Legal Aspects of Investment based Crowdfunding
What is Crowdfunding?
Crowdfunding at its most basic level, is an open appeal to the public for funds for a specific project or for a specific objective.
Crowdfunding can be divided into two categories, the non-financial return category (donation based, pre-payment or rewards based (people give money to receive a reward, service or product)) and the financial return models (investment in return for the issuing of equity or debt securities or units in a collective investment scheme or the lending of money in return for a financial reward) all of which have different characteristics for those seeking the money and those giving the money.
The concept of the non-financial reward model is not new and has been around for centuries: for example appeals made by charities to the public for funds to achieve certain common good objectives. Indeed, crowdfunding has been mentioned as an important future source of funds for charities.
h2.The Emergence of Crowdfunding and for a vast arrange of projects
Crowdfunding platforms have really started to emerge as internet technology has evolved to allow two way communication and interaction between members of the crowd and the company seeking funds and also because of the financial crisis. Crowdfunding is used to raise money rapidly. The range of companies using it is a lot wider than one might think: a biotech company, a medical device manufacturer, a medical diagnostics company, an online estate agency, a brewing company, a wine producer, tech companies, and online property portal companies have all used crowdfunding either to start up or scale up. Most recently crowdfunding is being used as a means to purchase property, allowing small investors get access to property investment. In its February 2015 review, the FCA commented that about 95% of the funded deals were eligible for the Enterprise Investment Scheme or Seed EIS Schemes.
Investment based Crowdfunding
Our focus here is on investment based crowdfunding which is the financial return model of crowdfunding and is internet based. This is where people, or companies invest directly or indirectly in new or established businesses by buying shares, debt securities or units in an unregulated collective investment scheme (securities).
It is complex and of recent origin and is the category, along with loan based crowd funding that regulators are most likely to intervene. Investment based crowdfunding can provide capital to start ups and SMEs who might otherwise find it difficult to secure equity capital or loan funding from traditional sources.
In investment based crowdfunding there are generally at least three parties, the company seeking finance for a specific project (the project owner), the intermediary providing the internet crowdfunding specific platform (platform) and the investors (who are not typically professional investors) forming part of the crowd who fund the project through the platform, communicate through the intermediary and then invest.
Depending on the model used, the investor may acquire securities in the project owner either in his or her own name or through a nominee, provided by the intermediary. In another variant, the investor may acquire a security in a special purpose vehicle (SPV) or collective investment scheme (CIS). The SPV or CIS will in turn either hold securities in the project owner or have some other interest in the project owner.
In terms of who does what, the intermediary through his platform provides services to the project owner which include a mechanism for the project owner to find potential investors and commitments from those who decide to invest. The intermediary may also provide assistance in developing the promotion for the platform, legal assistance with for example the preparation of the securities issue or acting as registrar for the issuer as to the ownership of securities. The project owner will pay a fee to the intermediary where the campaign is successful. Additional fees may also be payable to the intermediary for additional services.
The intermediary may carry out limited due diligence on the project and in that context may limit the extent to which they take responsibility. Potential investors often have to register with the platform before accessing the full information on the promotion. Once the target amount is reached, the funds are transferred to the project owner or the issuer where the issuer is not the project owner, in return for the ownership of the security or, in some cases, beneficial ownership of rights in the security.
A few platforms charge fees to investors as well as to project owners.
Some platforms are within an appropriate regulatory framework where it applies and some structure the transaction so as to avoid regulation. The advantage where the transaction is structured to comply with a regulatory structure such as MiFID, is that passporting rights can be obtained, enabling the platform (assuming it is the authorised party) achieve economies of scale.
Differing approaches to investment based and loan based crowdfunding have been taken by national regulatory authorities. Indeed some national authorities do not specifically regulate investment based crowdfunding. Whether specifically regulated or not, any project owner, issuer or intermediary would want to ensure, amongst other things, that they do not infringe company law and also either fit within an exemption to the Prospectus Directive or meet any applicable requirement to publish a Prospectus. The intermediary would also need to ensure investor funds were held and transferred by an authorised payment services provider and not by the intermediary.
Risks with Crowdfunding
The risks with investment based crowdfunding are significant, and include loss of some or all of the capital (and with no access to Investor Compensation Schemes), risk of dilution, lack of dividends, limited possibility to exit, minimal information about the project (when compared to investment in a listed firm), and the potential for investors to overestimate the amount of due diligence undertaken by the platform and the potential for conflicts of interest where the intermediary is remunerated by the investors and the project owner.
FCA Regulation of Investment Based Crowdfunding
The FCA have regulated investment based crowdfunding for some time on a limited basis if it involves a person carrying on a regulated activity in the UK such as arranging deals in investments or the communication of a financial promotion.
However in 2014, the FCA changed its approach to specifically regulate firms operating investment based crowdfunding platforms. The aim was to make this market more accessible to retail clients, to help foster competition and to facilitate access to alternative finance options, while still aiming to ensure that only investors who can understand and bear the risks participate in the market. The changes are not expected to impact firms corporate finance businesses or venture capital businesses and firms carrying on regulated activities for professional clients.
The new rules which in fact commenced October 2014, apply to the sale of non-realisable securities (in short unlisted shares or unlisted debt securities).
Given the significant risks investors face when investing in unlisted securities that are hard to value independently or sell on a secondary market, the FCA require (in brief) that firms offering such investments on crowdfunding platforms (or using other media) promote only to certain types of investor. These are:
- professional clients,
- retail clients who are advised,
- retail clients classified as corporate finance contacts or venture capital contacts,
- retail clients certified as sophisticated or high net worth, or
- retail clients who confirm that they will not invest more than 10% of their net investible assets in these products.
Where no advice has been provided to retail clients, the FCA apply the appropriateness test, so all firms (both MiFID and non-MiFID) would need to check that clients have the knowledge or experience to understand the risks involved.
In February 2015 the FCA set out what its expectations are in relation to applications for the authorisation of crowdfunding businesses. The FCA encourages firms to (i) submit a suitable and detailed regulatory business plan (setting out the activities proposed and risks, budget, and resources); (ii) have adequate financial and non-financial resources; (iii) have a website that is either up and running or at a suitably advanced stage (including a test site or app, screen shots of a planned website or app that would demonstrate the user interface and functionality available to users) to demonstrate how it will operate should the firm be authorised; (iv) understand the FCA authorisation requirements and the permission profile they wish to apply for, (v) then submit a completed application including an outline of which regulated activities the firms plan to conduct.
In the context of market supervision, the FCA emphasised, that were looking to see that platforms were disclosing all relevant information to enable potential investors to make informed decisions on whether or not to invest. This information must not be misleading.
The FCA propose to carry out a full post implementation review of the crowdfunding market and regulatory framework in 2016 to identify whether changes are required at that stage.
Given the lack as yet of a framework in Ireland for crowdfunding, but at the same time the existence here of a definitive legal framework for alternative investment funds which is complemented by the new Companies Act from the 1st of June, we have a solid base to build a framework similar to England for this innovative method of raising funds.
© Copyright McKeever Solicitors, 15th May 2015. All rights reserved.
This article is for information purposes only and must not be taken as legal advice or as a substitute for legal advice. If you have any queries on this article, please contact either Paul Foley, Partner or Andrew Clarke, Associate.
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