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Crowdfunding: Regulation Imminent

About The Author

Chris Bridges (Executive Editor)

Chris is an IT and Data Protection solicitor at a top 20 full service firm and the founder of Keep Calm Talk Law. He also contributes to Computers and Law and other sector specific publications.

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The economic climate over the last 6 years as led to a surge in an alternative solution to financing new and existing business projects. Instead of pitching a business concept to a bank in the hope that they will see merit in financing it, you pitch an idea to private individuals or private venture capitalists and other similar organisations. This is done via a ‘crowdfunding platform’, which is essentially a forum (usually online) for potential ‘partners’ to meet. As you may have sensed by the name, finance is rarely provided by one person. Instead, anything from just a few financers, to thousands of financers can be involved.

In 2009, an estimated USD $530 million was ‘crowd-sourced’ globally. In 2013, this had increased to an estimated USD $5.1 billion, an increase of nearly 1000%. Unsurprisingly, given this staggering increase, the number of crowdfunding platforms has also expanded rapidly, from 283 in 2010, to 536 in 2012. During this time, crowdfunding has been somewhat of a grey area when it comes to regulation. Its modern ‘cyber-roots’ do not fit nicely into the holes drilled by comparatively antique FCA regulations. However, with such extensive growth it would be naïve to think this could continue, and sure enough, the FCA are imposing new rules, coming into force on 1st April 2014.

Before we get into the nitty-gritty of these regulations, I shall run through some of the basics of crowdfunding, as it is can take several distinct forms, which will have an impact on what regulations apply.

Donation based crowdfunding

This, you would rightfully say, is nothing new. Charity fundraising is essentially an early crowdfunding model. If 1,000,000 people each donate £5, the charity will have £5,000,000 to put to their cause. This is the cornerstone of crowdfunding – many individuals can invest small amounts, meaning small risks (in a commercial context), but with the same result for the entrepreneur.

Reward based crowdfunding

In exchange for your investment, the backer receives something of monetary value in return for their investment. This can take various forms. You may have come across ‘Tile’, a small Bluetooth tile that you attach to your keys, phone, or any other item which you frequently use, which can then be tracked with a phone app, and set to ring. Tile funded their first batch by taking pre-orders; while arguably not crowdfunding in the purest sense, it demonstrates the idea. Doing this, they were able to raise USD $2,681,297 from 49,586 backers.

Loan Based crowdfunding

Also known as credit based crowdfunding. This is where crowdfunding-proper begins, and is by far the most popular type of commercial crowdfunding within the UK, raising around £480 million in the UK alone last year. This is finance in its purest sense – the backer lends either a fixed amount or an amount they are happy with, and in return receive interest on their investment. Example platforms include Crowdfunder. Other variants, such as Funding Circles, have allowed backers to tender for the loan; each backer submits an amount they are willing to lend and at what interest rate and the fundraiser decides which to accept.

Equity based crowdfunding

In exchange for their backing, backers are given equity (shares) in the company. While this form of crowdfunding does not experience the same scale as loan based crowdfunding, it is a rapidly expanding model. In 2013 £28 million was crowdfunded this way within the UK, an increase of 618% compared to 2012 (loan based grew around 169% in the same period). BrewDog, a well-known boutique brewery have recently adopted this model, selling £4 million worth of shares on its website. You may ask, what are the advantages over an IPO (an initial public offering – floatation on a public market)? IPOs are time consuming, costly and often reserved for the biggest corporations (AIM has mitigated this to some extent), whereas crowdfunding cuts out the middleman, and allows fundraisers to go straight to the market, which in this day and age is online, and has the potential to go viral via social media.

The Case for Regulation

Whilst the first two forms of crowdsourcing mentioned above are innocent enough, the latter two forms seem somewhat suspect. Why should small lenders be able to escape regulation? There is potentially a case for greater regulation as they often have a lack of experience and financial knowledge. Therefore, the FCA changes focus on the second two categories.

Likewise, you may think the fourth, equity based, method, is just a way to get around the regulation and bureaucracy of public flotation in its true form, and you may be right. Why should this be allowed? Regulators surely believe this bureaucracy is in place for a reason, to protect investors and prevent macroeconomic financial instability.

The essential argument is, if you are taking part in the same activities, you should be playing by the same rules, and even more so when opening corporate finance up to ill-qualified people. Whilst this is great for boosting lending, especially in times where traditional borrowing is not so easy, and can provide benefits to all, it needs to be kept in check.

The Regulatory Changes

First, you must be aware of the starting point, which an excerpt from the FCA policy paper (PS14/4) nicely summarises:

Crowdfunding already falls within the scope of regulation by the FCA 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 in relation to securities. If a crowdfunding platform enables a business to raise money by arranging the sale of equity or debt securities, or units in an unregulated collective investment scheme, then this is investment-based crowdfunding. As such, it is regulated by the FCA and the firm operating the crowdfunding platform needs to be authorised, unless an exemption is available.

Loan Based Crowdfunding

As you can see from the above, current regulations affect mainly investment-based crowdfunding, and therefore, unsurprisingly, the bulk of the regulatory changes are focused on loan based methods. It was decided that generally, loan based crowdfunding platforms should abide by existing FCA rules, namely:

  • conduct of business rules (in particular, around disclosure and promotions)
  • minimum capital requirements
  • client money protection rules
  • dispute resolution rules and
  • a requirement for firms to take reasonable steps to ensure existing loans continue to be administered if the firm goes out of business.

The minimum capital requirements are however not identical to existing capital requirements. Loan based crowdfunding platforms must maintain:

The sum of:

  1. 0.2% of the first £50 million of total value of loaned funds outstanding;
  2. 0.15% of the next £200m of total value of loaned funds outstanding;
  3. 0.1% of the next £250m of total value of loaned funds outstanding; and
  4. 0.05% of any remaining balance of total value of loaned funds outstanding above £500m

Some concessions to the above have been made for a transition period, ending 31st March 2017.

What is clear from these rules is that they are in place to protect the consumer, which is both the lender and the borrower.

Investment Based Crowdfunding

The primary difficulty the FCA see with investment based crowdfunding, above and beyond existing rules which already apply, is that often crowdfunded investments are not liquid in the sense that there is no open marketplace for the shares. As with most private limited company shares, you will often have to solicit a buyer, or be solicited by a buyer. In other words, you could be stuck with shares you do not want, with no chance of releasing their cash value.

With that in mind, the FCA have chosen to restrict the type of investor that can be offered crowdfunding promotions, however these restrictions will only apply if the assets are not publically traded, or will not be in the near future. These closed groups are:

  • professional clients;
  • retail clients who confirm that, in relation to the investment promoted, they will receive regulated investment advice or investment management services from an authorised person; or
  • retail clients who are venture capital contacts or corporate finance contacts; or
  • retail clients who are certified or self-certify as sophisticated investors; or
  • retail clients who are certified as high net worth investors; or
  • retail clients who certify that they will not invest more than 10% of their net investible financial assets in unlisted equity and debt securities (i.e. they certify that they will only invest money that does not affect their primary residence, pensions and life cover).

Therefore, the layperson is restricted to investing no more than 10% of their net investible assets in these products, if doing so in response to a specific financial promotion.


Unsurprisingly, these new rules have not been welcomed with open arms by start-ups and other businesses that have so far relied on crowdfunding to finance their projects, who believe these rules will take the crowd out of crowdfunding, and dry up available finance. However, how much are these new rules likely to affect the borrower?

Loan Based Crowdfunding

The new regulations do not directly affect the consumer (neither the debtor, nor the debtee). The regulations apply to crowdfunding platforms, and are there to protect the consumer. In practice, this should ensure crowdfunding remains a feasible and safe option for entrepreneurs to raise finance for their ventures. This is no bad thing.

With proper regulation, trust can be maintained in the industry, and it will likely far surpass the financial crisis. Regulation has come about at the right time. The industry has just started booming, and is well and truly on its feet. These changes will ensure crowdfunding remains a viable option for entrepreneurs for the significant future, even when the banks start actively lending again, assuming they do.

If a crowdfunding platform is unable to satisfy the capital requirements, they are not safe to be operating, and consumers will be thankful these rules are in place if the platform was ever to go bust. Although consumers are not covered by the Financial Services Compensation Scheme (FSCS), they are protected in a number of other ways.

Clients that invest have at least some certainty over what would happen should the platform go bust after they have invested, whether their money has been forwarded to the borrower or not. This includes rules governing how client money will be redistributed, and although clients are unlikely to receive the full amount, they know it will be done fairly. Furthermore, the rules make it a requirement for platforms to make provisions for the management of loans after they go bust; meaning loans are not left in limbo, unrecoverable, or unobtainable.

There seems to be a deep-seated notion that crowdfunding is a safe way to lend, and a safe way to borrow, safer than untrustworthy banks. However, this neglects the fact that you are still dealing with a profit driven intermediary that will likely want to cut as many corners as possible in order to maximise profits. Whilst the lender may have the best intentions of helping out start-ups, you are not dealing with them directly.

These regulations are a good thing, and should not dry up available finance. If a crowdfunding platform disappears due to these regulations, you probably did not want to be using them anyway, so find another that is financially stable. Even crowdfunding platforms executives support the move, including the founder of Funding Circles.

Equity based crowdfunding

It is easy to glaze over a few important points here. These changes initially sound like they do indeed take the crowd out of crowdfunding, limiting the layperson to only 10% of their net investible assets. Wrong.

These rules apply to financial promotions. As the FCA policy paper explains:

To be a direct offer the promotion needs to contain an offer or invitation, and specify the manner of response or include a form by which a response may be made. So, if a promotion does not specify how to respond, then that promotion is not caught by the restriction. For example, if a communication simply gives marketing information about the firm operating the platform or information about who can be invited to invest, then the marketing restriction will not apply to it.

In reality, these changes may not make a huge difference to the finance available. Whilst a financial promotion can be via the medium of a website, it may be possible for crowdfunding platforms to frame any offer or information in such a way that they are not caught by these rules. This is yet to be seen. Regardless of this, since crowdfunding, in the vast majority of cases, is about pulling together many small contributions to create a large pot, how many investors are likely to be investing more than 10% of their net investible assets? [Paragraph edited 25/03/2014]

The FCA also make a big point about the rules only applying to non-liquid assets. However, I suspect in the vast majority of cases, crowdfunded projects are dealing with non-liquid assets. After all, one of the attractive features of crowdfunding is that you do not have to be listed on AIM to obtain the finance you need.


Final Remarks

Crowdfunding has proven to be a popular and easier way for small and medium businesses to raise finance, and proper regulation ensures this will continue to be the case. It is easy to associate regulation with doom and gloom, but in reality, this is a positive step for crowdfunding. It ensures its continuity, and it increases trust in the industry. I for one will be more receptive to crowdfunding knowing that it is a regulated industry, with the implication there are little to no cowboys operating.

Further Reading

FCA Policy Statement PS14/4, The FCA’s regulatory approach to crowdfunding over the internet, and the promotion of non-readily realisable securities by other media, 6th March 2014.

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Tagged: Banking & Finance, Commercial Law, Regulators

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