| Abstract: |
Summary
Crowdfunding is a growing phenomenon that encompasses several
different models of financing for business or other ventures. Despite the
hype, equity crowdfunding is still the smallest part of the crowdfunding
market. Because of its legal framework, Europe has been at the forefront of
equity crowdfunding market development.
Equity crowdfunding is more complex
than other forms of crowdfunding and requires proper checks and balances if it
is to provide a viable channel for financial intermediation in the seed and
early-stage market in Europe. It is important to explore this new channel of
funding for young and innovative firms given the critical role these start-ups
can play job creation and economic growth in Europe.
We assess the potential
role of equity crowdfunding in the overall seed and early-stage financing
market and highlight the potential risks of equity crowdfunding. We describe
the current state of play in this nascent industry, considering both the
innovations introduced by market operators and existing regulation. Currently
in Europe there is a patchwork of national legal frameworks related to equity
crowdfunding and this should be addressed in a harmonised way.
Introduction
Crowdfunding is increasingly attracting attention, most recently for its
potential to provide equity funding to start-ups. Providing funding to young
and innovative firms is particularly relevant given their importance for job
creation and economic growth (OECD, 2013; Haltiwangner et al, 2011; Stangler
and Litan, 2009). In addition, at a time when banking intermediation is under
pressure (Sapir and Wolff, 2013), it is important for European Union
policymakers to further explore alternative forms of financial intermediation.
But questions remain about the appropriateness of crowdfunding for providing
seed and early stage equity finance to new ventures and how this market could
be developed and regulated.
While there is growing hype around crowdfunding,
there are also many wrong perceptions. The bulk of crowdfunding is for
philanthropic projects (in the form of donations), consumer products often for
creative ventures such as music and film (in the form of pre-funding orders)
and lending. Equity crowdfunding, sometimes called crowdinvesting is
relatively new and currently comprises the smallest part of the crowdfunding
market. However, it is currently more active in Europe than in other regions.
Growth of crowdfunding
Crowdfunding can be defined as the collection of
funds, usually through a web platform, from a large pool of backers to fund an
initiative. Two fundamental elements underpin this model and both have been
enabled by the development of the internet. First, by substantially reducing
transaction costs, the internet makes it possible to collect small sums from a
large pool of funders: the crowd. The aggregation of many small contributions
can result in considerable amounts of capital. Second, the internet makes it
possible to directly connect funders with those seeking funding, without an
active intermediary. Crowdfunding platforms assume the role of facilitators of
the match.
While people tend to talk about crowdfunding in general, the
crowdfunding phenomenon encompasses quite heterogeneous financing models.
There are four main types:
Donation-based, in which funders donate to causes
that they want to support with no expected compensation (ie philanthropic or
sponsorship-based incentive).Reward-based, in which fundersâ?? objective for
funding is to gain a non-financial reward such as a token gift or a product,
such as a first edition release.Lending-based (crowd lending), in which
funders receive fixed periodic income and expect repayment of the original
principal investment.Equity-based (usually defined as crowdinvesting), in
which funders receive compensation in the form of fundraiserâ??s equity-based
revenue or profit-share arrangements. In other words, the entrepreneur decides
how much money he or she would like to raise in exchange for a percentage of
equity and each crowdfunder receives a pro-rata share (usually ordinary
shares) of the company depending on the fraction of the target amount they
decide to commit. For example, if a start-up is trying to raise â?¬50,000 in
exchange for 20 percent of its equity and each crowdfunder provides â?¬500 (1
percent of â?¬50,000), the crowdfunder will receive 0.20 percent (1 percent of
20 percent) of the companyâ??s equity.
The four models vary in terms of
complexity and level of uncertainty. The donation-based model is the simplest.
Legally the transaction takes the form of a donation. The risk is that the
project does not achieve its declared goals, but the backer does not expect
any material or financial return from the transaction. Equity crowdfunding is
the most complex. From a legal standpoint, the funder buys a stake in the
company, the value of which must be estimated. Moreover, the level of
uncertainty in equity crowdfunding is much greater compared to the other
models because it concerns the entrepreneurâ??s ability to generate equity
value in the company, which is extremely difficult to assess. Overall, these
complexities pose problems that are distinct and more fundamental than those
of the other crowdfunding models. These complexities require special attention
from policymakers, as this Policy Contribution will discuss.
In general,
crowdfunding is experiencing exponential growth globally. In the period
2009-13, the compound annual growth rate (CAGR) of the funding volumes was
about 76 percent with an estimated total funding volume of $5.1bn in 2013. In
terms of geography, the biggest market has been North America (and mostly the
US where the concept of crowdfunding started) with 60 percent of the market
volume, followed by Europe, which has 36 percent.
Equity crowdfunding is
the smallest category of the overall industry and had a CAGR of about 50
percent from 2010 to 2012. Most of that growth was through European
crowdfunding platforms because legal barriers currently prevent the
development of equity crowdfunding in the US (see Box 2). As a result, Europe
is currently the leading market for this financing model (see further
discussion in section 4).
While in Europe equity crowdfunding is growing,
the understanding of its risks and opportunities is still limited. We first
assess the potential role of equity crowdfunding in the overall seed and
early-stage financing market. Second, we point out the potential risks of
equity crowdfunding. Third, we describe the state of this nascent industry
considering both the innovations introduced by market players and existing
regulation. Finally, we discuss the implications of our analysis for policy.
The seed and early-stage financing market
Equity crowdfunding is receiving
attention from policymakers as a potential source of funds for start-ups, a
segment of the economy that has limited access to finance. Young firms have no
track record and often lack assets to be used as guarantees for bank loans. In
addition, information asymmetries make it difficult for investors to identify
and evaluate the potential of these firms.
Traditionally there have been
three sources of equity funding for young innovative firms: founders, family
and friends; angel investors; and venture capitalists.
The most common source
of funding for new ventures is the foundersâ?? own capital, even if that is
funded through credit cards. Family and friends sometimes also provide finance
to the entrepreneur in the first phases of development of the start-up (seed
stage).Angel investors are experienced entrepreneurs or business people that
choose to invest their own funds into a new venture. They typically invest in
seed and early stage ventures with amounts ranging from $25,000 to $500,000.
Angels invest not only for the potential financial return, but in many cases
to give back by helping other entrepreneurs.Venture capital is considered
â??professionalâ?? equity, in the form of a fund run by general partners, and
aims at investments in firms in early to expansion stages. The source of
capital pooled into venture capital funds is predominately institutional
investors. Venture capital firms typically invest around $3m and $5m per round
in a company.
The contributions of angel investors and venture capital firms
are not limited to the provision of finance. They are actively involved in
monitoring the companies in which they invest and often provide critical
resources such as industry expertise and a valuable network of contacts
(Gorman and Sahlman, 1989; Baum and Silverman, 2004; Hsu, 2004).
The
importance of angel investors has increased in recent years given the
difficulties young innovative firms face in securing finance from other
channels (Wilson, 2011). As a result of the financial crisis, banks are even
more reluctant to fund young firms because of their perceived riskiness and
lack of collateral (Wilson and Silva, 2013). Meanwhile, venture capital firms
are focusing more on later-stage investments and have left a significant
funding gap at the seed and early stage. Angel investors, particularly those
investing through groups or syndicates, are active in this investment segment
and thus help to fill this increasing financing gap.
Equity crowdfunding
departs from the models of traditional angel investors and venture capital
firms because transactions are intermediated by an online platform. Some
platforms play a more active role in screening and evaluating companies than
others (see section 4). Also, their role during the investment and
post-investment stages can vary dramatically. While there is a great deal of
variation among the approaches adopted by the different platforms (Collins and
Pierrakis, 2012), equity crowdfunding platforms generally follow the phases
described in Figure 3.
Platforms usually charge companies a fee, typically
5-10 percent of the amount raised, plus sometimes a fixed up-front fee. Some
platforms also charge fees to investors that are either fixed or a percentage
of the amount invested or a percentage of the profit for investment. For
example, Crowdcube charges entrepreneurs 5 percent plus a £1,750 fee for
successful fund raising. Symbid charges entrepreneurs a â?¬250 registration
fee plus 5 percent of the amount raised and charges investors 2.5 percent of
the amount invested. Seedrs charges entrepreneurs 7.5 percent of the amounts
raised and charges investors 7.5 percent of the profits from the investment.
To understand how equity crowdfunding can complement the market incumbents in
seed and early-stage finance, we have to consider characteristics such as
investment size, investment motives, the risk/return profile, the investment
model and investor characteristics.
Figure 4 shows the funding per project in
equity-based crowdfunding. Compared to the other sources of finance described
above, we can see that equity crowdfunding mostly operates in the financing
segment covered by angel investors1.
Another characteristic that equity
crowdfunding has in common with angel investors is that financial return is
not the sole motive for an investment. Crowdfunders might also derive social
and emotional benefits from financing a company. In other words, they are
likely to be motivated to provide funding to a company to be connected with an
entrepreneurial venture that shares their own values, vision or interests. A
survey of Seedrs2 users revealed that the three top motivations for investors
to fund start-ups are the desire to help new businesses get off the ground,
the ability to exploit tax reliefs3, and the hope of achieving meaningful
financial returns (Seedrs, 2013).
In terms of investment preferences, venture
capitals tend to concentrate on technology-based companies, which typically
are high-risk/high-return investments. Angel investors tend to invest in a
wider range of sectors and geographies, covering some investment segments in
which venture capital typically would not invest (Wilson, 2011). Because the
crowd might encompass quite heterogeneous investment motives, the investment
spectrum of equity crowdfunding can be even broader. For example, Seedrs users
have invested in sectors as diverse as food and drink, high-tech, art and
music, fashion and apparel, real estate and many others (Seedrs, 2014). The
fact that crowdinvestors derive also non-financial benefits from the
investment implies that they might also be willing to accept higher risks or
lower returns than an investor seeking to maximise financial returns (Collins
and Pierrakis, 2012).
Unlike venture capital and angel investment, equity
crowdfunding requires entrepreneurs to publicly disclose their business idea
and strategy. This early information disclosure might be harmful for firms
with an innovative business model that can be easily imitated (Hemer, 2011;
Agrawal et al, 2013; Hornuf and Schwienbacher, 2014a). Therefore, crowdfunding
might be most beneficial for start-ups that can protect their intellectual
capital through means other than secrecy, or for start-ups whose business is
not particularly innovative.
Another common element shared by business angels
and crowdinvestors is that neither type of financing model necessarily
involves an active financial intermediary that makes the investment decisions.
Venture capital firms pool financial commitments from institutional investors
into funds and then select a portfolio of companies over time in which they
invest. For angel investors and crowdinvestors, the decision to finance a
company is ultimately made by the individual investor. Some equity
crowdfunding platforms pool the funds of the crowd into an investment vehicle
and act towards the company as the representative of the interests of the
crowd. However, even in this case the platform does not act as a financial
intermediary in portfolio management for the crowd, and the decision to invest
in a specific company is taken by the individual investor.
While angel
investors are typically high net worth individuals who are sophisticated
investors, crowdinvestors are individuals that might or might not have
experience and knowledge of financial markets and early-stage financing.
Moreover, while angel investors tend to invest locally, crowdinvestors might
invest in start-ups that are quite distant from them. Agrawal et al (2011)
show that the average distance between a revenue-sharing crowdfunding
platform's entrepreneurs and investors was approximately 3,000 miles (4,828
km). According to their study, only 13.5 percent of the investors provided
funds to entrepreneurs within 50 km.
Table 1 summarises the key
characteristics of equity crowdfunders, angel investors and venture
capitalists, highlighting their similarities and differences.
Overall,
equity crowdfunding can provide a complementary channel through which
start-ups can obtain finance. In addition, equity crowdfunding can provide
some advantages by fully exploiting the potential of the internet.
For
example, crowdfunding allows a start-up to gain online visibility in the first
phases of its development. As crowdinvestors are also potential consumers, an
entrepreneur can benefit from crowdfunding through early advertisement of its
products and by obtaining information on potential market demand and product
preferences (Agrawal et al, 2013; Hornuf and Schwienbacher, 2014a). This early
assessment of demand could help to reduce inefficient investments in start-ups
with weak business potential.
Compared with traditional angel investing
transactions that rely mostly on word-of-mouth, crowdfunding can improve the
efficiency of the market by enabling faster and better investor-company
matches. Moreover, geographical factors that might affect traditional forms of
seed and early-stage financing might be less important in crowdfunding
(Mollick, 2013a; Agrawal et al, 2011 and 2013).
Finally, the crowdfunding
industry is well-positioned to benefit from the so-called 'big data' paradigm
(Agrawal et al, 2013). Being online-based, crowdfunding deals leave data
trails on investors, entrepreneurs, companies and deals, unlike angel
investment and even most venture capital transactions. Through time, the
analysis of this data could enable crowdfunding platforms to provide better
matches between investors and companies and maximise the correlation between
the crowd and product demand.
Risks in equity crowdfunding
Seed and
early-stage financing can be high risk but with the hope of a high return.
Eurostat data4 show that in EU the one-year survival rate for all enterprises
created in 2009 was 81 percent, while the five-year survival rate of all
enterprises started in 2005 was only 46 percent. Despite the expertise of
professional investors, the risk of investing in start-ups remains high.
Shikhar Ghosh, senior lecturer at Harvard Business School, analysed data from
more than 2,000 US companies that received venture financing and found that
about 30-40 percent of them fail, while more than 95 percent fail to generate
the expected return on investment (WSJ, 2012). There is a misconception about
success rates and returns on investment in start-ups (Shane, 2008) and the
average individual is not aware of the risks.
The characteristics of
crowdfunding can make investments in seed and early-stage companies even
riskier. Information asymmetry problems common to seed and early-stage
financing are exacerbated in equity crowdfunding. Below we describe some of
the issues that might arise in each phase of the investment.
Selection and
valuation
Before investing in a company, business angels and venture
capitalists routinely perform due diligence to assess the potential value of
the firm. This can be costly in terms of time and resources. However, evidence
shows that due diligence is a major determinant in achieving returns on the
investment (Wiltbanks and Boeker, 2007). This expense is often justified in
light of the considerable size of such investments. Because their investments
are relatively small, crowdinvestors have less incentive to perform due
diligence. Moreover, individual investors have the possibility of free-riding
on the investment decisions of others. This implies that the crowdfunding
community may systematically underinvest in due diligence (Agrawal et al,
2013).
Crowdfunders also likely lack the expertise and skills to perform
adequate due diligence. Since everyone is able to join, the crowd often
includes non-professional investors, who do not have the knowledge or
capabilities to properly estimate the value of a company.
Finally, company
valuation performed by a crowd might be affected by social biases and herding
behaviour5. Evidence suggests that a crowdfunderâ??s investment decision might
be affected by those of the other investors (Agrawal et al, 2011; Kuppuswamy
and Bayus, 2013). Moreover, different studies have found that both the crowd
and entrepreneurs are typically initially overoptimistic about potential
outcomes (Mollick, 2013b; Agrawal et al, 2013).
Investment
Equity
crowdfunding often relies on standardised contracts that are provided by the
portal. However, equity investment into seed and early-stage firms often
requires tailored contracts to align the interests of the entrepreneur to
those of the investor. For example, venture capital and business angels use
various covenants in their contracts, such as anti-dilution provisions that
protect against down-rounds6, tag-along rights7 that facilitate exit
opportunities, and liquidation preferences that secure higher priority in the
distribution of value (Hornuf and Schwienbacher, 2014a). Moreover, in order to
reduce risk exposure and increase control over the entrepreneurâ??s behaviour,
seed and early-stage investors often split their investments into tranches
that are conditional on the attainment of defined milestones. All of these
mechanisms are difficult to replicate in the crowdfunding setting.
Another
strategy applied by venture capitalists and business angels is to invest in a
portfolio of companies in order to diversify their risk. Equity crowdfunders
might be able to replicate this strategy given that crowdfunding platforms
expose them to a variety of projects. However, non-professional investors
might not be aware of the importance of this strategy and could potentially
concentrate all their investments in a single venture. For example, Seedrs
statistics show that 41 percent of investors hold only one company in their
portfolio (Seedrs, 2014).
Moreover, crowdfunders might not be able to
participate in follow-on investment rounds. The failure to do so might mean
that the investorâ??s shares get diluted, thus reducing their chances to
attain a positive return from the investment.
Post-investment support and
monitoring
As we have described, business angels and venture capitalists not
only provide finance to start-ups, but are also actively involved in
increasing the value of the company. While the crowd could potentially provide
active support to the venture, there are reasons to believe that this support
can be less valuable than that provided by traditional seed and early-stage
financiers. Given their typical small level of investment, crowdfunders have
less incentive to provide active support to the company because the return for
their action is lower (Agrawal et al, 2013). However, if too many investors
choose to become active, it could be excessively costly for a small firm to
manage a crowd of investors that want to participate. This is particularly
relevant considering that the venture has limited ability to select its
crowdinvestors.
Moreover, high information asymmetry also characterises the
post-investment phase, thus limiting the monitoring potential of the crowd.
One of the elements contributing to the increase in information asymmetry is
geographical distance between funders and the entrepreneur. While this
characteristic enables backers to attain access to a wider pool of
entrepreneurs (and visa-versa), it also entails higher monitoring costs.
Literature suggests that distance increases the costs that an investor must
bear in order to monitor the venture (Grote and Umber, 2007). This is in line
with the observation that venture capital funds invest predominantly in firms
close to them (Lerner, 1995).
Finally, the lack of repeated interactions
reduces the potential of reputation as a mechanism to incentivise the
entrepreneur to behave in line with the interests of the investor (Agrawal et
al, 2013). In other online marketplaces, such as eBay, participants have a low
incentive to misbehave because, if they do, they might, in effect, be
prevented from participating in the market in the future because of the
feedback and ratings mechanisms. Since sourcing equity finance through the
internet is often a one-time event for an entrepreneur, the incentives for
behaving correctly are lower, which can lead to potential fraud. More active
crowdfunding platforms screen companies. However, not all platforms have the
same standards.
Exit
The lack of adequate monitoring is particularly
worrisome in a setting in which investments often take 5-10 years or more to
produce a return, if any. Crowd investors might not appreciate that long
periods are necessary for these investments to either succeed or fail, or that
most of these investments are unlikely to yield any return. Moreover, equity
investments are mostly long-term illiquid assets. Therefore, it is important
that non-professional investors are adequately informed about the illiquid
characteristics of this asset class.
For equity investments to provide a
return to investors, a positive 'exit' must take place at some point. This can
be through an initial public offering (IPO) or, as more often the case,
through a merger or acquisition (M&A). Unfortunately, these positive exits
became increasingly rare during the financial crisis. In Europe, EVCA data
(2013) shows that only 15 percent of venture capital exits in 2012 (in terms
of number of companies) were through trade sales, and even fewer, 5 percent,
were IPOs. These numbers are clearly lower than pre-crisis (2007) figures that
pointed to 22 percent of exits through trade sales and 8 percent through
IPOs.
For angel investments and equity crowdfunding investments, the path to
a positive exit can be longer and even less likely. IPOs and M&As do not
happen by chance. Venture capitalists and the firms themselves often have an
exit strategy in mind from the beginning and proactively work towards making
it a reality over a long period (Wilson and Silva, 2013).
In conclusion, the
lack of adequate pre-investment screening and due diligence, weaker investment
contracts and poorer post-investment support and monitoring can make the risk
associated with equity crowdfunding significantly higher than the risk usually
borne by business angels and venture capitals. Moreover, while the potential
for fraud is exacerbated in the equity crowdfunding setting, information
asymmetry makes investments in the start-ups of even well-intentioned
entrepreneurs riskier, since the competence of the entrepreneur and the
quality of the business plan cannot be properly assessed.
While there are
some successful equity crowdfunding cases (such as the biotech start-up
Antabio8 in France, which succeeded in producing a positive return for its
investors) and failure cases (such as the liquidation of betandsleep9 or
sporTrade10 in Germany), the industry still lacks a sufficient track record to
assess its ability to create value for both investors and entrepreneurs.
Crowdfunding platforms and the regulatory environment
The issues we have
raised demonstrate the greater exposure that equity crowdfunding market has
compared to other forms of seed and early-stage investment. In particular,
adverse selection problems could increase the cost of capital up to the point
at which only low-quality ventures will eventually choose to seek financing
through crowdfunding, while high-quality ventures will continue to secure
venture capital or angel investor financing (Agrawal et al, 2013). Competition
between platforms and between the crowdfunding industry and traditional
financing is pushing platforms to design innovative solutions to avoid the
unintended consequence of creating a â??market for lemonsâ??.
Overall, the
main limitation of equity crowdfunding is that it allows a non-professional
investor, who might lack the incentive and/or capabilities to adequately
assess and monitor a start-up, to make an investment. Efforts to address this
limitation to date have included the introduction of an intermediary between
the crowd and the company that is able to perform these tasks, or the
reduction of the crowd to only qualified investors.
The first approach
involves the provision of an active intermediary that could act as a
representative of the interests of the crowd in performing due diligence and
monitoring start-ups. Following this trend, many platforms are active in
performing due diligence, while others operate a nominee and management system
in which they represent the interests of investors with the crowdfunded
business (eg Seedrs). Another example is provided by platforms such as
MyMicroInvest in Belgium, which allows investors to co-invest with an
experienced business angel. In this case, the crowd benefits from the
financial contracting skills and from the post-investment monitoring of an
experienced active investor. While this approach provides some benefits, it
also entails some risks: by leveraging the investment decisions of a business
angel, this mechanism may increase the risk propensity of the angel, thus
biasing his or her investment decisions.
A second approach is to reduce the
crowd, by limiting the investment to a restricted group of people, possibly
accredited investors, each contributing more capital than the average crowd
investor. In this case, crowdinvesting would more closely resemble angel
investor groups than the typical crowdfunding model. Examples of this model
are CircleUp and FundersClub in the US or Seedups based in Ireland, whose
offers are restricted to accredited investors. Other examples are platforms
that impose high investment minimums, thus reducing the crowd to a few
investors. Finally, some platforms (such as Seedrs and Crowdcube in the UK)
require crowdinvestors to pass a test before investing in a company, to
certify that they are sufficiently aware of the investment risk.
The efficacy
of these measures needs to be evaluated and appropriate policies should take
into account these assessments. Moreover, while the market gives incentives to
platforms to adopt the best practice, some platforms could deviate from the
best practices because of lack of long-term vision, incompetence or other
hidden interests (Griffin, 2012). The financial crisis showed that leaving the
financial market to self-regulate can be costly. Many of these crowdinvestors
could lose their money before the market has time to self-correct and force
out inadequate platform models.
Crowdfunding platforms have an incentive to
build a good reputation by securing attractive deals for their crowds, since
in the long run reputation results in market-share gains. Apart from this
reputational incentive, platforms differ in the structure of fees they derive
from the deals. As described in section 2, most of the platforms derive
revenues as a percentage of the amount raised, while only a few (eg Seedrs)
derive monetary benefit from a successful exit by imposing a fee as a
percentage of investorâ??s profits. This typical fee structure implies that
platforms derive monetary incentive to close deals while there are only
reputational incentives to provide successful deals in the long run. If
long-run reputational incentives are lower than short-term monetary
incentives, conflicts of interest could arise and platforms might downplay
investment risk to the crowd in order to secure deals. In light of this
potential conflict of interest, a supervisory body for crowdfunding platforms
is probably desirable.
From a legal standpoint, equity crowdfunding is
currently possible in some jurisdictions by exploiting exemptions to existing
securities regulations (Hornuf and Schwienbacher, 2014b). Securities laws
generally require an issuer to register with the national securities authority
and to comply with strict reporting standards in order to gain access to the
general public. These requirements are prohibitively expensive for small
firms, which are the typical beneficiaries of crowdfunding.
In the EU,
exemptions as defined in national regulations pertaining to prospectus and
registration requirements, allow start-ups to gain access to the general
public through equity crowdfunding (Hornuf and Schwienbacher, 2014b).
Exemptions include the maximum amount that can be offered to the public, the
maximum number of investors to whom the offer is made, the minimum
contribution imposed on investors and whether the offer is made to
â??qualifiedâ?? or â??accreditedâ?? investors. While these exemptions to
existing securities legislation allow small firms access to the general public
for financing, they also imply weaker protections for investors.
EU member
states have adopted different practices on whether the equity crowdfunding
platform must register as an investment intermediary or obtain a bank license.
For example, in Germany, crowdinvesting platforms explicitly stating that they
do not provide any investment advice or brokerage service have no obligation
to provide any documentation in terms of advisory records or to act in the
interest of the investor (Dapp and Laskawi, 2014). As a result, most German
platforms are not registered as investment intermediaries (ECN, 2013). In the
UK, platforms are regulated by the Financial Conduct Authority (FCA) (ECN,
2013; Hornuf and Schwienbacher, 2014b). In France, equity crowdfunding
platforms such as Wiseed, Anaxago, Finance Utile and SmartAngels are
registered as financial investment advisers, since their activities consist of
advice in providing financing (ECN, 2013; Hornuf and Schwienbacher, 2014b).
Finally, national corporate laws can also have an effect on equity
crowdfunding (De Buysere et al, 2012; Hornuf and Schwienbacher, 2014b). For
example, because they are relatively inexpensive in most countries, closely
held company types (eg private limited liabilities companies) are the typical
entity type chosen by start-ups. However, in many countries these company
types have limitations or might be prohibited from offering equity to new
investors. Even when allowed, equity transactions for these kinds of companies
often require formalities, such as notarial intervention, which increases the
costs for start-ups.
Despite the harmonising role played by Directive
2010/73/EU (Box 1), the EU remains a patchwork of different regulations. This
lack of uniformity inhibits the development of a pan-European industry by
making cross-border deals more difficult, and highlights the lack of consensus
on whether equity crowdfunding could be welfare-enhancing or not.
Considerations for policymakers
Crowdfunding can be an additional tool for
providing seed and early-stage equity finance to new ventures. However,
policymakers should proceed with caution by carefully assessing the risks of
this new financial intermediation tool. We argue that the challenges that
equity crowdfunding poses are distinct and more complex than those posed by
other forms of crowdfunding. As we have outlined, the risks also differ from
other forms of seed and early-stage equity finance, such as angel investing
and venture capital. Equity crowdfunding can open up additional channels for
new ventures to access finance at a time when securing funding is difficult,
but the risks, including those related to investor protection, need to be
addressed.
These risks could result from potential fraudulent activities of
start-ups or platforms or, more likely, poor investment decisions made by
unsophisticated investors. The current legal framework mainly addresses this
issue by reducing the exposure that individual investors can have to riskier
assets. The goal is to make sure that the investor is able to bear a potential
loss. However, as the equity crowdfunding volumes continue to grow, this
solution does not prevent the potential loss of significant amounts of
capital.
Overall, the legal framework should not allow a crowd of investors,
who might lack the incentive and/or the expertise to invest in a start-up, to
do so without adequate intermediation and protection. If the crowd is made up
of non-qualified investors, we argue that there should be at least one
participant that legally represents the interest of the crowd in the
investment in a business. This participant could be the crowdfunding platform.
The crowd could also be allowed to co-invest alongside professional investors.
However, also in this case, the platform should take significant steps to
protect the interests of the crowd from the misbehaviour of other investors.
Finally, in order to monitor potential conflicts of interest of platforms,
supervision by national security authorities is important.
Crowdfunding
currently is a highly deregulated market with little legal protection provided
to funders. In the EU, some member states have introduced ad-hoc legislation
for crowdfunding, while some others will introduce new laws soon. The European
Commission is currently studying equity crowdfunding, along with the other
forms of crowdfunding, to assess its risks and opportunities. In this regard,
the Commission started a public consultation late in 2013 and published a
Communication in March 2014 (EC, 2014). At this stage, the Commissionâ??s
efforts are focused on increasing awareness of the opportunities and risks of
crowdfunding, spreading best practice and improving the general understanding
of this growing phenomenon. The Commission is also exploring the potential of
a â??quality labelâ?? to spread good practice and build user confidence.
Being based online, equity crowdfunding has the potential to contribute to a
pan-European seed and early-stage financial market to support European
start-ups. However, in order to maximise this benefit, harmonised policies to
address equity crowdfunding models should be adopted in common by all member
states. This approach would maximise the benefits of equity crowdfunding and
help to reduce the risks. We urge the Commission to work with member states to
address the current patchwork of national legal frameworks, which constitute
an obstacle to the development of this nascent model of funding across
Europe.
Finally, legislators should take a holistic approach in assessing the
regulatory burden on the industry. Corporate law in many countries imposes
limitations or prohibits closely held company types â?? the typical legal form
chosen by start-ups â?? from selling equity to new investors. These provisions
are another significant obstacle to the development of equity crowdfunding.
Corporate laws should be harmonised and should take into account this new
financing channel for start-ups. In addition, other financial regulations
which might interact with and have an impact on the market should be
assessed.
In conclusion, all types of crowdfunding can provide significant
and new sources of funding for many types of organisations, ranging from
charities to companies. Equity crowdfunding, however, is more complex and
requires the proper checks and balances if it is to provide a viable channel
for financial intermediation in the seed and early-stage market in Europe.
Notes
1. Nevertheless, this distribution might not reflect simply the
investment preferences of the crowd. Legal constraints currently provide upper
limits to the capital that can be raised from nonqualified investors. See
section 4.
2. Seedrs is an equity crowdfunding platform based in the United
Kingdom. It allows users to invest as little as £10 into the start-ups. In
the first 18 months since its launch in July 2012, Seedrs collected more than
â?¬6.8 million through 56 funded campaigns and counted more than 29,000 users.
3. In particular, the Seed Enterprise Investment Scheme (SEIS) launched by
the UK government in April 2012.
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