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Crowdfunding is an increasingly popular alternative method of raising finance. But what is crowdfunding? In this article we explain how crowdfunding works, the risks and rewards and the UK regulation.
Crowdfunding is the practice of raising money from a large number of individuals for the purposes of financing a project, venture, business or cause. Traditionally, crowdfunding has been carried out via subscriptions, benefit events and door-to-door fundraising. However, today the term is typically associated with raising money through website platforms, which allows crowdfunding to reach a larger pool of potential funders.
Crowdfunding usually takes place on a light-touch online platform rather than through banks, charities or stock exchanges. The business or individual seeking finance will typically produce a pitch for their business, project or venture, which is then uploaded to the online platform with the aim of attracting as many loans, contributions and investments as possible. Websites such as Kickstarter, Seedrs and Crowdcube are examples of the available online platforms, which enable project initiators to reach a pool of thousands, if not millions, of potential funders.
Loan-based: also known as peer-to-peer lending (P2P), this involves individuals lending to businesses or other individuals in return for interest payments and a repayment of capital over time.
Investment-based: individuals invest directly or indirectly in new or established businesses by buying investments such as shares, debt securities or units in an investment scheme.
Donation-based: people give money to individuals, organisations or enterprises they want to support, with no expectation of any return on their investment.
Pre-payment or rewards-based: individuals give money to receive a reward, product or service (for example, concert tickets, artwork, a new product etc.).
In addition, less-common forms of crowdfunding exist whereby funders invest in order to receive, for example, software value tokens (see A guide to initial coin offerings) or a share of the compensation from the results of litigation.
Crowdfunding‘s success is not just limited to industry – it has been used to successfully raise funds for a range of not-for-profit organisations and charitable causes. Children‘s charity, Kids Company, successfully raised over £100,000 in under two months in 2014/15 with their campaign on the platform Crowdfunder. In 2016, crowdfunding campaigns raised £12.3 million on the platform JustGiving, a platform for online charitable donations.
That said, businesses are also benefiting from crowdfunding initiatives. Starting in 2007 as a two-man partnership, BrewDog successfully crowdfunded their way (using an equity-based platform) through year-on-year growth to become an international company valued at circa £1 billion in 2017. Perkbox, a cloud-based employee perks and engagement platform for businesses, raised circa £4.3 million with its campaign on Seedrs. Finally, in 2016 Crowdcube raised circa £6.7 million, effectively making the crowdfunding platform its own biggest success story.
In the UK only certain crowdfunding activities are regulated. Donation-based and rewards-based crowdfunding are not regulated, whereas firms carrying on activities associated with loan-based or investment-based crowdfunding may require FCA authorisation under the Financial Services and Markets Act 2000 (FSMA). Accordingly, what follows is a high-level summary of the regulation of both loan-based and investment-based crowdfunding in the UK.
In 2013, with loan-based crowdfunding becoming an increasingly popular means of raising money and recognising that it was difficult to regulate the practice under existing regulatory provisions, the FCA took the step of adding a new activity, at article 36H, to the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI 2001/544) (RAO).
Under article 36H of the RAO, loan-based crowdfunding became regulated as the “activity of operating an electronic system in relation to lending”. Under this provision, online platforms facilitating loan-based crowdfunding between two individuals or between individuals and businesses will be carrying on a regulated activity and will, therefore, require FCA authorisation (unless certain exemptions, such as for charities or appointed representatives apply).
Generally speaking, where the borrower is an individual (or a partnership or unincorporated body of individuals), and the investor is lending in the course of a business, the terms upon which the loan is made may constitute a regulated credit agreement and consequently be subject to the full requirements of the Consumer Credit Act 1974 (CCA). The investor will then need appropriate FCA authorisations for the provision of consumer credit and will be required to comply with the relevant rules in the FCA Handbook (CONC in particular). To help with this, the FCA has published a webpage, which provides a useful summary of the key provisions of the FCA Handbook that apply to loan-based crowdfunding firms.
Where the investor is not acting in the course of business, so that the agreement is a non-commercial agreement under the CCA the investor will not require FCA authorisation. There are, however, additional obligations on the operators of the platforms in CONC to help protect consumers from some of the risks associated with these non-commercial agreements.
Participants acting by way of business should also take care not to inadvertently carry out other regulated activities when crowdfunding. In this context, the FCA has warned that businesses which borrow through a crowdfunding platform with a view to lending this to other individuals may be carrying out the regulated activity of accepting deposits – which will require additional authorisation.
The FCA regards investment-based crowdfunding as a high-risk investment activity, with the potential for capital losses. This is likely due to the fact that the instruments traded on such investment-based crowdfunding platforms are non-readily realisable securities that are not listed on regulated stock markets and are instead traded over the internet and via other means.
Unlike the bespoke regulatory rules for loan-based crowdfunding, activities associated with investment-based crowdfunding platforms typically fall under the existing rules, including article 25 of the RAO which covers both arranging deals in investments and making arrangements with a view to participating in deals in investments. Accordingly, online platforms facilitating investment-based crowdfunding are likely to be carrying on a regulated activity and therefore require FCA authorisation.
While the FCA has not published a webpage summarising the FCA Handbook provisions applicable to investment-based crowdfunding, it is thought that many of the provisions applicable to loan-based crowdfunding will be relevant to investment-based crowdfunding.
The FCA introduced further rules around financial promotions applicable to firms operating investment-based crowdfunding platforms in 2014. As a result, such firms may only make direct offer financial promotions to retail clients if such clients either:
have taken regulated advice
are high net worth or sophisticated investors (as defined in the COBS provisions of the FCA Handbook)
have confirmed that they will invest less than 10% of their net assets in the relevant investment.
Regulated platform operators must also be able to assess whether retail clients understand the risks involved with investing if they do not take regulated advice – the FCA expects this to be done as part of the online registration process for the platform.
Businesses buying and selling investments through crowdfunding platforms should take care not to accidentally fall within the UK’s regulated activities and financial promotions regime. In particular, businesses contemplating raising equity finance via investment-based crowdfunding platforms should be careful not to fall foul of the restriction on offers to the public under section 755 of the Companies Act 2006. For more information on the implications of this legislation on investment-based crowdfunding, see our previous article Crowdfunding: restriction on ‘offers to the public’.
How is regulation likely to change/develop in the future?
In December 2016, the FCA published a feedback statement (FS16/13) in response to their previous call for input to the post-implementation of their crowdfunding rules. Following the publication of the feedback statement, the FCA has indicated that it intends to consult on, among other things, additional requirements relating to wind-down plans, cross-investment of loans on different loan-based crowdfunding platforms and mortgage lending standards where the investor is not lending by way of business.
In addition, the FCA has raised concerns regarding the quality of communications with potential investors on loan-based and investment-based crowdfunding platforms. Accordingly, it intends to consult on more prescriptive rules in respect of financial promotions and the content and timing of disclosures.
What is the UKFCA code of conduct?
The UK Crowdfunding Association (UKCFA) is a self-regulatory body that was set up in 2013 with the purpose of promoting the interests of crowdfunding platforms, their investors, and clients. Members of the UKCFA are required to agree to the code of conduct which, among other things, promotes and implements transparency, security, appropriate safeguards and compliance with applicable laws and regulations.
Involvement – investors may find it rewarding to be involved in the development of a specific business, project, venture or cause. Crowdfunding enables potential funders to choose how they invest their money more freely.
Returns – crowdfunding may offer investors higher returns than those available from other, more traditional, financial products.
Costs – by obviating the need for various intermediaries such as brokers, investors may receive benefits via reduced search and transaction costs.
Accessibility – crowdfunding enables borrowers to access finance where it may not necessarily have been available to them from banks or other institutional lenders.
Numbers – crowdfunding enables individuals and businesses to receive finance from a potentially unlimited pool of investors and with relatively low associated access costs.
Exposure – raising finance via crowdfunding provides borrowers with significant exposure may help to raise the borrower’s profile and provides them with free access to market feedback.
Information asymmetry – potential funders may face the problem of information asymmetry and find that they lack the ability to conduct proper due diligence on the borrower.
FSCS – investment via crowdfunding platforms does not provide the investor with any access to the government’s Financial Services Compensation Scheme, which may leave the investor with no access to compensation in the event that the borrower becomes insolvent.
Liquidity – due to the lack of any established secondary market for crowdfunded investments, investors may find it difficult, if not impossible, to cash-out their investment.
Start-ups – many borrowers on crowdfunding platforms are start-ups or businesses in the early stages of their development. There is a significant risk that the borrower business will fail, resulting in a capital loss to the investor.
Shares – it is unlikely that shares issued on crowdfunding platforms will carry any associated voting rights or rights to dividends for the investor. In addition, the value of any investment many be significantly diluted if more shares are issued.
Reputation – whether through lack of experience or time-pressures, borrowers may fail to achieve their proposed goals set out in their initial pitch. This may result in irreversible reputational damage to their business and the borrower’s public support.
Intellectual Property – in order to receive public backing, borrowers may find that they have to make a trade-off between producing a detailed and thorough initial pitch and exposing designs or products that have not yet been properly protected.
Management – successful crowdfunding campaigns may result in a borrower having to manage a large number of investor’s expectations, demands and investments. Without the appropriate resources, borrowers may struggle to successfully carry out this task.