Holding back the crowds: How regulators are stifling the crowdfunding industry

31 July 2014

Crowdfunding is nothing new. Over the past few years, it has evolved from a little-known and rarely-used concept by which small businesses could raise money, to a truly viable alternative to venture capital.


At its heart, crowdfunding is simply a method of financing individuals, businesses, charities and other projects by bringing together a number of unconnected contributors, usually on an online platform. The idea is simple enough, and more and more people are jumping on board. As a result the crowdfunding industry has rocketed in the past few years; in 2013, an estimated $5.1 billion was raised by crowdfunding platforms globally. The UK was perhaps a little late to the party, but with a 50% rise in the number of home-grown crowdfunding platforms last year it seemed that we were finally poised to tap into its full potential. However, new rules from the Financial Conduct Authority have put the industry at risk of being stifled by red tape. Crowdfunding is at a crossroads, and the implications of taking the wrong path could be huge.

Crowdfunding as we know it today falls into four main categories, generally distinguished by reference to the outcome for investors. Firstly, "charitable crowdfunding" involves no return on investment for the contributor; individuals or firms simply donate a sum to a project. Similarly, "reward crowdfunding" also carries no financial incentive for the contributor. Instead, the individual, company or project supplies a defined benefit in return for the contributed funds (a signed copy of the book being funded for publication, for example). "Debt crowdfunding", or peer-to-peer lending, matches borrowers who are seeking funds with lenders who provide funding by way of loans. This is advantageous for all; borrowers can raise capital even if their credit status makes it difficult to secure a traditional bank loan; lenders have the autonomy to decide who to lend to and can set interest at a rate to suit them; and, as most P2P lending services operate automatically, overheads are kept to a minimum, resulting in lower "arranging" fees than traditional loans. Finally, "equity crowdfunding" is essentially a form of small scale venture capital, where investors provide funds in return for unlisted equity. What they all have in common is that they are simple and, at least until very recently, regulation was minimal. As a result, those involved on both sides could operate with autonomy, freedom and ease.

What was once seen as little more than a fundraising tool for tech start-ups and independent movies has since branched out into countless different industries and experienced dramatic growth.Debt and equity crowdfunding have emerged as potent sources of capital for young businesses, and crowdfunding is increasingly seen by policy-makers as a beneficial economic driver. And it's not just early-stage businesses and start-up companies that stand to benefit.

Energy, a sector which has long been dominated by the "big six" energy providers, offers a perfect example. The UK is well behind most of Europe when it comes to renewable energy, and with the big six focused almost entirely on fossil fuels, there is an increasing feeling that crowdfunding could provide something of a solution. It's a model that seems to be working abroad; a quarter of Germany's electricity comes from renewable energy sources, almost half of which are owned by individuals, community groups and private developers. In many cases, crowdfunding was instrumental in getting these projects off the ground. Similarly, in the US the country's largest solar power provider has estimated that crowdfunding will provide $5 billion of investment for rooftop solar projects within five years. A recent report from ResPublica set out how crowdfunding could help realise a similar community energy revolution in the UK, and Co-operative Energy has already got the ball rolling with power purchase agreements with community energy groups and strategic relations with innovative crowdfunders.

With the crowdfunding snowballfast gathering pace, the level of media attention surrounding the concept is unsurprising. This has been aided by an increasing number of high-profile success stories emerging from websites like Kickstarter and Indiegogo. It was perhaps inevitable, therefore, that the online platforms which facilitate crowdfunding would eventually draw the attention of the regulatory spotlight too. The Financial Conduct Authority (FCA) already regulated certain types of crowdfunding insofar as they involved carrying out a "regulated activity", but new rules introduced by the FCA last month (June 2014) mean that the industry will now be much more closely controlled. Since 1 April, equity crowdfunding has been restricted to savers who are advised by professionals or linked to corporate finance or venture capital firms. Those who don't tick one of these boxes will have to sign a statement saying they will spend no more than 10% of their assets on crowdfunding in any given year. Similarly, P2P lending platforms have been brought under the umbrella of FCA regulation and away from the remit of the Office of Fair Trading (OFT). Although P2P regulation will be lighter than regulation of investment-based platforms, there are a number of obligations which could require significant adjustments to the particular firm's business model.

The new rules have been met with real concern by the industry, which fears that the unique selling point of crowdfunding, i.e. its freedom, will be lost. There has been much talk of "taking the crowd out of crowdfunding" and locking out ordinary investors. The FCA says its aim is to protect the vulnerable, particularly those who may be "more susceptible to the emotive advertising highlighting the social benefits" of a particular venture. But heightened sophistication and regulation are likely to erode the appeal of crowdfunding, which is at its core a delightfully simple concept. The more hoops a potential investor has to jump through, the less likely it is to invest, and regulators should be wary of the long-term implications of this before crowdfunding is killed off altogether. The Government may be wise to take a leaf out of France's book in this regard. The French government recently moved in the opposite direction by relaxing the rules on this kind of finance and encouraging individuals to invest in crowdfunding. Unless the UK re-thinks its regulation strategy and follows suit, there is a danger that the evolution of crowdfunding in the UK will be prematurely stunted.

Ben Kerry

Image attribution: https://creativecommons.org/licenses/by/2.0/

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