Crowdfunding: its bene ts, risks and rising popularity

Crowdfunding is an increasingly popular way for individuals and companies to obtain finance for discrete projects and start-up business ventures as well as more established enterprises.

This guide provides an overview of the various types of crowdfunding available and some of the key issues that businesses should consider when seeking to raise funds on a crowdfunding platform.

What is `crowdfunding'?

As the name suggests, crowdfunders seek to raise funds by attracting often relatively small amounts of money from a large number of people (the `crowd'). The internet has made it possible for even the smallest businesses to pitch to vast audiences of potential investors.

There is a growing number of online platforms (for example Crowdcube, Seedrs and Indiegogo) which bring crowdfunders together with those potential investors. Typically, crowdfunding platforms will host a large number of company pitches at any one time, allowing investors to spread their investments (and thereby their risk) across a wide range of opportunities that interest them.

What types of crowdfunding are there?

Crowdfunding can take a number of different forms:

  • donation-based: where investors typically receive nothing more than a good feeling or token gift in return for their contributions;
  • reward-based: popular among small business owners who, in return for small contributions, will reward investors with a product or service, typically on a one-off basis. For example, start-up businesses might reward funders by promising a prototype or first edition model of the product that they are attempting to develop;
  • loan-based: where investors lend money to a company or project in return for an interest rate and a right to repayment in future; and
  • equity-based: where investors provide money in return for shares in the company, with a view to receiving dividends as a shareholder and making a profit if and when the company is sold.

There are significantly more donation and reward-based crowdfunding campaigns than any other kind. However for established businesses, loan-based and equity-based forms are more common.

Loan-based crowdfunding may be secured against a company's assets, or unsecured, depending on the particular circumstances. The company may have to make interest payments to investors on a regular basis, or interest may be rolled up and payable at the expiry of the loan period.

For equity-based crowdfunding, you are giving up a proportion of your company, and a portion of the ultimate sale proceeds, in return for the capital investment to get your project off the ground.

"Crowdfunding is one alternative to `mainstream' sources of funding for projects or business ventures which might not fit the model for traditional forms of debt or equity finance"

What is crowdfunding used for?

Traditionally crowdfunding has been used to fund entrepreneurial ideas and early-stage business ventures. It has served as an alternative to `mainstream' sources of funding for projects which might not fit the model for traditional forms of finance. For example, many crowdfunded businesses are knowledge-based, lack tangible collateral or are not yet revenue-generating so perhaps do not meet the lending criteria of banks or other funders.

However, more frequently, we are seeing both new and established businesses use crowdfunding for its secondary benefits such as connecting with the customer base and generating a `buzz' around its product, service or brand. Campaigns by Monzo Bank and BrewDog are good examples of that raising finance while driving publicity and engagement with consumers.

Crowdfunding has also been used effectively to fund community benefit projects. Habitat for Humanity, a US-headquartered NGO, has launched a 15 million campaign for its volunteer-based house building programme, Global Village. In the UK, funds have been successfully raised by The National Trust and various local groups to fund restoration works for heritage buildings and civic spaces.

So crowdfunding should not just be thought of as a tool for the hi-tech start-up community. Projects and ventures in all sectors including third sector and established businesses have used crowdfunding for its combination of access to funds and stakeholder engagement opportunities.

What are the main attractions of crowdfunding?

Crowdfunding's principal benefit is that it taps into previously under-utilised sources of capital, making it available to businesses that might otherwise have struggled to obtain funding from traditional sources. As mentioned above, stakeholder engagement is another potential benefit. Crowdfunding can result in a broad investor base which, if tended to under the right conditions, will support and actively promote the business / project through word of mouth and social media channels.

The most successful crowdfunding campaigns leverage both of these aspects. For example, it is not uncommon for investors to be offered special gifts or rewards in parallel with their investment. That can be a powerful tool in creating brand loyalty at a small marginal cost to the crowdfunder.

Who can invest?

`Crowds' vary in size and nature according to the platform one uses. Some are pre-vetted syndicates of sophisticated investors. Others are open to members of the public generally, provided they have signed up and met certain pre-investment conditions. Some platforms specialise in specific business sectors or types of investing (for example, `green' or ethical investments) that target investors of a particular profile.

So the first step towards implementing a crowdfunding campaign is to determine your target investor pool and choose a platform that gives you the best opportunity to reach out to them. There are important legal restrictions on the marketing of investments to the public (For details see Legal and regulatory aspects below). You need to be sure that your chosen platform vets its particular `crowd' and facilitates your pitching to that crowd in a way that is lawful. An experienced adviser can review the platform's processes and regulatory permissions to check this for you.

What are the main practical issues?

There are legal and practical risks in raising money through crowdfunding, so it pays to be aware of the facts early on. Please note this guide is not intended to be a comprehensive statement of the law, your duties or obligations it is only possible to flag the kind of issues that you and your advisers should be working through as part of your planning.

Top tips for investee companies

  • Get your house in order early. Does the company own or properly license its key intellectual property? Do you have contracts in place to underpin key business relationships? Are the company's articles of association `investor-ready'? Campaigns can fall by the wayside due to a lack of preparedness. This could result in negative consequences for the business, including reputational damage and a costly waste of already limited resources. Most credible crowdfunding platforms will carry out a level of due diligence on your company and its structure and constitution. However, often this will only occur after you have substantially completed your raise. At this point in time it may be too late to gracefully withdraw the campaign or change your pitch narrative if issues arise.
  • Be aware of your legal duties and obligations. Promoting investments to the public through crowdfunding is regulated by the Financial Conduct Authority (FCA) which brings into play potential personal liability for directors and management of investee companies, in the event of misconduct or failure to comply with applicable rules. In some circumstances the company may be required under the UK's Prospectus Rules to produce a formal prospectus, meeting strict regulatory requirements. This issue is particularly relevant to loan-based and equity-based crowdfunding. This is a complicated area of the law and it is essential that you work with your advisers to ensure (i) that due and proper processes have been followed, (ii) that your chosen platform has the necessary regulatory authorisations in place, and (iii) that your crowdfunding pitch is accurate, not misleading and adequately discloses potential risks to potential investors. There are significant civil and criminal sanctions for non-compliance (up to and including imprisonment in the most serious cases). You should always take advice on the obligations and responsibilities for you and your company before communicating any investment opportunity to the public (via a crowdfunding platform or otherwise).
  • Be comprehensive and realistic in your pitch. It is important to be upfront in your pitch documentation about what you can and can't deliver and what dependencies exist. Your advisers should help you undertake a thorough verification exercise to test the statements you have made in your pitch, to ensure that all facts are accurate, opinions are based on reasonable grounds and the pitch as a whole does not mislead investors (including by omission). This includes full disclosure of the risks affecting the project and your ability to deliver it. Crowdfunding does not usually afford investors any real opportunity to perform due diligence on your business, so they will be making an investment decision on the basis of the information you provide. There can be personal liability if you mislead investors; remember that this applies equally to any investor presentations or other communications you or the platform may make outside of the formal pitch document.
  • Be prepared for a change in dynamic. Investee companies should also bear in mind the implications of moving from a small group of stakeholders to, potentially, a very large and diverse investor base. With that comes increased administration and cost not to mention the scrutiny applied by various third parties who may have invested in your business in the hope of generating a financial return. Even if you have set realistic expectations and fully disclosed the risks, you will need to be resilient and respond well to criticism if things don't go as planned. Many crowdfunding platforms offer a nominee service, whereby a nominated entity administered by the platform will collectively hold shares for the benefit of individual investors. You should carefully consider the terms and conditions upon which a nominee entity is engaged and there is usually a fee payable to the platform / nominee for this service. Of course, you need to weigh all of this against the potential benefits of crowdfunding including that the company's enlarged stakeholder base could become its business' greatest supporters and promoters.

Legal and regulatory aspects: Financial promotions

Loan-based and equity-based crowdfunding may involve `regulated activities' for the purposes of the Financial Services and Markets Act 2000 (FSMA) the key piece of legislation that governs the marketing and conduct of financial services in the UK. It is unlawful to conduct regulated activities in the UK without being appropriately authorised or exempt. In addition to the rules relating to regulated activities, FSMA prohibits the making of a `financial promotion' (that is, inviting or inducing someone to engage in investment activity) unless the relevant communication is either approved by a person authorised by the Financial Conduct Authority (FCA) or an exemption applies. In response to the growing popularity of investment-based crowdfunding, the FCA introduced from 1 April 2014 certain specific exemptions to the financial promotions restriction. Such exemptions cover promotions made to investors who are professionally advised or satisfy certain high net worth or sophisticated investor criteria.

A further exemption is available where the promotion is made to `restricted investors' who have declared that they will not invest more than 10% of their net investible assets (excluding their primary residence) in unlisted shares or debt products. This exemption is aimed squarely at permitting crowdfunding platforms to promote opportunities to members of the public who do not meet the advised, high net worth or sophisticated investor criteria.

The FCA has commented that it recognises the overall economic and market benefits of crowdfunding in terms of access to capital. Nevertheless, it has stated that it will closely monitor the industry and continue to publicly consult on the current regulatory regime. The FCA's position reflects the perceived high risk nature of this type of investing crowdfunded companies are often early-stage and unproven, meaning that there is a relatively high incidence of business failure.

Investment crowdfunding platforms must be authorised by the FCA. It is critical for crowdfunders to verify the regulatory authorisations held by their preferred crowdfunding platform and to ensure that the platform's on-boarding process for investors complies with the relevant legal requirements.

"Loan-based and equity-based crowdfunding platforms may involve `regulated activities' for the purposes of the Financial Services and Markets Act 2000."

Current legislation requires risks to be adequately disclosed to potential investors, and the nature and content of those risk warnings depends on the particular category of investor to which the investment is promoted. FSMA also makes it generally unlawful for a company to offer shares to the public without issuing a regulated prospectus and further prohibitions contained in the Companies Act 2006 prevent privately-held companies from offering shares to the public at large, unless specific exemptions apply. Crowdfunding platforms will often seek to utilise these exemptions by limiting who can and will receive relevant offers to invest, or the total amount to be raised. This is done primarily through the registration process that must be completed by individuals when joining the platform, which confirms that they fall into a group of persons to whom it is lawful to make the financial promotion. The industry and regulatory consensus is that crowdfunding platforms are here to stay. The FCA is quick to highlight the risks associated with investing in assets that are not readily realisable. Nevertheless it has recognised the overall economic benefit of a growing and competitive crowdfunding industry that is capable of providing access to finance where banks and other investors may not.

Next steps

Depending on the size, resources and strategic direction of your business, crowdfunding can provide a viable and efficient pathway to capital. At Brodies we regularly advise clients on such matters and can assist you with any aspect of crowdfunding as it relates to you and your business.