Welcome > Blog > Blog Posts > So, you’re considering crowdfunding?
7th July, 2016
Congratulations! …… but as either an investor or a fund raiser you need to do your research to understand the different types of crowdfunding and the legal issues surrounding each of them. Crowdfunding is such a new and, thus far, little understood arena, that it is impossible to give full legal advice in one blog.
However, what I can do for you is very briefly raise some of the issues that arise to give you a starting point upon which to begin your own research, or to contact a legal professional for further advice. I’ll try not to put too much emphasis on the usual caveats but that doesn’t mean they don’t hold true.
There are a huge number of articles already on the web which outline specific legal regulations and so, with a tip of the cap to the real experts – you should really check out the FCA’s own guidance – I’m simply going to try and bring to your attention some of the ‘Oohs’ and the ‘Gotchas’ that you may not have considered.
Firstly, what IS Crowdfunding?
Well actually it isn’t just one thing, and many of the biggest name crowdfunding platforms that you might have heard of actually do very different things. It’s all too easy to categorise crowdfunding as debt v equity, when there are some quite distinct differences within these categories.
Let’s explore these and perhaps attach some labels to distinguish them, before looking at specific risks and benefits attached to each;
1. Donations-based crowdfunding (Crowd-donation):
2. Reward-based crowdfunding (Crowd-reward);
3. Loan-based crowdfunding (Crowdlending); and
4. Equity-based crowdfunding (Crowd-investment).
Usually unregulated, crowd-donation is just that; a platform for a project to seek donations to further its cause. Kickstarter is one of the best known platforms for this type of project; allowing artists, bands and other creative types to seek funding to achieve their goals. There is no specific return promised or offered to investors, other than, for example, the chance to have been a part of bringing their favourite band back to life after a 20-year hiatus.
One step along are the pre-payment or Crowd-reward scenarios. In this type of crowdfunding, the fundraiser offer the investor an opportunity to receive either a ‘gift’ or a version of the product they are funding. Again, not generally regulated because these platforms are more of a marketplace. Examples include film projects offering a signed still from the production process or dinner with the director or a promise to supply investors with the first production-ready prototypes of the particular product before the general market receive them (although often at a premium).
This is peer-to-peer (or P2P) lending and is almost always regulated, whether directly or indirectly. A debt-based model of crowdfunding, the fundraiser is asking the general public (or a sample thereof) to lend them some money, on agreed repayment terms. How that repayment is structured and described can cause its own problems (which we’ll dance around a bit later) but in essence it is that simple – the investor acts as a bank and expects to get their money back plus ‘interest’.
Finally, standing squarely in the middle of a regulatory-minefield, is what most people typically think of when the phrase crowdfunding is used. In 2014, according to Nesta and the University of Cambridge, the average amount raised through equity-based crowdfunding was £199,095. Fundraisers offer to give away an element of the equity in their company in return for a financial investment. Conceptually, you might think of each platform as a mini-stock exchange for private companies, start-ups and new ventures; some genuine, others more accurately described as, ahem, ‘ill-thought through’.
Much of the actual activity covered by crowdfunding is not new – after all businesses have been seeking investment, loans or other security from private investors for many years.
What is new is the power of technology, the internet and a more investment-ready culture to accelerate and amplify the scope of these investment-seeking activities.
In the past, only select high-net worth individuals would have been plugged into these investment-seeking circles. Now, literally anybody with a laptop or a mobile phone could in theory sink their life savings into a shaky venture over their morning coffee.
This has driven the UK’s regulatory powers (predominantly the FCA) to take an increasingly involved position in the debate, with new regulations in 2014 forcing almost all crowd-lending and crowd-investments platforms to be regulated.
What are the benefits and risks of crowdfunding?
Crowd-donation and crowd-reward are usually unregulated and offer little exposure to the individual investor. Short of a slight disappointment that the specific project you funded did not happen or the gadget you pre-ordered failed to arrive, the potential for loss is usually limited.
Be warned though, there can be tax-traps for the unwary, as donations may trigger an income or corporation tax charge. Sending a shiny reward back the other way, whether or not it was asked for or anticipated, will almost certainly be treated as a VATable supply, unless it isn’t – and it really will depend on the specific circumstances, so make sure you consider this in advance.
Crowd-lending (eg Funding Circle) is actually the fastest-growing form of crowdfunding, with some estimating that it might be a £12bn market by 2030 and £749m of business loans created in 2014 alone.
Now regulated by the FCA, platforms must;
(i) hold minimum capital reserves.
(ii) keep separate their own money from that of investors.
(iii) have contingency plans in place to maintain payments in the event that the platform goes bust.
(iv) be much more explicit about the risks involved with crowd-lending – a regulatory reaction to the earliest platform promises of these loans being equivalent to a bank account.
For the business seeking investment, the obvious benefit is quite simply the opening up of a seemingly untapped and unlimited market of funders who might be able to support their venture; where traditional bank loans may not be available.
Another opportunity is the emerging trend for revenue-sharing repayment, where the original loan is capitalised and repaid at the end of the loan period (or in some cases not repaid at all) in return for the investor receiving a share of revenue, rather than a fixed interest payment. This mitigates the cost of servicing the loan in instances where forecasted revenues are lumpy.
Drawbacks, outside of the usual ‘can the loan be serviced’ question, centre on the strength of the platform to actually achieve a successful loan placing and the cost of any fees payable to the platform itself, both on entry or exit of the loan. From a tax perspective, the loans will be generally treated as any commercial loan, with the relevant corporation tax write-offs and balance sheet treatment as a bank loan.
For the investor (lender), crowd-lending tends to be slightly lower risk than crowd-investment and fewer regulatory hurdles apply. The risks mainly centre on the lack of sophistication that ‘crowds’ are likely to have compared to institutional lenders such as banks. The lender is therefore relying on the platform to consider things such as anti-money laundering, credit checks and scoring to verify the viability and provenance of the business seeking funding.
Even then, given that most businesses turning to crowdfunding are start-ups, these loans are inherently riskier than leaving your cash in the bank and recent FCA complaints have highlighted the lack of honesty in some marketing material provided by crowd-lending platforms. Admittedly this was part of their pre-regulatory research and it is possible that the ‘bad apples’ are being weeded out.
Nevertheless the lender must consider how plausible any claims of revenue forecasting or credit viability are, whether made by the platform or the business itself along with the availability of any assets or security that the lender could use if the business defaults.
Remember that platforms are inevitably in a slightly conflicted position, as they are usually generating their fees based on successful loans placed, which has in the past caused some of them to underplay the severity of the risk of these loans not being repaid.
New changes in 2016 which enabled investors to lend money through a tax-efficient ‘innovative ISA’ scheme have been fraught with delays but do represent attempts to recognise the new wave of lending. They are expected to provide a major boost to the Crowd-lending fraternity, however it is too early to evaluate their real impact .
Crowd-investment ….. and finally, the equity play. This is where things get really exciting, complicated, and impossible to neatly summarise. You have to consider both the regulatory impact of the FCA (the platform should be FCA regulated) and the impact of the Financial Services and Markets Act (FSMA) which regulates the type of shares that can be offered, and to whom.
For the business seeking investment, the advantages of crowdfunding include:
Access to a much wider pool of investors (although see below, be careful it is not too wide);
Generally involves giving away substantially less equity per £ invested than a traditional angel or private equity round, largely because no one investor is investing enough cash (or perhaps has the relative sophistication) to value the venture accurately;
Limits the control given away – for example where an institutional investor may require a larger slice of the equity and insist on a seat on the board; individual crowdfunders are unlikely to have the sophistication, or the inclination, to demand this;
The process itself may generate publicity/marketing for the new venture (which may also have drawbacks, see below);
Harnesses the ‘herd’ effect – if you can gain traction on a crowdfunding platform there is a real possibility of the ‘me-too’ mentality (technically known, I believe, as ‘FOMO’) that can generate larger-than-expected investment pledges
Downsides perhaps mirror those of any equity investment, however for the unsophisticated start-up, particularly one without a seasoned advisor, this may be a regulatory minefield – with potentially criminal sanctions for getting it wrong, even if much of the burden is passed to the platform. In particular, businesses should consider the following:
Have you vetted your chosen platform to ensure it is FCA regulated?
Assuming yes (and if not, run), make sure you are not guilty of ‘financial promotion´ – a criminal offence which centres on attempts to offer shares in a private business to the general public? (platforms often get around this by inviting people to become ‘members’ of the platform, limiting the scope of who gets to see it).
Are you in a position to produce and provide clear information, prospectuses, forecasts and investor materials? These must adequately and accurately highlight the risks of investing in your business.
Are you going to give away valuable intellectual property by showing information on the platform/website? Unless you have protected your product (ie trade marks, patents, design rights etc) you run the risk of competitors stealing your ideas. Even if you have protected them, there is still a risk of copying taking place, so be prepared.
For the investor information asymmetry is the major flaw in the crowdfunding model, from an investor’s perspective. While these platforms open up a world of investment opportunities to the general public, many of these potential investors will not have access to the kinds of tools, information and experience that an average institutional investor has to hand.
And so the potential benefits are huge – you could make a strategically tax-efficient investment in the next Trunki or Facebook.
Prior to regulation the FCA highlighted major risks with some platforms over-emphasising the benefits of crowd-investment while seemingly ignoring the risks, often by omitting or cherry-picking the information provided.
Regulations do exist to try and mitigate this by restricting the pool of people that investments can be offered to. This is where it gets really complicated and in truth, outside of the scope of this note and one for the platform to wrestle with, rather than the business itself. In brief they often involve the platform requiring investors to ‘self-certify’ themselves as either a high-net worth or ‘sophisticated’ investor (capable of spending their money as foolishly as they please) or a ‘restricted’ investor.
Investments to restricted investors (Joe and Joanne Public, essentially) often involve a cap on the amount raised or the individual amounts invested, either in real terms or as a % of the investor’s assets.
There are significant tax advantages to many of the investments available on crowdfunding platforms, being new startups. These include Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) reliefs. Investments attracting this relief benefit from an immediate income tax reduction between 30% – 50% and a reduced or zero obligation to pay capital gains tax when the shares are sold.
Although not directly benefiting the businesses looking for funding, these schemes are so attractive to investors that they can mitigate the riskiness of crowd-funding, leading to increased funding being achieved.
The tax treatment of investment will again be the same as any equity round, with corporation tax and implications dependent on the particular business, its profitability and success.
Conclusion and other thoughts
From a legal perspective, particularly for the business seeking funding, it is important to remember that there are likely to be two key relationships governed by terms and conditions that must be checked.
First is your relationship with the chosen platform. How does this govern fees, risk, obligations over regulatory requirements and enforcement of any failures on the part of the investor/lender.
Secondly is your relationship with the ultimate investor/lender. What credit or other checks have been carried out. What implications are there for future investment rounds or repayment obligations and are there any obvious tax implications that have been overlooked.
Overall, the great opportunities afforded by crowd-funding of all types are starting to become apparent.
However, it is impossible to conclude an article like this – however frustratingly – without liberal use of phrases like “it really depends on the circumstances”, “speak to a grown-up about tax” and “make absolutely sure that you don’t accidentally engage in financial promotion by offering your shares to a global audience and end up in a US jail”.
Written by Richard Turner of Alt Legal Ltd on behalf of LawyerFair
Launch your project to raise funds for your startup or growing small business with Cavendish Crowd – the crowdfunding platform specifically supporting small businesses across the country.
Click for downloadable document giving overview of the legal considerations to undertake when considering crowdfunding, either as an investor or a fundraiser.
Contact Richard if you have any legal questions about crowdfunding.
Cavendish Enterprise has teamed up with Crowdfunder Ltd to bring Cavendish Crowd to startup and growing small businesses across England. Crowdfunder Ltd carries out equity crowdfunding activities through its associate partner Crowdcube Capital Ltd, which is authorised and regulated by the Financial Conduct Authority (No. 650205).
Alt Legal Limited is part of Alt Professionals – providing joined-up professional support for SMEs across legal, financial, HR and advisory services, under one roof.