NEW KID ON THE BLOCK.

Jannah Patchay of Agora Global Consultants looks at why crowdfunding is capturing the UK government and investors’ imagination.

Crowdfunding has gone mainstream. Even the UK government is on board, investing directly in small-to-medium enterprises (SME’s) via platforms such as Crowdcube and Funding Circle. Market commentators laud it as the antidote to SME funding issues, and the retail investor’s new best friend in a market sorely lacking in decent returns on investment.

Crowdfunding is a disintermediary, using the power of the internet and developments in financial technology to bring together both investors and SMEs normally beyond the reach of traditional capital markets. For the UK government, it is a means of not only demonstrating internet-savvy but also of investing easily and directly into this crucial end of the market, touted as crucial for economic recovery and growth, without itself having to administer costly loan schemes.

In March 2014, the Financial Conduct Authority (FCA), somewhat late to the party, published “The FCA’s regulatory approach to crowdfunding over the internet, and the promotion of non-readily realisable securities by other media”. This longwinded titled report followed on from a consultation paper and contained the final rules applicable to this burgeoning industry.

It distinguished between five types of crowdfunding activities:

• Donation-based – including charity fundraising sites such as Crowdfunder.
• Pre-payment or rewards-based – investing in exchange for a reward, service or product, e.g. via Kickstarter.
• Exempt – schemes such Enterprise Schemes or withdrawable shares issued by Industrial and Provident Societies, which are exempt from FCA authorisation or regulation.
• Loan-based – schemes facilitating the lending of funds by investors to businesses i.e. peer-topeer lending.
• Investment-based – schemes facilitating investment in businesses via shares, debt securities or unregulated collective investment schemes.
• The FCA further noted that only the latter two activities fell under its remit. These are referred to broadly as crowdfunding, with the overt distinction being made only where necessary. Furthermore, it stipulated that these activities were, broadly speaking, to be governed by existing rules for consumer credit providers. This is a diverse category encompassing credit card providers, payday lenders and pawnbrokers, amongst others.

Customisations for crowdfunding platforms included stipulation of regulatory capital requirements and arrangements in place whereby the outstanding loan or investment book may continue to be administered and run in the event of the platform operator itself folding. Interestingly, from an investor point of view, the FCA decided that, whilst crowdfunding investments would not be covered by the Financial Services Compensation Scheme (FSCS), participation in investment-based schemes would be limited to a maximum of 10% of a retail investor’s investible assets.

The advent of crowdfunding, arguably the vanguard of the wider fintech paradigm, has led to an increased appreciation from both the UK government and the FCA of the need to be at the forefront of such an innovative area. For the government, fintech is high on the agenda because it offers a new industry with massive growth potential. It provides not only a channel for investment, but also a target for it.

In August, George Osborne announced a doubling of the initial £100m investment in fintech companies and development of innovative finance products. There are also now provisions for tax breaks for both fintech firms and investors (including, for the first time, allowing peer-to-peer lending in investment savings accounts). In parallel, the FCA is moving forward with proactive regulation, culminating in the launch in May 2014 of Project Innovate. The service is aimed at facilitating communication between fintech start-ups and the FCA, and assisting them in navigating the regulatory environment.

Traditionally, early-stage SME financing has been dominated by bank lending and angel or venture capital investment. Peer-to-peer lending platforms have done well to address the deficits now inherent in the former, while investment-based schemes such as Angel’s Den have made the latter easier and more successful than ever.

Peer-to-peer lenders are typically and rightly perceived as being less risky to retail investors due to the smaller amounts invested, the ability to withdraw funds and the potential for spreading loans across multiple recipients. This has resulted in a lower and more diversified risk profile. As for investment-based schemes, it is notable that an angel investor is a very different beast to an average retail investor. They are more sophisticated, with a greater understanding of market fundamentals. They understand the need for a solid business model and prospects for return on investment, which together promote investor confidence.

Investment-based crowdfunding platforms may provide them with liquidity and market infrastructure that were previously unavailable. An interesting exercise would be to explore the breakdown between the retail investor, more sophisticated angel investor and government investment across the various crowdfunding platforms. The aim would be to understand the extent to which investment-based crowdfunding has been adopted by retail investors. Furthermore, to what extent do retail investors understand the risks involved in investing in these schemes?

The government’s own statistics note that between 50% and 70% of start-ups fail in their early years. The wild success of investmentbased crowdfunding platforms has not borne out these statistics. To some extent, this may be a self-fulfilling prophecy: many businesses on these platforms are second-or-third time fundraisers, and easy access to funding can help overcome some of the initial cashflow challenges in launching a new service or product.

However, there is no substitute for a strong business model and good corporate leadership. Once the initial funding issues have been resolved, it remains to be seen how many of these crowdfunded start-ups will survive. It may be too early to ascertain the true success but one thing is for certain – the failure of a large crowdfunded scheme (whether investment- or loan-based), or an economic event resulting in the collapse of multiple enterprises, and subsequent losses incurred by retail investors, would pose a fundamental challenge to the industry that has not yet been adequately explored.

[divider_line]©BestExecution 2015

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