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Tuesday, March 6th, 2012

A Regulatory Hand for Crowd-funding?
posted by Ross Dawkins

In much of Europe a major constraint on funding smaller businesses (particularly with risk capital) is the lack of a robust ecosystem to act as a conduit for the capital.  An ecosystem here means not just well-designed legal and tax structures conducive to capital investing but also lawyers, financiers and so on with appropriate skills.  This kind of ecosystem only grows up when the long-term policy context is favourable (i.e. there’s a clear, long-standing political commitment to building better funding infrastructure — or at least to not messing around with it when it works).

In the absence of such an ecosystem it is harder to route capital into early-stage and fast-growing firms.  Europe is witnessing a decline in risk appetites and a crunch in credit which will only exacerbate this situation — but these fast-growing businesses are exactly what are required in order to reinvigorate the economy. 

It's an attractive idea to see crowd-funding as at least making a contribution here.  This is where a large number of individuals make small investments which in aggregate meet the company’s needs.  There are already examples of intermediaries stepping in: crowdcube.co.uk which as of 6th March 2012 listed about 60 opportunities requiring investment from £30,000 up to £1 million, with £100–£150,000 being fairly common.  

It can be seen as a variation on the traditional private placement approach, but with the clear intention of remaining below the thresholds set within the Prospectus Directive.  A prospectus (under the revised Prospectus Directive) is required if raising at least €5 million or if there are at least 150 investors (which is assessed on a Member State basis).  The latter is the issue because prospectuses are expensive.  For example, this means that there needs to be a limit on how many investors are involved in any one issue.  It’s with this and similar issues in mind that has made many believe that the regulatory framework needs redesign in order to accommodate crowd-funding and similar innovations. 

The Entrepreneur Access to Capital Act — currently waiting a Senate vote — aims to bring some extra clarity to the regulation of crowd-funding in the USA by providing an exemption to 1933 Securities Law.  The Act as currently drafted would allow an exemption if the funds raised in the previous twelve months did not exceed $1 million (raised to $2 million if the fund-raising were accompanied by audited accounts).  The exemption is not complete: warnings and various assurances to both investors and the SEC.  Similarly, an individual investor’s contributions are capped at the lower of $10k or 10 per cent of annual income.  The latter seems sensible in intent (if rather generous given the likely risk profile of investments and the desirability of investing across a mix of firms in order to diversify away a portion of that risk) but the wording of the Act implies that the issuer (or the intermediary) would need to check, which is likely to prove a practical nuisance (costly and dissuading from participation those sensitive of disclosing their income).

The UK Government is interested and has met with representatives of the nascent industry and has also proposed the Sees Enterprise Investment Scheme, which aims to encourage entrepreneurship. 

There are potential arguments against crowd-funding's being a success:

(a) By splitting the investment amongst many parties it is possible that no-one has sufficient skin in the game to make effective due diligence pre-investment and monitoring post-investment worthwhile.  Whilst the cost of basic research (e.g. checking a firm’s online presence) is pretty low, so is the cost of faking it.  Mainstreaming of the idea in the next few years may open it up to such problems.

(b) Most small firms do not succeed — whilst they may not fail outright, simply failing to grow sufficiently such that a worthwhile exit for the investors can be achieved may disappoint less experienced investors.

It remains an idea that many people are enthusiastic about but it has not yet been conclusively proven.  Starting conditions in USA compared to (at least large parts of) Europe are more favourable: higher expectancy of macroeconomic conditions revert to growth (sooner or later), a better track record of fostering innovation and a larger population of sophisticated investors.

Still I think that crowd-funding and similar social initiatives could merit similar treatment in Europe to that proposed in the USA.  However reduced investor protection and — no matter how worthy the cause — would be an anathema to many European policy-makers.   With the Prospectus Directive freshly revised further change might be seen as unnecessary.  Increased use of the concept of up to 149 investors per Member State would enable a well-designed cross-border opportunity a large population of investors to spread capital around to.

In the more financially developed countries in Europe (e.g. the UK) these offerings provide lower transaction costs (albeit still around five per cent of the funds raised).  This is important both in cash terms (obviously important when a firm is raising money) and in time (critical where the money is wanted to exploit a new opportunity or idea).  They also fill a common equity gap, where more is required than can be sourced internally from the company or from family & friends, but below the level that institutional venture capital is interested in.  Where equity capital provision is less developed, crowd-funding could represent an institutional mechanism to short-cut the lack of an ecosystem.  Obviously, this brings additional risk relative to markets where there is a pre-existing pool of investors experienced enough to understand the nature of the beast being tackled.

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