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Crowdfunding: a legal update

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Crowdfunding provides a means for businesses to raise capital in return for equity via online platforms. Given the user-friendly nature and mass market appeal of the platforms, supporters of crowdfunding have hailed its arrival as the “democratisation” of investing.

Companies also benefit from the increased exposure and so-called network effects gained from contributions from a large number of what can be very small investments.

Crowdfunding has emerged as an innovative source of funding for early-stage tech companies with a great idea but little trading history and therefore little chance of obtaining debt or equity funding through the traditional channels.

As banks have become increasingly more cautious in their approach to lending, crowdfunding has emerged as an alternative option for businesses and in particular start-ups to reach a large range of investors including sophisticated angel investors, syndicates, institutions and private retail investors seeking market and interest rate beating returns.

For businesses struggling to obtain credit from a bank, the appeal of crowdfunding is clear.

Much like a stock exchange, each individual crowdfunding platform sets its own rules for listing and so the level of trading history required can be little to none depending on the requirements set by the particular platform. While many entrepreneurs might be concerned that offering equity at such an early stage will set them on a slippery path to a loss of control, they can take comfort from market practice dictating that only the largest investors (£10,000 plus) are usually offered voting shares.

It is clear that crowdfunding acts as an excellent conduit for the growth of small businesses and a place for “return-hungry” private investors to put their money but how does this “disruptive” funding model fit into the current regulatory landscape?

In the UK, the Financial Services and Markets Act 2000 (FSMA) sets out a framework intended to regulate the processes of offering shares and making promotions to the public.

As you might expect, the Financial Conduct Agenct (FCA) has been monitoring crowdfunding for quite some time. Until now, crowdfunding platforms have been structured in such a way as to capitalise on the legal permissions and exemptions in the legislation, and avoiding unintended regulatory breaches.

However, this is due to change. The FCA’s consultation paper, released in October 2013, stated that they intend to regulate crowdfunding so as to strike a balance between: on the one hand, businesses and retail clients seeking alternative sources of funding/investments and on the other, protecting customers such that the market is only populated by participants who understand the risk.

Accordingly, the FCA are proposing to restrict the direct offer of financial promotions of unlisted shares by firms to the following self-certifying groups:

  • sophisticated retail clients;
  • high-net worth individuals;
  • those that confirm that they will seek investment advice; and
  • those that will not invest more than 10% of their investment portfolio.

Furthermore, it is proposed that crowdfunding platforms have limits imposed on them relating to their ability to promote individual investment opportunities and a requirement that they ensure that investors understand the risks involved where no investment advice has been given.

In truth, many of these proposals reflect current market practice. While any moves by the FCA not to interfere in the spread of new business models should be applauded, it is rather surprising that the FCA have applied such a “light touch” approach.

In spite of the risks, the recent FCA consultation paper and the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) clearly show that Government policy is moving towards encouraging investment in smaller higher-risk trading companies. This is further evidenced by the flexible regulatory landscape which lends itself to a number of different business models for the crowdfunding platforms to adopt.

Uncertainty over regulation has certainly not impeded the growth of crowdfunding platforms.

Indeed, over £10m was invested in small UK businesses via crowdfunding between 2012 and 2013 and that amount is expect to double over the next year

Söla Paterson-Marke is a solicitor in the corporate group at DLA Piper.

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