Crowdfunding – A new way for raising capital?

23 October 2015
Crowdfunding is a means of raising finance for projects from ‘the crowd’ often by means of an internet-based platform through which project owners ‘pitch’ their idea to potential backers, who are typically not professional investors.  It takes many forms, not all of which involve the potential for a financial return. The investors providing funds may do so as a donation, in return for a reward.
There are generally two main areas of crowdfunding:
  1. Loan based sector, where peer to peer or peer to business lending may take place. The reward here is usually non-monetary.
  2. Investment based crowdfunding. Here, the return may take the form of debt, equity or other security (hence the name “investment based”).
Investment based crowdfunding usually involves three parties:
-          The project owner seeking finance.
-          The internet platform that acts as the intermediary between the project and the investor. The platform provides a mechanism for projects to find investors and vise versa.
-          The Investor.
This method of raising capital usually attracts unlisted, smaller businesses and may be start-ups, innovative or otherwise. Project sizes are relatively small, most crowdfunding platforms also being small businesses.
Crowdfunding is still a relatively new phenomenon of the internet generation, with modest volumes but growing quickly. In the UK alone, the market has experienced growth at a rate of 400% per year. It involves mostly retail investors and small unlisted companies, start-ups, innovative or otherwise. Crowdfunding is relatively straight forward and one of its appeals is that it is convenient and simple (you can learn about new fundraisings from the convenience of your ipad, rather than having to go to presentations or read bulky material). It all sounds perfect, but is it?
Since crowdfunding usually involves new innovative ideas and startups, there is a significant potential of capital loss (due to high failure rate). There is a risk of dilution through further capital raising, lack of realistic exit options, potential conflicts of interest between investment platforms and issuers, the potential impact of a platform failure and the danger of not being covered by any investor compensation scheme, plus the information provided by the platform regarding the issuer may not provide an accurate picture of the issuer and potential investors may be misled. In any case, the information provided is not subject to any recognized transparency rules or recognized format (like for example a prospectus).
EU regulation was not designed with crowdfunding in mind, therefore member states and national competent authorities have been trying to work out how to treat crowdfunding, with some regulators dealing with it on a case-by-case basis, some seeking to clarify how crowdfunding fits into existing rules and others introducing specific requirements. In particular, Italy has some form of regulation since 2012, the UK has introduced relevant regulation in April 2014, France followed in October 2014 and Spain in April 2015. Member states like Germany and Austria apply their Payment Services Acts and their Prospectus Laws where applicable, whereas Finland, the Netherlands, Sweden, Latvia and Denmark are currently examining the prospect of creating crowdfunding legislation. 
The objective is to support crowdfunding platforms and give them legal certainty, improve financing for issuers and provide alternative sources of finance. The components of a potential regulatory regime should therefore include:
- Proportionate capital requirements (to cover for a potential platform failure)
- Segregation of assets (an investor protection tool)
- Proportionate organizational rules
- Nature and extend of the platform’s responsibilities in relation to investors
A potential crowdfunding regime should more or less encapsulate similar protections as the ones afforded by MiFID and in return, would grant a passport to crowdfunding platforms that meet the qualifying conditions to seek investors from all over the EU.
In practice, platforms seem to structure their business so as to avoid the Prospectus Directive or MiFID requirements.This means that investors may never get vital information that concerns their investment and the size of the offer has to be limited in order to fall below the Prospectus Directive thresholds. With the growing prospect that some risks may be left unaddressed, member states are trying to regulate crowdfunding and/or raise awareness among market participants.