Crowdfunding opens up to the market

By Simona Strimaityte on May 22nd, 2012

Just as it takes time for start-ups with freshly-raised capital to turn their ideas into profitable businesses, it will take a few years before we hear about investment success stories that have started on equity-based crowed funding platforms.

Likewise, there have not yet been any big incidents of fraudulent trading or scams which have taken place on crowdfunding platforms. But both will occur: success and fraud.

In the meantime, much regulatory work is being undertaken to minimize risks and assure protection for potential winners and losers in new investment opportunities. It is worth keeping an eye on it, because the public equity crowdfunding market is like a start-up itself; its future will be determined by the laws and incentives, by the first success stories and the bad apples.

Disruptive online financial services are riding a wave of success. There is no better time than now to establish access to quick and cheap money platforms that bypass the banks, which are unable to invest in start-ups and small businesses.

UK-based Funding Circle, launched in August 2010, has so far lent over £30 million to small businesses. MarketInvoice has built a platform where growing companies can auction their invoices to raise flexible working capital, now trading around £3.5 million a month.

There is an ongoing domino effect in the development of online financial services. One business model is leading into another. Peer-to-peer lending (Zopa, UK) has led into peer-to-business lending (Funding Circle, UK); online charity fundraising has led to reward-based crowdfunding projects (Kicktarter, US). Emerging online financial intermediaries are filling narrow gaps: equity-based crowdfunding is built for cash hungry start-ups and investors tempted by high-risk and high-return ventures.

In the online financial services context, equity crowdfunding stands out as the most disruptive model, because it challenges a highly-regulated stock market. On the other hand, it also extends unregulated over-the-counter trading as start-ups’ shares are unlisted. Due to its novelty, equity crowdfunding is quite an unspoiled grey market, but without relevant regulation it might become a dirty grey, while with too much, it could become an empty market. Where are we now?

Born in Europe

The stock market was “invented” in Europe centuries ago and Europeans have led financial innovation since, by implementing equity-based crowdfunding. The laurel goes to Crowdcube, which was launched last year in Exeter.

Even if Americans wanted to start equity-based crowdfunding first, they wouldn’t have been able to because of the regulatory hurdles. These restrictions have now been removed as a result of President Barack Obama signing the Jumspstart Our Business Startups (JOBS) Act, on April 5, 2012.

Relaxed regulation makes it easier for private companies to raise capital without going public. For example, the number of shareholders that companies can have before opening their books has been increased from 500 to 2,000. According to the new law, entrepreneurs will also get more room to solicit securities, and non-accredited investors will be able to shop around. This new bill has disrupted the Securities Exchange Acts of 1933 and 1934, but equity crowdfunding in the US will not take off until 2013, after the Securities and Exchange Commission completes implementation of the new rules.

Discussions about how equity crowdfunding should be regulated in the US create much noise internationally. This is a big year for equity-based crowdfunding, highlights NESTA, a UK think-tank focusing on the innovation: “Because of what’s happening in the US, this is the year when it starts to come into focus over Europe,” says Liam Collins, currently working on the NESTA’s research project on crowdfunding. “It’s probably because of other models of crowdfunding that are so much bigger in the US, it’s becoming more topical.”

The American Kickstarter programme is almost synonymous to crowdfunding. This 3-year-old reward-based platform has raised more than £110 million for projects, ranging from video games to 3D printers and whatever else interests the general public. In less than 24 hours, independent video game studio Double Fine managed to raise over £1 million. In return, the unaccredited investors will be rewarded with a copy of a game. Such potential to raise capital has been enough to kick-start the revolution of US securities regulation.

“Compared to the security laws they have in the US, it’s like a walk in the park here in the UK,” comments Danvers Baillieu, a former senior associate in the IT and technology at Pinsent Mason. Disagreeing with most crowdfunding founders, funders and entrepreneurs, he is not supportive of the ongoing changes in the US:

“The laws have been built up over years for a good reason. People are crying out for more regulation in the financial system, not less. The last thing we need is to allow people with limited amounts of money to put their money into high-risk internet ventures, and then to lose all their money. Investing is a very risky business, even in the stock markets for big companies. For example, allowing to invest savings into the latest tech start-up when people don’t have a clue where they put their money into and that turns out to be the worst type of company, forged and so on, I think it’s a terrible idea.”

But the genie is already out of the bottle in the UK when it comes to public equity investing in start-ups. In terms of regulation, it’s not as revolutionary as in the US, it has been more evolutionary. It becomes obvious when comparing two UK-based equity crowdfunding platforms: Crowdcube, which launched last year and Seedrs, which is just about to open its doors.

There are two main differences: the legal frameworks and the level of involvement in investments. Firstly, “the world’s first equity crowdfunding platform” Crowdcube is not a financial intermediary, its service is authorised by the Financial Services Authority (FSA) as a financial promotion.

“When you first visit the Crowdcube website, we give away a very small amount of information before someone registers to find out more. That’s a regulated activity to publicise a financial promotion, there are quite strict laws around that, so you have to be careful with what you say,” explains Luke Lang, a co-founder of Crowdcube.

During the registration process you acknowledge that “the investment opportunities on Crowdcube are not authorized by the FSA”, but after the account is created you can watch video pitches, explore business plans, and get involved in forum discussions. Once a user has decided to invest, the actual exchange of shares will be completed by the third party.

However, recently Crowdcube has submitted an application to become FSA authorised that is likely related to rising competition. The new platform Seedrs has been approved by the FSA, bringing equity crowdfunding on a whole new level.

Angel investor and ex-banker Kayar Raghavan, who has invested through Crowdcube, is an investor in Seedrs and predicts that it is going to be a more robust platform. Another difference between two crowdfunding platforms is that Crowdcube does not get involved in reviewing disclosures and protecting investors’ rights after the investment has been made as much as Seedrs is going to be.

Both platforms, however, seek to be under the regulatory umbrella; both would also like to add a touch of innovation. Luke Lang from Crowdcube says that the FSA requirements “need to be updated”, especially when it comes to the financial promotions: “People should be able to talk a little bit more freely about their business and need for investment in a public manner – that would be certainly a regulation that we would like to modernize.”

That is the liberalisation that will be embraced with the JOBS Act in the US. Jeff Lynn from Seedrs comments that the laws are 90 per cent right: “I don’t think that we need a whole set of changes. It would be very worthwhile to look at reform as an incremental process.” He specifies that more clarity around nominee structures would help to solve some tax-related issues.


However, the archaic or modernized regulations might not be enough to counterbalance the off-putting uncertainty of equity crowdfunding, when nobody knows what this financial innovation will bring. But some incentives can do the trick.

On April 6, 2012 George Osborne launched a tax break, the Seed Enterprise Investment Scheme (SEIS), to boost investment in start-ups. Through the SEIS, an equity-based tax relief applies for investing in unquoted company and offers an income tax relief at 50 per cent of the amount invested, which comes together with an exemption from capital gain tax where shares are held.

Such tax incentives surely don’t hurt, comments Jeff Lynn: “One new big thing the SEIS scheme will do is that it will reduce the high risk of venture investment substantially as you get some money back through taxes.” However, Matthew Rowbotham, tax law senior associate at Pinsent Masons, underlines that SEIS focuses only on direct investment in start-ups. So an investor using Seedrs as its nominee shareholder doesn’t get the direct access to such tax reductions. Rowbotham concludes that Seedrs has to sort out the compatibility issues between nominee structures and tax break permission. An investor using Crowdcube deals with the applicable laws, taxations and tax breaks individually. [Editor’s note: Since publication, we have been made aware that investors who use Seedrs will indeed be able to claim SEIS and EIS relief, assuming the companies themselves are eligible and all the other standard requirements are satisfied. “Nominee structures are expressly eligible for these tax reliefs: that’s how EIS funds operate, and it’s set forth clearly in section 250 of the Income Tax Act 2007,” explains Jeff Lynn.]

The given tax incentives just show how equity crowdfunding fits and benefits from the government’s agenda to help risky and early-stage companies to raise external capital. The agenda itself is not new, but the measures are changing in favour of alternative finance.

The government, in a bid to ease access to finance for SMEs and start-ups, launched Project Merlin in 2011. This was an agreement between the government and four major high-street banks which promoted lending, particularly to small businesses. However, the initiative was not renewed and the Financial Times has reported that the project has missed its targets.

This year, the government’s credit easing package includes alternative finance platforms, through committing to invest £100 million through non-bank channels to supply SMEs and start-ups. A pioneer of “credit easing” as a means of accelerating Britain’s economy is Sam Gyimah MP, who suggests diversifying the provision of credits in the UK, instead of increasing banks’ exposure to the market share, which would help the banks “get government support as far as credit to the SMEs is concerned”. Therefore, he promotes equity crowdfunding as one of the alternatives.

Global or local?

Legalised in the US and becoming more comfortable within the UK regulatory framework, the crowdfunding industry’s success very much depends on the national legal and economic environment. But the greatest need for crowdfunding to raise serious amounts of money is the size of the crowd.

There’s a greater chance that a company, for example aiming to produce wood fuel, will raise more capital more quickly in the US compared to the UK because environmental investing in the US is almost four times higher, according to national reports on socially-responsible investing. This is another incentive for crowdfunding platforms to go international – the more money raised, the bigger the profit.

Crowdfunding platforms, such as Kickstarter or Crowdcube, charge just a five per cent fee on successfully funded projects and businesses. Therefore unlocking national regulations to access international crowd investors, especially in a heterogeneous Europe, would sustain the growth of crowdfunding.

The idea of European crowdfunding has already been captured through the creation of the European Crowdfunding Network (ECN). However, without exemptions given by the legislators, equity based crowdfunding won’t be able to go Europe-wide, comments Eva Serlachius, an ambassador of the Nordics and an internal coordinator of the network.

“Countries are using local niches in abiding to securities laws. On the other hand, more and more online networks pave the way for crowdfunding platforms to develop and integrate with other finance players online. Regulation as a financial services intermediary will be unavoidable if equity crowdfunding becomes a commodity,” she says.

Today most European securities laws restrict marketing of non-listed equities, or limit the number of investors that can be approached to sell non-listed equities, for examples up to 100 in Belgium.

When questioning the potential of Europe-wide crowdfunding, one thing becomes clear: due to the high legal hurdles, it’s going to be a very lengthy process. In the US it’s taken almost a year to put equity crowdfunding into practice, whereas European legislators are nowhere near to considering making it an internationally-available financing option.  “We’re just leaving the early adopter phase,” Serlachius adds.

Besides the time-consuming legal formalities, Europe’s diversity adds more haziness to the European crowdfunding perspective, notes NESTA researcher Liam Collins. “Look at Brazil, where for no apparent reason they have some kind of collaborative culture. When it comes to Europe, it’s an entirely different question. The cultural thing might make it difficult for a model to work. The difference is not only culture, but the size of the markets and languages.”

Crowdcube is not planning to move to the continent so far. It’s not about legal issues, Luke Lang comments. Investing in start-ups is about more than looking for financial returns: “It’s also about having some sort of connection with that business: whether knowing the individual, market, knowing the people behind the company. The further it goes and crosses borders, the more these things and experiences diminish. It’s very different when you invest in multinational PLCs, because there’s a lot of information about them and they often trade on the global scale, but if you’re looking at a small tech start-up, in its early stages – that’s a very different proposition.”

Today, equity-based crowdfunding is a young business model and a financial opportunity, but it’s growing fast. Last year, equity-based crowdfunding was born in Europe; this year the Americans decided they are ready for it. The US will start trading start-up shares next year.

With no fingers burnt so far, equity crowdfunding is getting used to the home rules, and because the model has been born in the current economic climate, the business model is being given incentives, such as tax breaks. But it’s too young to go international.

Considering its pace of growth, the future of crowdfunding – local or global, under-regulated or over-regulated – looks everything but grey.