One of the hottest debates in crowdfunding at present is around its use for equity-based funding for capital formation. And there is good reason for this. Whilst this has been permissible in some countries, it has not been permissible in the USA, where some of the most widely known and successful crowdfunding platforms exist. But that may be about to change, hence the debate.
So, we thought we could take a quick tour through the world of equity-based crowdfunding, the legislative issues, some examples, and a look at what may lie ahead. Most of the crowdfunding platforms work on the basis of some type of reward based investment– even when the subject of the investment is a commercial entity. For example, if you are putting money into an invention-based initiative that is seeking to raise enough money to take a new product to market, then typically you will receive a version of the product with some value add. You might perhaps get it cheaper than the anticipated retail price, a special edition, ahead of the market etc. in return for your “investment.”
Through the publicity generated by some outstanding successes, with people like TicTok Lunatik on Kickstarter, we are familiar with the model. But this is distinct from an equity-based model, where in return for your cash you receive equity or a share of the company as well. As a shareholder, you have a genuine and ongoing investment in, and some ownership of, the firm and those shares can go up or down in value. As we explained in the first of this series of posts, crowdfunding is different to many funding models in that it is based on the widest possible participation and tapping into “The Long Tail.” To do this, it has to reduce the barriers to participation, so it must reduce the friction and cost in the process and leverage the power of the networked engaged world where individuals are less constrained and able to re-imagine themselves into new roles, in this case as investors.
The process of investing in equity is heavily regulated in most jurisdictions and it is in this that the friction and costs typically exits and that has made it historically difficult to tap into the long tail and make crowdfunding equity sustainable. The arguments for the regulation are primarily founded in the notion of risk mitigation and fraud prevention. Rules around transparency, authority to buy and sell are complex. The trick then is to develop a mechanism that mitigates the risks, reduces the costs, and offers security. The lure of a democratised investment is not just a notion of corporate responsibility and inclusiveness, there is sound business logic in it too. The argument for wider scrutiny and endorsement of a business model has attractions for a business particularly if it is seeking to use other capital raising mechanisms as well. But a block of small loyal stable investors who are probably brand loyal and with a different expectation of return than perhaps other more traditional investment groups has many attractions.
Certainly we can look at Brewdog– a brewery in the UK- as a fascinating example of that form of inclusive crowdfunded investment. Brewdog was the first European company to run an online IPO, tapping into the asset of their brand loyal community nurtured through social media channels. The company launched its first equity sale in 2009. Not wholly successful in that it was a very expensive process, share parcels were quite costly and they didn’t reach their original target, they did however manage to raise £750,000 in 5 months. Learning from that experience, they launched a second round of so called Equity For Punks in July 2011 with cheaper minimum shares, a track record, and the use of computer shares to transact the process. They raised £500,000 in two days, £1 million in four weeks.
Trampoline is another innovative crowdfunding story. In 2009, Trampoline became the world’s first technology business to raise finance through equity crowdfunding. They are seeking to raise £1 million pounds across four rounds, the first two of which are completed. Again, this is an example of using the notion of a wider group of investors but they are not using a proprietary system to transact this and, in order to be compliant with Financial Services Authority (FSA) legislation, they are restricting the offer to people of “certified high net worth” or existing share holders.
So, the real innovation in crowdfunding beyond tapping into your tribe or casting the net a bit wider comes with the advent of turnkey platforms that open the field up to much wider groups of investors beyond the “certified high net worth” individuals- in other words, you and me.
One of the most widely known platforms that adhere to this model of equity-based crowdfunding platforms is Crowdcube based in the UK. It recently saw a world crowdfunding record achievement with theRushmore Club raising £1 million to invest in the expansion of the bar and clubs group. Set up by Darren Westlake and Luke Lang and launched in February 2011, they are pioneering the democratising of investment in the UK.
The model that Crowdcube operates requires that, as an investor, your register with the site and deposit an amount of money into a Crowdcube account. Once done, you can review the offers and bid on the portfolio of projects on the site. For the entrepreneurs looking for investment, you need to register also and submit a proposal, which then undergoes a checking process on the part of Crowdcube, who will decide to accept or reject it into the portfolio on offer. Some key features are:
- Minimum amount to be raised is currently £5,000, and there is no maximum, although Crowdcube suggest £150,000 as a typical maximum.
- Minimum investment is £10, and transaction costs for companies raising money are relatively limited by comparison to a traditional equity sale process.
- Set legal costs are passed on to the entrepereneur, and Crowdcube takes a fee.
- As an investor, you must be UK-based, and the onus is on you to undertake your own due diligence in the investment process.
- Similarly, the entrepreneurs must be UK residents, and the company, or resulting company, must be UK-registered
The site itself is deemed to be advertising shares, and as such, needs to be authorised by an FSA-registered body, in this case a firm of Chartered Accountants.
Some argue that this model is in contravention of part of the Companies Act 2006- section 7556 to be precise- which says a private company cannot offer shares to the public without going down the IPO path. But Crowdcube will tell you that they have worked with the FSA from day one. Their model has been subject to exceptionally rigorous due diligence by Ashfords Law firm, and there is nothing secretive or stealthy about it. It’s all up front, they say, and the key element in this is that investors are essentially members of a “club,” and in essence, the offer is not being made directly to the public. I am not a lawyer so don’t take my word for it, but one would have to think if the process itself were questionable, the FSA for all its faults would be taking a closer interest. As for the quality of each investment, it is a case of caveat emptor. Crowdcube themselves used this method to raise some £300,000 in the last week in return for 9% of their equity.
An alternative model is used by Symbid in the Netherlands, where they use a cooperative vehicle as the collecting mechanism for the investment- so pooling the individual contributions into a sole legal entity that invests in the entrepreneur. The idea of being in a club or community or having some buffer between the investor and entrepreneur seems key to meet the various restrictions in different geographies. It either means the process is not entirely public (the club method) or it is not an individual-direct investing (the vehicle model).
With that in mind, what seems to be happening in the USA? Possibly the most high profile initiative is theEntrepreneur Access to Capital Act H.R. 2930, introduced by Congressman Patrick McHenry, and which was passed overwhelmingly by the House (407 -17) and as explained in this video.
What it seeks to do is to amend section 4a of the Securities Act of 1933, to allow certain exemptions to registration with the Securities and Exchange Commission (SEC). It would allow entrepreneurs to run a crowdfunding programme to raise up to $2 million per year in investment capital directly from individuals without having to register the investors with the SEC. Some key features are:
- To take advantage of the $2 million limit, entrepreneurs must provide audited financial statements, otherwise, without those statements, the cap is set at $1 million.
- The commencement and completion of each process must be registered with the SEC, but the investors don’t need to be.
- The process must reach 60% of its declared target to proceed, and the financial transactions and money management must be handled by a third party.
- Each individual investor is capped at $10,000 investment or 10% of their annual income- which ever is less- however this total is linked to the CPI so is adjustable over time.
- Shares cannot be sold for a year, unless the investor is an accredited or registered investor or issuer.
Additionally, there are at least two other crowdfunding related items currently in the Senate. Senator Jeff Merkley introduced the “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act,” S 1970 (snappy title!), which would legalize and regulate the raising of start-up capital for small businesses on the Internet. Also the “Democratizing Access to Capital Act,” S 1791 (certainly pithier), was introduced by Senator Scott Brown which seeks to exempt small investments of $1,000 per investment, with total size of the stock offering capped at $1,000,000, while at the same time providing strong investor protections.
The proposal to legitimise and regulate crowdfunding for equity is not without its critics, and the debates are too long and varied to cover in this blog. But what is clear is that the appetite for finding alternative mechanisms to raise capital through selling equity is growing and is likely to continue to do so as the entrepreneurial urge is being liberated in the networked and collaborative world, and whilst traditional capital markets are constrained.
As success stories of crowdfunding generally, and equity based funding in particular, increase I can only see its popularity burgeon, and we seem to be at the threshold of a whole new, democratic and inclusive funding model.