Are you exploring crowd-funding? If so, what do you need to know?
Crowd funding is not a new concept. We used to ask people to donate, purely as an act of charity or in return for a product. For example, take a band. Someone contributing £10 could receive a CD, £25 could receive a signed CD and £50 could be named on the album sleeve. This kind of process was not usually of concern to financial regulators because it was basically pre-ordering a product.
However the landscape has been changing, with more businesses looking to crowd-funding as an alternative to VC investment. Potential investors also see taking small equity or profit share stakes in a business as a low-exposure way of earning potentially larger returns than those currently available in the retail deposits/funds markets.
Somewhat understandably, unsophisticated individuals taking an equity interest (and therefore taking an investment risk) is something that causes the Financial Services Authority (FSA) significant concern.
In fact such potential investors are exactly the people the FSA was set up to protect following the boiler room scandals of the past. In August 2012, the FSA said that “most crowd funding should be targeted at sophisticated investors who know how to value a startup business [and] understand the risks involved”. This effectively says that those who stand to benefit the most from crowd-funding shouldn’t be involved.
The FSA’s concerns are well-meant, in that they list the risks as:
1) the majority of startups failing,
2) lack of returns and dividends from startups,
3) dilution if further shares are issued, and
4) illiquidity caused by a lack of a market for the shares.
However it is essential to keep in mind that the majority of investments are of the sub-£100 level, so the risk of causing significant harm to an individual is low.
So what are the barriers to offering shares?
The barriers are four-fold.
1) The company and/or crowd funding platform seeking to raise funds is likely to be seen as carrying out a “regulated activity” such as arranging or bringing about deals in investments, making arrangements with a view to transactions in investments or establishing, operating or winding up a collective investment scheme. Conducting such activity would require the company or platform to hold an FSA authorisation.
2) Private companies (i.e. non-PLCs) are prohibited by the Companies Act 2006 from “offering shares to the public”. Whilst this prohibition is unlikely to affect a “friends and family” fundraising round, it is likely to bite if an offer is being made to a wider audience.
3) Thirdly, the “financial promotion” rules under the Financial Services and Markets Act 2000 prevent a party who does not have the appropriate FSA approval from communicating an invitation or inducement to engage in investment activity. The key exceptions to these rules are non-real time offers (as would most likely be the case with a crowd funding website) made to certified high net worth individuals and sophisticated investors (Financial Promotion Exemptions). There is a further exception in the case of the sale of 50% or more of the target’s shares but this is a very unlikely scenario if a business is looking for crowd funding. This leads to a contradiction. One of the best things about crowd funding is that the sums required to be invested are of a level where they could attract less sophisticated investors. However, despite some platforms believing otherwise, any certifications have to be made in advance of seeing the details of an investment, therefore deterring smaller potential investors from jumping through all of the necessary hoops.
4) In addition, the FSA’s Prospectus Rules require companies making an offer to the public to publish a prospectus (which is a document requiring FSA approval). However in reality this is unlikely to cause too much concern for most businesses because there is an exception to share issues of less than €5m in a year.
So how can a UK company take advantage of crowd funding?
The simplest way in the UK remains not issuing shares and just taking effective pre-payments. The potential for such a model is powerful as it allows a business to build a community of fans who are willing to support product development in exchange for tangible products, often at a discounted price.
Given the tight regulation described above, none of the existing crowd-funding platforms provides a satisfactory solution:
1) A given platform may choose to fully comply with the regulations, in which case the fundraising process becomes quite expensive and the offers are only available to the very small proportion of the population who are sophisticated or high net worth individuals. This somewhat misses the spirit behind crowd funding.
2) On the other hand, if they comply (in various degrees) with the regulations, the platform and target business become at risk of FSA investigation and possible penalties (including criminal sanctions) and investors are likely to have lost the protections usually available to retail investors through the financial ombudsman. One of the most concerning features of some of the non-compliant platforms is the apparent lack of protection for client money – many platforms do not seem to have the relevant FSA authorisations to hold client money and therefore may not hold the necessary minimum capital resources required by the FSA and may not provide investors with the protections usually offered by the Financial Services Compensation Scheme.
In short, equity crowd funding open to the general public as most people imagine it is not yet legally possible in the UK.
What needs to change?
The FSA and the associated legislation were not designed with crowd funding in mind. They were intended to protect people who were entrusting others with significant amounts of their money. As currently drafted, the legislation cannot differentiate between someone making an occasional £10 – £100 punt and someone who is putting life-changing sums of money at risk. Therefore, if the UK government wants to see small businesses benefiting from the potential that crowd-funding offers, changes to the legislation are required.
As is often the case, the US appears to be setting the benchmark. The recently adopted JOBS (Jumpstart Our Business Startups) Act makes special provision for businesses seeking up to $1m of equity funding in a year and places strict caps (the greater of $2,000 or 5% of income or net worth for those earning less than or with net worth less than $100,000, the lesser of $100,000 or 10% of income or net worth for those earning more than or with net worth more than $100,000). This reflects a risk-based approach whereby the US government has determined that the usual restrictions on offering securities can be relaxed not because the investment itself is less risky but because the maximum size of investments lowers an individual’s risk.
Taking an approach similar to that of the US’, coupled with the UK’s investor-friendly EIS and Seed EIS regimes, could open up a whole new source of seed funding to fledgling businesses and possibly even help to drive the next wave of UK entrepreneurs.
What’s your experience of crowd-sourcing? Share your best-practice tips below
About the author: James Wilkinson, Associate at Kemp Little LLP, leading technology and digital media law firm. James can be contacted on firstname.lastname@example.org