a major macro trend that is seeing people want to participate much more in wider aspects of the world we live in. By personalising capital allocation it makes a much wider group of people investors, reducing the reliance on capital markets, banks and traditional introducers who have previously been the necessary gatekeepers for accessing capital.

 

 

Graph 

 

“the VC industry invests an average of $30 billion each year. Meanwhile the crowdfunding industry is doubling or more, every year, and is spread across several types of funding models including rewards, donation, equity, and debt/lending. In particular, equity crowdfunding – now being legalised in the US – holds huge disruptive potential.”[2]

 

The global market for crowdfunding

The use of technology and dispersion of new crowdfunding platforms (CFPs) will also allow crowd capital raising to climb the value chain, allowing even greater capital intensity for interesting diverse projects.

Disruption and disintermediation is likely to hit the old world of city-based deal introducers and arrangers hardest at first. The more innovative banks (particularly private banks), hedge funds, private equity groups and venture capitalists will continue to have a significant role in this new world. In many cases, the investment from CFPs will sit alongside existing capital providers (e.g. CFPs may help raise mezzanine debt in order to secure bank finance or it can encourage matched equity participation). In addition successful crowdfunded businesses can move up to public capital markets.

 

Interestingly, over the last few years, we have also seen many major capital market players move more of their allocation to private enterprises (giving rise to the so called increase in tech 'unicorns') and we are seeing longer lead times for successful start-ups to make their way to public offerings, such as Uber. This gives a foretaste of the potential for crowdfunding to blur the boundaries between use of public and private capital markets.

 

Renewables - an area under pressure that is ready for crowdfunding 

The renewable energy sector is likely to be a key beneficiary of this trend, as the sector intersects a number of significant growing trends for participatory investment and involvement in projects that have a major environmental, social and political impact.[3] In addition, the current vertiginous decline in the energy equity and debt markets means that crowdfunding may provide a much needed lifeline for disruptive new entrants. Renewable projects tend to favour long-term debt finance more than equity - though both types of investment are required. 

 

In order to be successful renewable CFPs will need to help solve the following challenges:

 

Trust: CFPs must try to ensure that investors can be confident that their interests are being considered and will be protected. This is particularly important in the renewable energy space, given the highly technical issues and the long-term nature of returns on investment. Intelligent investors would usually rather invest in a project that professional investors and other financial institutions are invested in — this gives additional comfort on issues like due diligence. CFPs have a major role to play in helping to seed the CFP with significant investors and to give even greater support in seeding and marketing the most attractive crowd-chosen projects on the CFP.

 

Alignment of interests with investors: How can we ensure that CFP and investor interests are aligned? Some CFP regulatory models prohibit investment by the CFP and related parties (‘introducer’ model) whereas others permit it or rely on it (‘manager’ model). In the UK we see an interesting contrast between the ‘introducer’ model (e.g. Crowdcube which has so far raised over £125m for companies) and the funds ‘manager’ model (e.g. Seedrs, the second largest equity CFP in the UK). Whether the model is ‘introducer’ or ‘manager’ the key element is ensuring that returns for the CFP are not too strongly front-loaded or based on short-term success as this would clearly give rise to the risk that CFPs will favour quantity more than quality (e.g. reduced suitability reviews for the member base, lack of investment structural risk reviews and inadequate due diligence). 

 

Structural credibility: project finance in this sector must be built on the assumption that the longevity of most CFPs may well be less than the duration of the renewable projects being funded. The CFP structure must be built to reflect this and future proof for this likely issue.

 

Education & Training: people must be educated about the nature of renewable energy investments, the risks (including liquidity risk and macro risks in the energy space) and how their interests are protected in the event of CFP or project failure (and the remaining risk that cannot be mitigated). We must not be blindly optimistic, the huge demand for renewable investments also opens up investors to poor projects and investments offered by unscrupulous or at least very inexperienced operators.

 

State support: energy investment requires even more state engagement in terms of regulation, price balancing and taxation to flourish. This means not only protecting investors but also allowing and encouraging investment using efficient tax structures, such as self-invested pension plans and investment tax wrappers (e.g. UK SIPPs & ISAs, American IRAs and 401k’s), investment tax relief (income tax and capital gains deductions against qualifying investments) and helping to moderate short-term market fluctuations that inhibit long-term financing (e.g. use of carbon credits and feed in tariffs).

 

 Positive Circle Image

(Abundance Investment)

 

 

 

A personal example of the potential power of CFPs - Peter Howitt of Ramparts

Peter recently made his first equity investment using a UK CFP (crowdcube.com) and invested in a P2P platform start-up, MonetaFlex, listed on that CFP. Monetaflex is building a platform to allow businesses to trade invoices (receivables) with investors (which is also an area of professional interest).

 

“Crowdcube asked me to certify that I was aware of the high risks of investment in a start-up and that I had some experience in investments given the size of investment I was making. The investment attracted 50% income tax relief (under the UK Seed Enterprise Investment Scheme) thus reducing my net investment considerably. The investment is a great example of the potential of CFPs to allow investors to access entrepreneurs that are engaged in projects that they find interesting or in which they believe they may even be able to add some value (go MonetaFlex!). Whilst this investment may prove unsuccessful, given most start-ups fail to achieve their stated objectives, I was happy to take the risks involved using a small part of my capital for the chance to be involved with entrepreneurs that I liked and that are trying to transform the future business landscape  –  innovation and change requires energy and risk capital” (Peter Howitt)

 

 

Where could crowdfunding take us?

It is hard to foresee the full impact crowdfunding will have in the world at this early stage, though it is likely to have much greater impact than many anticipate.

 

For example, we at Ramparts think Uber is a great example of the power of the application of technology to transform the old world. However, not all agree and some have even suggested that it is not truly disruptive:

 

Christensen & co are obviously irritated by the valley’s conviction that the car-hailing service is a paradigm of disruptive innovation and so they devote a chunk of their article to arguing that while Uber might be disruptive – in the sense of being intensely annoying to the incumbents of the traditional taxi-cab industry – it is not a disruptive innovation in the Christensen sense, for two reasons.” [4]

 

Whilst Christensen & Co claim that it is not appropriate to use the word ‘disruptive’ in respect of Uber, it appears to us that they may be failing to consider the likely Uber business strategy in sufficient detail. Uber’s disruptive nature is not simply in the disintermediation of taxi companies (though that is its first obvious effect). Uber’s real innovation is that it makes nearly any person a potential taxi driver and nearly any vehicle a potential private hire vehicle. With the coming age of driverless vehicles, we start to glimpse the greater potential impact of their disruptive business model.

 

We believe that the same analysis can be applied to crowdfunding. At first it will primarily disintermediate introducers and arrangers of private capital in certain sectors and territories. However, the real disruption will happen once it becomes large scale and then international, we will then realise what it means for any project anywhere to be open for funding by everyone in the world. This represents an unprecedented amount of private capital and diversity of investment opportunities for different sectors and at different scales.

 

CROWDFUNDING MODELS

 

 

There are 4 main types of crowdfunding platform:

 

  • DONATION  

Investors donate for nothing in return. The top CFP in this space is gofundme.com which is a platform used for personal fundraising.

 

  • REWARD   

Contributors fund in return for a reward, for example receipt of a prototype product. The value of the reward may vary depending on the size of the investment. Kickstarter is one of the largest CFPs of this kind, specialising in creative projects. It runs an all or nothing model, so if the target funding is not reached, contributors receive their funds back.

 

  • INVESTMENT/EQUITY   

Investors receive shares in the company that they invest in. Crowdcube.com claims to be the world’s leading investment CFP, with over 300 projects successfully funded to date[5].

 

  • LOAN BASED / DEBT / P2P 

Investors lend money in return for interest payments and repayment of capital over time. Fundingcircle.com is a UK CFP that has so far lent over £890 million to thousands of people, this has been supported also by the UK government via the British Business Bank. Loans via CFPs for small businesses are really gathering momentum, and Funding Circle even advertises its services on mainstream television.

 

REGULATION IN EUROPE & USA

There is no harmonised market for crowdfunding investment across Europe. Various existing European directives may apply (depending on the CFP model and investment structure), such as MIFID, the Prospectus Directive, AMLD III and PSD. However, without authorisation under EU wide law there is no easy ability to ‘passport’ the financial services authorisation of a CFP from one European territory to the rest of Europe. This will make cross-border CFPs prohibitively expensive for all but the biggest/best funded.

 

The regulations that apply depends on where the CFP is established and the location of investors. This means that it is crucial to understand national appetite for CFPs and the approach of regulators within the European member states to the structure of CFPs they will permit (if any).

 

The European Securities and Markets Authority (ESMA) is analysing the investment model, and working with the European Banking Authority (EBA), who are also looking at the loan model, to identify how a level playing field throughout the EU could work. Key issues identified with the investment and loan models are:

 

Investment

 

Loan


  • high risk of failure
  • no secondary market
  • securities are unlisted
  • difficulty scaling up as no ‘passporting’ rights

 

  • risk of fraud
  • lack of transparency
  • misleading information
  • money laundering risks

 

   

 

SNAPSHOT OF THE UK & US CROWDFUNDING REGULATIONS

 

 

UK

US

Type of CFPs regulated

Loan[6] and equity

Equity only

 

Regulatory Authority

Financial Conduct Authority (FCA)

 

All regulated CFPs must be authorised by the FCA.

Securities and Exchange Commission (SEC)

 

All regulated CFPs transactions must be conducted via an SEC-registered intermediary, either a broker-dealer or a funding portal.

 

Main Legislation

Financial Services & Markets Act 2000 (FSMA)

 

Financial Services and Markets Act 2000 (Regulated Activities) Order 2001

JOBS Act 2012

JOBS Title III

Restrictions on investment

CFPs can only offer investments to those who:

 

  1. take regulated advice
  2. qualify as high net worth or sophisticated investors; or
  3. self certify that they are not investing more than 10% of their net assets and will not do so in the next 12 months.

 

 

 

CFPs can only offer investments to:

 

  1. Accredited Investors (net worth = $1m or income = $200,000 pa)
  2. Anyone - if annual income is:

<$100K: then max = 5% of the greater of (i) income or (ii) net worth

>$100K: 10% of the greater of (i) income or (ii) net worth

 

Generally securities can’t be sold until after one year.

 

Maximum investment raised via CFP by a company is $1,000,000 per annum.

 

Limit on investment by an individual per year

 

As above for investors in category 3.

$100,000 maximum annual CFP investment limit for investor having income or net worth > $100,000.

Do restrictions fall away?

This will depend on the requirements of the CFP as to whether you can self certify as a sophisticated or advised investor.

 

No.

Does the CFP have to register with the regulatory body?

 

Most loan and equity based CFPs require a FCA licence (subject to some interim arrangements for previous holders of consumer credit licences from the OFT prior to April 2014).

The CFP will have to file certain information with the SEC, and disclose prescribed information to investors. Registration with the SEC is not required until it raises in excess of $1m.

 

 

Tax breaks

Seed or enterprise investment tax relief (SEIS & EIS) can mean:

  • between 30-50% of the investment is deductible from income tax.
  • capital gains relief may also be available allowing you to offset the investment amount against capital gains.[7]

 

In addition debt investments on CFPs can now be made within tax wrapper products (ISA, pensions).

It is not clear that this necessary element has been structured into the current US tax regime.

 

In the UK loan CFPs are obliged to ensure individual lenders are provided with the information needed to properly assess the risk they’re taking, protect client money and plans are in place to ensure repayments continue even if the platform collapses. The system is a light touch one designed to encourage responsible investment in SMEs and promote the UK as a hub for crowdfunding.

 

Tax issues

Taxation of any funds raised depends on the type of crowdfunding used. A few issues to watch out for are:

  • Platforms that provide rewards have to remember that money raised may be classed as taxable income (if the rewards issued have a value similar to the investment received);
  • CFPs will not collect or remit tax on behalf of companies.

 

Conclusion

Crowdfunding is a major catalyst for economic transformation - it represents the democratisation of access to private capital. It is also a grand experiment in the wisdom and folly of the crowd.

 

 

 

 

Contributors:

 

                                                                                                   

                                     

 

Peter Howitt                                       Jessica Calvert                                               

Director                                             Senior Associate                                

 

Contact: 

E: info@ramparts.eu

2nd Floor, 3 Hardman Square, Spinningfields, Manchester, M3 3EB

Tel: +44 161 914 9785

Fax: +44 161 457 0002

 

Ramparts is a European law firm based in Gibraltar and the UK specialising in finance & technology. Our clients include individual entrepreneurs, early stage innovation companies and publicly listed multi-nationals in the e-commerce, e-money and payments, online gambling, private client and capital markets sectors. 

Ramparts: “no assumptions, just solutions”

 

DISCLAIMER

This article is for information purposes only. Any opinion, statement or information expressed above is not intended as legal advice and should not be relied upon as such. If you would like legal advice please contact us. We are qualified to provide legal advice on English, Gibraltar and European law.

 
 

[1] Crowdfunding Industry Overtakes Venture Capital and Angel Investing, Louis Emmerson, Symbid, July 8, 2015

[2] Ibid.

[3]The opportunity to make a positive social impact was an important factor for 86% of investors in debt securities issued in support of renewable energy projects” – ‘a review of the regulatory regime for crowdfunding and the promotion of non-readily realisable securities by other media’, FCA, February 2015

[4] Uber is certainly slick but it’s not ‘disruptive’, John Naughton, The Guardian, 22 November 2015 -

[5] As at 2 December 2015

[6] Discounting or factoring trade receivables remains largely unregulated but has also seen major growth with the establishment of receivables funding platforms like MarketInvoice.

[7] In 2014, the average amount raised through equity-based crowdfunding was £199,095. Almost 95% of the funded deals were eligible for the Enterprise Investment Scheme (EIS) or Seed EIS (SEIS) schemes.

 

 

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