Crowdfunding is a major catalyst for economic transformation - it represents the democratisation of access to private capital - a grand experiment in the wisdom and folly of the crowd The world is only just waking up to consider the impact that crowdfunding will have on entrepreneurship, investment and economic growth in the 21st century.
“By 2016 the crowdfunding industry is on track to account for more funding than venture capital, according to research firm Massolution’s annual report. With an estimated market value of $34 billion in 2015, crowdfunding has come a long way since its valuation of $880 million in 2010.”1 The recent introduction of Securities and Exchange Commission (SEC) rules in the USA allows investment in private projects by a larger portion of the American public. It is likely to propel the interest and use of crowdfunded finance to new heights. However, the USA (like the most of Europe) appears to be moving much more slowly than the UK towards an integrated regulatory and tax regime for investment in start-ups and SME’s, holding back its full potential. Crowdfunding covers a wide range of behaviour including business and consumer peer to peer (P2P) lending and equity investment and invoice trading. It allows project and enterprise fundraising from a much wider range of sources and at a more diverse level of investment. Many entrepreneurs will have already realised the difficulty in accessing bank and private equity finance for their start-up or early stage projects. The ability to get direct access to the ‘crowd’ should not be underestimated as a force for social change and engagement. At its best crowdfunding surfs the wave of a major macro trend that is seeing people want to participate much more in many aspects of the world we live in. By personalising capital 1
Crowdfunding Industry Overtakes Venture Capital and Angel Investing, Louis Emmerson, Symbid, July 8, 2015
allocation it makes a much wider group of people investors, reducing the reliance on capital
markets, banks and traditional introducers who have previously been the necessary gatekeepers for accessing capital.
“the VC industry invests an average of $30 billion each year. Meanwhile the crowdfunding industry is doubling or more, every year, and is spread across several types of funding models including rewards, donation, equity, and debt/lending. In particular, equity crowdfunding – now being legalised in the US – holds huge disruptive potential.”2 2
Ibid.
The global market for crowdfunding The use of technology and dispersion of new crowdfunding platforms (CFPs) will also allow crowd capital raising to climb the value chain, allowing even greater capital intensity for interesting diverse projects. Disruption and disintermediation is likely to hit the old world of city-based deal introducers and arrangers hardest at first. The more innovative banks (particularly private banks), hedge funds, private equity groups and venture capitalists will continue to have a significant role in this new world since, in many cases, the investment from CFPs will sit alongside existing capital providers (e.g. CFPs may help raise mezzanine debt in order to secure bank finance or it can encourage matched equity participation). In addition successful crowdfunded businesses can move up to public capital markets. Interestingly, over the last few years, we have also seen many major capital market players move more of their allocation to private enterprises (also giving rise to the so called increase in tech 'unicorns') and we are seeing longer lead times for successful start-ups to make their way to public offerings, such as Uber. This may give us a taste of the potential for crowdfunding to blur the boundaries between use of public and private markets.
Renewables - an area under pressure that is ready for crowdfunding One area that highlights the potential of crowdfunding is renewable energy, as this intersects a number of significant growing trends for participatory investment and involvement in projects that have a major environmental, social and political impact.3 In addition, the current vertiginous decline in the energy equity and debt markets means that crowdfunding may 3 “The opportunity to make a positive social impact was an important factor for 86% of investors in debt securities issued in support of renewable energy projects” – ‘a review of the regulatory regime for crowdfunding and the promotion of non-readily realisable securities by other media’, FCA, February 2015
provide a much needed lifeline for disruptive new entrants. Renewable projects tend to favour long-term debt finance rather than equity - though both types of investment are required. In order to be successful in the long term, renewable CFPs will need to help solve the following challenges: Trust: ensuring investors are confident that they will be protected in the long term, as this is particularly important in the renewable energy space given the technical issues and long term nature of returns on investment. Alignment of interests with investors & CFPs: How can we ensure that CFP and investor interests are aligned? Some CFP regulatory models prohibit investment by the CFP and related parties (the mere introduction model) whereas others permit it. In the UK we see an interesting contrast between the introducer and arranger model (e.g. Crowdcube which has so far raised over ÂŁ125m for companies) and the funds manager model (e.g. Seedrs, the second largest equity CFP in the UK). However, whether the investment is direct or managed by someone else, intelligent investors would usually rather invest in a project that professional investors and other financial institutions are invested in - this gives additional comfort on issues like due diligence. This
means that CFPs have a major role to play in helping to seed the CFP with significant investors and to give even greater support in seeding and marketing the most attractive crowd-chosen projects on the CFP. Structural credibility: project finance in this sector must be built on the assumption that the longevity of most CFPs may well be less than the duration of the renewable projects being funded. The CFP structure must reflect this and future proof for this likely issue. Education: people must be educated about the nature of renewable energy investments, the risks (including liquidity risk and macro risks in the energy space) and how their interests are protected in the event of CFP or project failure (and the remaining risk that cannot be mitigated). We must not be blindly optimistic, the huge demand for renewable investments also opens up investors to poor projects and investments offered by unscrupulous or at least very inexperienced operators.
State support: energy investment requires even more state engagement in terms of
regulation, price balancing and taxation to flourish. This means not only protecting investors but also allowing and encouraging investment using efficient tax structures, such as selfinvested pension plans and investment tax wrappers (e.g. UK SIPPs & ISAs, American IRAs and 401k’s), investment tax relief (income tax and capital gains deductions against qualifying investments) and helping to moderate short-term market fluctuations that inhibit long-term financing.
(Abundance Investment)
A personal example of the potential power of CFPs - Peter Howitt of Ramparts Peter recently made his first equity investment using a UK CFP (crowdcube.com) and invested in a P2P platform start-up, MonetaFlex, listed on that CFP. Monetaflex is building a platform to allow businesses to trade invoices (receivables) with investors (which is also an area of professional interest). “Crowdcube asked me to certify that I was aware of the high risks of investment in a start-up and that I had some experience in investments given the size of investment I was making. The investment attracted 50% income tax relief (under the UK Seed Enterprise Investment Scheme) thus reducing my net investment considerably. The investment is a great example of the potential of CFPs to allow investors to access entrepreneurs that are engaged in projects that they find interesting or in which they believe they may even be able to add some value (go MonetaFlex!). Whilst this investment may prove unsuccessful, given most start-ups fail to achieve their stated objectives, I was happy to take the risks involved using a small part of my capital for the chance to be involved with entrepreneurs that I like and that are trying to transform the future business landscape –after all innovation and change requires risk capital” (Peter Howitt)
Where could crowdfunding take us? It is hard to foresee the full extent of the impact crowdfunding in the world. It is too early to say where it will take us, but it is likely to have much greater impact than many anticipate. For example, we at Ramparts think Uber is a great example of the power of the application of technology to transform the old world. However, not all agree and some have even suggested it is not truly disruptive:
“Christensen & co are obviously irritated by the valley’s conviction that
the car-hailing service is a paradigm of disruptive innovation and so they devote a chunk of their article to arguing that while Uber might
be disruptive – in the sense of being intensely annoying to the incumbents of the traditional taxi-cab industry – it is not a disruptive innovation in the Christensen sense, for two reasons.” 4
Whilst Christensen & Co claim that it is not appropriate to use the word ‘disruptive’ in respect of Uber, it appears to us that they may be failing to consider the Uber business strategy in sufficient detail. Uber’s disruptive nature is not simply in the disintermediation of taxi companies (though that is its first obvious effect). Uber’s real impact is that it makes nearly any person a potential taxi driver and nearly any vehicle a potential private hire vehicle. With the coming age of driverless vehicles, we start to glimpse the even greater potential impact of their disruptive business model. We believe that the same analysis can be applied to crowdfunding. At first it will primarily disintermediate introducers and arrangers of private capital in certain sectors and territories. However, the real disruption will happen once it becomes large scale and then international as we will then realise what it means for any project in the world to be capable of being funded by everyone. This represents an unprecedented amount of private capital and diversity of investment opportunities for different sectors and scale.
CROWDFUNDING MODELS There are 4 main types of crowdfunding platform: o DONATION Investors donate for nothing in return. The top CFP in this space is gofundme.com which is a platform used for personal fundraising. o REWARD
4
Uber is certainly slick but it’s not ‘disruptive’, John Naughton, The Guardian, 22 November 2015 -
Contributors fund in return for a reward, for example receipt of a prototype product. The
value of the reward may vary depending on the size of the investment. Kickstarter is one of the largest CFPs of this kind, specialising in creative projects. It runs an all or nothing model, so if the target funding is not reached, contributors receive their funds back. o INVESTMENT/EQUITY Investors receive shares in the company that they invest in. Crowdcube.com claims to be the world’s leading investment CFP, with over 300 projects successfully raised to date5. o LOAN BASED / DEBT / P2P Investors lend money in return for interest payments and repayment of capital over time. Fundingcircle.com is a UK CFP that has so far lent nearly £1bn to thousands of SMEs, supported by the UK government via the British Business Bank. Loans via CFPs for small businesses are really gathering momentum, and Funding Circle even advertises its services on mainstream television.
REGULATION IN EUROPE & USA There is no harmonised market for crowdfunding investment across Europe. Various existing European directives may apply (depending on the CFP model and investment structure), such as MIFID, the Prospectus Directive, AMLD III and PSD. However, without authorisation under EU wide law there is no easy ability to ‘passport’ the financial services authorisation of a CFP from one European territory to the rest of Europe. This will make cross-border CFPs prohibitively expensive for all but the biggest/best funded. The regulations that apply depends on where the CFP is established and the location of investors. This means that it is crucial to understand national appetite for CFPs and the approach of regulators within the European member states to the structure of CFPs they will permit (if any).
5
As at 2 December 2015
European Securities and Markets Authority (ESMA) is analysing the investment model, and working with the European Banking Authority (EBA), who are also looking at the loan model, to identify how a level playing field throughout the EU could work. Key issues identified with the investment and loan models are: Investment
Loan
•
high risk of failure
•
risk of fraud
•
no secondary market
•
lack of transparency
•
securities are unlisted
•
misleading information
•
difficulty
•
money laundering risks
scaling
up
as
no
‘passporting’ rights
SNAPSHOT OF THE UK & US CROWDFUNDING REGULATIONS UK Type
of
US
CFPs Loan6 and equity
Equity only
regulated Regulatory Authority Financial Conduct Authority (FCA)
Securities
and
Exchange
Commission (SEC) All
regulated
CFPs
authorised by the FCA.
must
be All
regulated
transactions conducted
via
registered
CFPs
must
be
an
SEC-
intermediary,
either a broker-dealer or a funding portal.
6
Discounting or factoring trade receivables remains largely unregulated but has also seen major growth with the establishment of receivables funding platforms like MarketInvoice.
Main Legislation
Financial Services & Markets Act JOBS Act 2012 2000 (FSMA)
JOBS Title III
Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 Restrictions investment
on CFPs can only offer investments to CFPs those who: 1. take regulated advice
can
only
offer
investments to: 1. Accredited Investors
2. qualify as high net worth or
(net worth = $1m or
sophisticated investors; or
income = $200,000
3. self certify that they are not investing more than 10% of
pa) 2. Anyone - if annual
their net assets and will not
income is:
do so in the next 12 months.
<$100K: then max = 5% of the greater of (i) income or (ii) net worth >$100K: 10% of the greater of (i) income or (ii) net worth Generally securities canâ&#x20AC;&#x2122;t be sold until after one year. Maximum investment raised via CFP by a company is $1,000,000 per annum.
Limit on investment As above for investors in category $100,000 maximum annual by an individual per 3.
CFP investment limit for
year
investor having income or net worth > $100,000.
Do restrictions fall This away?
will
depend
on
the No.
requirements of the CFP as to whether you can self certify as a sophisticated or advised investor.
Does the CFP have Most loan and equity based CFPs The CFP will have to file to register with the require a FCA licence (subject to certain information with the regulatory body?
some
interim
arrangements
for SEC, and disclose prescribed
previous holders of consumer credit information
to
investors.
licences from the OFT prior to Registration with the SEC is April 2014).
not required until it raises in excess of $1m.
Tax breaks
Seed or enterprise investment tax It is not clear that this relief (SEIS & EIS) can mean: •
between
30-50%
investment
of
necessary element has been the structured into the current
deductible US tax regime.
is
from income tax. •
capital gains relief may also be available allowing you to offset
the
amount
investment
against
capital
7
gains.
7 In 2014, the average amount raised through equity-based crowdfunding was £199,095. Almost 95% of the funded deals were eligible for the Enterprise Investment Scheme (EIS) or Seed EIS (SEIS) schemes.
In addition debt investments on CFPs can now be made within tax wrapper products (ISA, pensions).
In the UK loan CFPs are obliged to ensure individual lenders are provided with the information needed to properly assess the risk they’re taking, protect client money and plans are in place to ensure repayments continue even if the platform collapses. The system is a light touch one designed to encourage responsible investment in SMEs and promote the UK as a hub for crowdfunding. Tax issues Taxation of any funds raised depends on the type of crowdfunding used. A few issues to watch out for are: •
Platforms that provide rewards have to remember that money raised may be classed as taxable income (if the rewards issued have a value similar to the investment received);
•
In the UK, if income exceeds £82,000 then the company raising finance has to be registered for VAT; and
•
CFPs will not collect or remit tax on behalf of companies.
Conclusion Crowdfunding is a major catalyst for economic transformation - it represents the democratisation of access to private capital. It is also a grand experiment in the wisdom and folly of the crowd.
Contributors:
Peter Howitt
Jessica Calvert
Director
Senior Associate
Contact: E: info@ramparts.eu 2nd Floor, 3 Hardman Square, Spinningfields, Manchester, M3 3EB Tel: +44 161 914 9785 Fax: +44 161 457 0002 Ramparts is a European law firm based in Gibraltar and the UK specialising in finance & technology. Our clients include individual entrepreneurs, early stage innovation companies and publicly listed multi-nationals in the e-commerce, e-money and payments, online gambling, private client and capital markets sectors. Ramparts: â&#x20AC;&#x153;no assumptions, just solutionsâ&#x20AC;?
DISCLAIMER This article is for information purposes only. Any opinion, statement or information expressed above is not intended as legal advice and should not be relied upon as such. If you would like legal advice please contact us. We are qualified to provide legal advice on English, Gibraltar and European law.