In an economic climate where it is increasingly difficult for small and medium-sized enterprises (SMEs) to raise finance through loan facilities provided by banks and growth capital from venture capital funds, many are now turning to the “crowd” as a means of raising finance. This Briefing Note describes crowdfunding and some of the legal and regulatory issues that it gives rise to.
What is it?
Crowdfunding is the term given to the raising of funds for a particular project or business by appealing to a large number of people, usually by means of a website. Usually the “crowd” will be offered something in return for their funds.
How did it Start?
Crowdfunding emerged from artistic projects which used the internet as a means of reaching out to as many people as possible to raise the money required to get those projects off the ground. In return they would typically offer a benefit in kind (for example an invitation to the launch party) depending on the amount of the donation. Websites, such as Kickstarter, serve as a platform from which projects (using this “donations model”) can make their case to the “crowd”. The donations model relies on appealing to a fan-base with an emotional attachment to the project in question because it does not offer the participants a financial return.
Does it Work?
There are a number of success stories: for example, reportedly the video game Double Fine Adventure raised approximately US$3.45 from over 87,000 individuals and the film The Age of Stupid raised in the region of £450,000. According to its website, projects using Kickstarter have raised a total of $289m from over 69,000 projects but Kickstarter’s statistics also reveal that over 37,000 projects have not been successfully funded which gives an overall success rate of just under 44%.
The Investment Model
As a result of the perceived success of the donations model, businesses have sought to expand the concept of crowdfunding to models which allow investors to receive a financial return on their investments. These “investment” models, which generally involve a company offering its shares to the “crowd”, give rise to a number of legal and regulatory issues in the UK which do not affect the donations model and which need to be carefully considered to ensure that the investment proposal is not in breach of relevant statutory and regulatory provisions. In particular, the following may be relevant:
- Only FSA-authorised persons can carry out certain regulated activities, such as arranging or advising on deals in investments
- The financial promotions regime restricts the communication of invitations to invest unless either the communication has been approved by an FSA-authorised person or it falls within an exemption to the rules
- Depending on the investment model used, the restrictions on establishing, operating and promoting of a collective investment scheme may apply
- Where there is a share offering, depending on the amount sought from investors and whether or not an exemption applies, it may be necessary for the company seeking to raise funds to prepare a full prospectus: a document which must comply with the Prospectus Rules and be approved by the FSA
The above considerations are as relevant to websites that operate as platforms for crowdfunding as they are to businesses raising funds independently from such websites.
The UK’s legal and regulatory system presents a number of potential obstacles to investment models of crowdfunding and this has led some supporters to call for lighter touch regulation. There is a clear tension between the need to protect potential investors (who may have little or no experience of investing in early stage companies) and the desire for SMEs with limited budgets to have easy access to the mass market. It is generally accepted that some form of regulation is appropriate, but many believe that the existing legal and regulatory regime does not accommodate the specificity of investment crowdfunding models and that reform is therefore desirable to prevent stunting their growth.
Those in favour of reform point to the positive impact that the United States Jumpstart Our Business Startups Act (the JOBS Act) has had on crowdfunding in the US. The JOBS Act has relaxed the securities regulations for companies seeking to make certain types of small securities offerings provided a number of conditions are satisfied and this has made crowdfunding activities easier to operate in the US. Critics of the JOBS Act point to the fact that its relaxation of securities regulations will leave unsophisticated investors at an increased risk of exposure to scams and fraud.
Does Crowdfunding have a Future in the UK?
Yes it does. The donations model is relatively well established and there are also examples of successful fundraising using the investment model. However, for the investment model to flourish it needs to be regulated in such a way that adequately protects investors, perhaps, for example, by restricting the amount they can invest, whilst enabling projects to be promoted to the mass market without disproportionately restrictive requirements (such as those that currently apply to the promotion of collective investment schemes).
6 September 2012