Article:

Equity Crowd Funding

03 November 2014

Start-ups and small to medium businesses globally are increasingly looking at ‘crowdfunding’ as a way of raising finance quickly without having to deal with the often prohibitive rigours of traditional financing.

In its simplest form, crowdfunding uses the internet and social media networks to connect those seeking financial backing with those that can provide funds. From a commercial perspective it involves businesses signing up to a crowdfunding platform and raising finance by taking small investments, loans or donations from a large number of people.

Globally, this new ‘alternative finance’ market is causing a shift in start- up financing offering a much more public approach to supporting the entrepreneurial ecosystem than the traditional channels such as banks, underwriters or venture capitalists.

Industry pioneers have continued to work with regulators to find a balance between protecting investors and overregulating those companies seeking equity. The United Kingdom has been one of the first countries to make crowdfunding legal – initially with a patchy regulatory framework – but as of April this year, a more formalised approach has been taken with equity and debt based models.

One of the first – and most impressive – beneficiaries of this form of funding has been Scottish brewery Brewdog which rocketed to success on the back of three rounds of equity crowdfunding starting in 2008, with the most recent round pulling in £1M in just 24 hours. Brewdog now has 12 pubs, soaring beer sales and thousands of passionate shareholders/ brand advocates, who for a small sum receive rewards ranging from vouchers to lifetime discounts.

In New Zealand, small Blenheim firm Renaissance Brewery has been the first company to benefit from the new equity crowdfunding regime, raising a remarkable $700,000 in just one week from a crowd of 287 ‘brand advocate’ shareholders.

Regulated by the Financial Markets Authority (“FMA”), equity crowdfunding comes under the Financial Markets Conduct Act (“FMCA”) which came into effect on 1 April 2014. The Act enables companies to raise a maximum of $2 million in a 12 month period by offering equity through an FMA licenced equity crowdfunding platform. The Act also supports debt-based crowdfunding or peer-to-peer lending, where companies can borrow up to $2 million in any 12 month period via a licensed provider – again with simpler compliance obligations than a standard issue of debt securities.

The FMA has so far licensed two equity crowdfunding providers in New Zealand, PledgeMe and Snowball Effect, and has advised two more are in the throes of being licensed and several more are lined up to apply.

For the FMA, the licensing regime supports its brief to bolster capital markets and ensuring investors are informed and protected.

Equity crowdfunding certainly carries risks for investors due to the reduced compliance obligations that come with small capital-raisings. Other risks include illiquidity meaning it can be difficult to convert it back into cash , though companies can facilitate trading of shares between shareholders. Also both PledgeMe and Snowball Effect have suggested that online open market trading facilities will be authorised in the future.

But, for crowdfunding investors, it’s a case of caveat emptor. The FMA is very clear that people need to understand this is a higher-risk investment and they need to do their homework before investing their money. As such, there are three pieces of information a licensed crowdfunding service provider must give investors:

▶ The warning statement about the risks of crowd funding. As Snowball’s site states “you should only invest what you can afford to lose”, and PledgeMe “You may lose your entire investment, and must

be in a position to bear this risk without undue hardship,”

▶ The disclosure statement including how the service works, fees and the checks the service has and hasn’t done on the company,

▶ The client agreement.

Other than that, it is up to investors to carry out further investigations which can be facilitated by using the online chat facilities offered by the licensed platform providers. Not only is this a much easier and more congenial way to communicate with shareholders than providing a detailed prospectus that very few are inspired to read, but, it can also serve other purposes such as passing resolutions online.

There has also been little evidence of any fraud on current standards- based crowdfunding platforms globally. This is a risk that is mitigated by requiring all fundraising to take place on licensed platforms and ensuring background checks are done by issuers.

Crowdfunding in the mix of start-up financing options

Equity crowdfunding is an exciting new option in the mix of ways start- ups and small businesses can raise capital, ranging from selling assets, shoulder-tapping networks and applying for grants to going to angel investors, venture capital firms or banks.

They all have their advantages and disadvantages depending on the needs and preference of the business seeking funds. Certainly where privacy is required, crowdfunding would not be advisable.

Another option enabled under the FMCA is the “small offer” (or 20/2/12) where up to $2 million can be raised from up to 20 investors in a 12 month period, without the need for a prospectus or investment statement. It can be used in conjunction with other ‘non-public’ offers such as crowdfunding, subject to the $2 million cap not being breached for the 12 month period.

Why choose equity crowdfunding?

As a springboard for start-ups, early stage or growth companies, equity crowdfunding has multiple attractions, not the least of which is building a wide shareholder base from which to facilitate a potential future stock exchange listing.

As well as being a quick and relatively cheap and easy process that circumvents hefty compliance obligations, crowdfunding has the significant advantage of amassing an army of avid brand advocates who are keen for the company they have invested in to succeed. It also tends to generate positive media exposure.

Early-stage companies can also use crowdfunding to explore the viability of a product, not only attracting early adopters at lower costs and with low barriers to entry but also receive feedback. Furthermore, the online chat facility commonly becomes a forum for sharing of ideas and knowledge between the company and their investor crowd - many of whom may have a wealth of expertise and experience to support the company’s success.

What companies need to know

The secret to successful equity crowdfunding lies in knowing how to pull the crowd, developing a clever campaign around the products/services that will tap into advocates early on in the venture and keep them engaged throughout.

This starts with working with professional advisers to ensure company information is up to scratch, developing a clear business plan, financial statements and forecasts and, importantly, getting a realistic valuation.

With the marketing component of the campaign, while the crowdfunding platforms will provide support and advice in this area, it is up to the company to develop their own collateral such as online videos and to understand how to build and maintain a community of supporters before, during, and after the business/venture launches.

From a tax perspective, with crowdfunding very much in its infancy in New Zealand there are currently no specific tax implications for issuers or investors. However, in the UK investors can benefit from tax relief, which is dependent on the company being registered for the Enterprise Investment Scheme where tax relief is 30% or the Seed Enterprise Investment Scheme where it is 50%.

Finally, companies that build a shareholder base of over 50 also need to be aware that they may become subject to the Takeovers Code and the obligations of Code companies under the Financial Reporting Act.  So, it’s important to seek professional advice on how best to structure the company and the offer so they do not fall under the definition of a Code company.

What’s next?

As with any emerging industry, there is a rapid growth phase, with a rush of new entrants, followed by a consolidation phase. We are now starting to see this overseas with the evolution of regulations and the attrition of platform providers with the success rates of companies heavily linked to the performance of these platforms.

In New Zealand, we’ve just started and are yet to see how this exciting new ‘alternative financing’ market affects our strongly entrepreneurial economic environment.

In the meantime, any company considering a crowdfunding campaign should do so based on strong advice and a clear understanding of the implications.