Crowdfunding enters the mainstream – how to avoid getting swept away

The UK is putting itself at the forefront of the alternative finance revolution. As the government consults on including crowdfunding within the ISA consumer tax wrapper, we look at how the various platforms work and how best to choose between them.

Having been practicing in this area for around ten years, I’ve watched the emergence and growth of equity and peer-to-peer crowdfunding from platforms in the UK from 2006. Since then, crowdfunding has had a meteoric rise, more than doubling year on year from 2012.

And throughout I’ve watched the media’s take on this new world of alternative finance with interest, focusing as it often does on individual transactions or platforms that capture public interest, and the often sweeping categorisations the media tends to make about the sector.

However it takes a much more comprehensive and wide-ranging look to truly start to come to an appreciation of the issues involved and a strategic long term view of the alternative finance market.

What do we mean by crowdfunding?

Crowdfunding loosely means the provision of finance by the public or a section of the public to a business or person via an online platform. This sector of the finance market is referred to as “Alternative Finance” as it is an alternative to more traditional funding sources, such as banks and venture capital (although banks and VCs are increasingly getting involved).

Crowdfunding covers three main type of activities:

  • Donation or reward-based funding
    Donation and reward-based platforms allow people to donate money to causes or ventures. The philanthropic giving is reward-based where the donor receives a non-monetary reward such as a mug or t-shirt or publication acknowledgment in return. This type of funding is often perfect for creative or community projects … you may well have already been approached by a friend seeking funding for her independent film, or a charity looking to solve an environmental problem in the third world, for example. Donation and reward fundraisings tend to be at the smaller end of the scale, with the average amount raised from £4-6,000 with an average donation of about £50. However larger fundraisings are possible, for instance the €1.9 million Greek bailout pot raised on Indiegogo raised from 108,654 people in eight days. 
  • Debt funding
    This is by far the most prevalent form of crowdfunding, with enormous variation in the amounts raised, the structure of the investment and the types of people, projects and businesses funded. Types of debt crowdfunding include: 
    • Peer-to-peer (P2P) or peer-to-business (P2B) lending, by far the largest and best known debt lending activity, where investors loan money at interest to individuals or businesses needing finance. This can be used for anything from family and friends lending an individual money to purchase a second hand car, to huge corporate lending. Until this summer P2P lending dominated the peer lending market, however cumulative consumer P2B lending has lately equalled or overtaken P2P as investors chase higher potential returns from riskier business ventures. 
    •  Invoice trading, where the platform enables a business to sell selected invoices to investors at a discount, often through the mechanism of an auction of the invoices to a group of interested investors. 
    •  A number of other types of debt finance, including crowdfunding debentures, a non-collateralised (or unsecured) debt obligation to be paid back over a specified period. This particular quasi-equity-quasi-debt product has not been used a great deal in the UK so far, and most commonly for community support of local renewable energy projects. However, Wanda's 5 billion Yuan raise this July in respect of a similar debenture product on a Chinese crowdfunding platform hit the global news.
  • Equity funding
    The equity model enables individuals to buy shares in early stage businesses. Where an equity structure is used, investors may be able to access attractive tax relief through the EIS and SEIS schemes.
    Why does it matter? Because although some existing platforms are limited to one activity, many platforms operate in more than one arena, and conversely some platforms are very niche, for instance operating only in a specific product, like secured loans, or in a specific sector, like social enterprise. So if considering entering into the alternative finance market, it is important to take a long-term view about all of your financing needs/investment plans and ensure the long-term plans of the platform with which you engage are a good fit.

How is crowdfunding regulated?

In the UK, most types of crowdfunding fall within the control of the Financial Conduct Authority and require FCA authorisation. One exception is the operation of donation or reward facilities – these currently fall outside securities legislation. The FCA introduced a new regulated activity “operating an electronic platform in relation to lending” in April 2014 which in general covers online debt lending and otherwise equity and debenture offerings are classed as "non-readily realisable securities". These can only be offered to certain classes of investor who meet the criteria for a required level of understanding. Depending on the activities the platform undertakes, it may require a number of separate permissions.

So far the FCA has taken a very light-touch approach, but there is every indication that some of the more obvious loopholes, for instance in relation to reckless financial promotions, are likely to be tightened, and the structures and behaviours of the platforms vary hugely in their approach to regulation and investor protection.

Why does it matter? You might ask why is this a concern for platform users? Surely the platforms are responsible for their own regulatory compliance? But differing regulatory and contractual models mean that some financial products and platforms engage in more indiscriminate marketing, and are subject to lower levels of protection.

Various problem scenarios can arise, with unsophisticated investors receiving obtuse and complex risk warnings, for example, or platform operators turning a blind eye to inappropriate or misleading financial promotions by the companies. There is wide variation in the approach platforms take. Some are looking ahead to further regulation and putting good systems in place even before the FCA brings in incremental regulations, but others take a minimum-requirement approach, leaving both fundraisers and investors potentially exposed.

Before taking the plunge either as an investor or fundraiser, you need to be clear about the pros and cons of the platform you choose: the behaviour of the platform with which you associate could have reputational and/or strategic consequences in the shorter or longer term.

Platform Structure and Terms

Although many platforms look identical from an outside view, often they are not.

For instance, an equity platform can be structured numerous ways, including: 

  • Direct investment with all shares issued to the named individual investors on equal terms.
  • Dividing investors into classes, the larger investors getting a better class of share and the smaller investors receiving a second class of shares, such as non-voting shares. 
  • Creating a nominee vehicle which will hold all investor shares on behalf of all of the investors.

In respect of donation funding, some platforms make their money by keeping any donations made where the funder doesn’t meet its target and not charging any fees where the target is reached, whereas other platforms charge no fee for an unsuccessful raise and only charge on success.

Why does it matter? Because how a platform is structured and the terms on which it operates can make a huge difference in respect of (1) how a transaction is valued, (2) how much control the company or fundraiser has over the transaction (3) how much the platform assists you through the process (4) how much information an investor receives, and how much negotiating power he has, and what investor rights he receives; and (4) potential risks for claims in the long term.

Words of warning…

Crowdfunding looks here to stay. So far the UK government is taking an encouraging approach. It is, for instance:

  • Bringing in light-touch regulatory reform on an incremental basis.
  • Consulting on bringing crowdfunding products within ISA tax-wrappers (see more in our blog post).
  • The British Business Bank ring-fencing £40 million investment to provide debt finance through the lending platform FundingCircle.

Crowdfunding could therefore be a great opportunity, but it could also be a very risky one.

If you are considering entering into the alternative finance market, Mills & Reeve have a team of experienced lawyers with specialist expertise and an in-depth understanding of this field. Please do contact us if you’d like some help navigating the wonderful and often flummoxing world of crowdfunding.

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Every piece of content we create is correct on the date it’s published but please don’t rely on it as legal advice. If you’d like to speak to us about your own legal requirements, please contact one of our expert lawyers.

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