In the last few years, a new source of finance for start-ups, known as ‘crowdfunding’ (‘CF’), has become widely available. This involves raising capital from a large number of individuals, each of whom typically contributes a small sum. The internet has lowered the costs of raising funds in this way, by facilitating the dissemination of information about small projects. Use of CF has grown exponentially. Industry statistics estimate a total of $34 billion was raised worldwide using crowdfunding in 2015.
While the availability of CF is clearly good news for entrepreneurs, its merits for those providing the funding are less certain. Because funders typically invest only small sums in projects, CF may appeal to consumers, that is, unsophisticated individuals. However, consumers have limited capacity to assess the prospects of a business, and are prone to making investment decisions subject to biases and herd behaviour. In addition to losses to funders, this can cause finance to be misallocated to inferior business projects. These risks raise important questions for regulators.
In our article The Promise and Perils of Crowdfunding: Between Corporate Finance and Consumer Contracts, forthcoming in the Modern Law Review and available as an earlier pre-publication version here, we sketch out a normative roadmap for the regulation of CF in relation to business start-ups.
We begin by considering the use of CF and the characteristics of typical CF contracts. One type of CF contract—the ‘reward’ model, in which funders are rewarded with units of product—offers both firms and funders the promise of reducing uncertainty by generating new information about consumer demand. By using reward CF, founders capture synergies between their product and capital markets. Rather than raise capital and aggregate information about likely success as a by-product (through the price mechanism), they tap the product market, thus directly testing demand, and raise capital as a by-product.
In contrast, with ‘equity’ CF, where funders buy shares, their valuations are based on estimates of others’ future consumption of the product and the venture’s profitability, about which they have no special expertise. There is consequently a real peril that consumers (whom hereinafter we refer to as ‘retail investors’ when they invest in equity CF) will simply ‘herd’ into backing projects that early adopters have previously found attractive, which can lead to misallocation of capital.
We then review the regulation of CF in the UK (which largely reflects the implementation of EU law) and the US. Because CF is a novel practice, regulatory policy has tended, to some degree, to take the form of the application of existing frameworks designed with other contexts in mind. This has led to inconsistent, and in places misconceived, regulatory treatment.
Reward CF binds together a start-up firm’s financial and product markets. The involvement of the product market means that the practice appears to be subject, in the UK, to the regime established by EU consumer protection rules, mandating amongst other things that consumers have an option to cancel the transaction and reclaim their money. This, we argue, fails to take account of funders’ dual function as product consumers and financiers, in the latter aspect of which they bear risk associated with the product’s completion. In contrast, few mandatory terms are imposed on consumer contracts in the US. This gives parties greater freedom to design reward CF arrangements. While reward CF is virtually non-existent in the UK, it has flourished in the US.
Equity CF involves issuing securities to investors, and for that reason is formally within the domain of ‘securities law’. A central plank of securities law is mandatory disclosure, the compliance costs of which are often prohibitive for small firms. Despite the reduction of these costs in the US through a special regime for equity CF, with effect from May 2016, they still seem too high to foster the development of equity CF in that country. In contrast, equity CF has flourished in the UK, where there is an exemption from disclosure obligations under the Prospectus Directive for small offerings. In our analysis, the way equity CF markets operate is sufficiently different from traditional securities market contexts that the justifications for mandating disclosure in those other market contexts do not carry across.
The structure of the problems of CF are common to many consumer finance transactions. However, evidence-based regulatory solutions in consumer finance tend to be context-specific, and poorly-crafted intervention can easily make things worse rather than better. At this early stage of the market’s development, we consequently advocate a permissive regulatory regime. This allows the promise of reward CF to be fulfilled, and offers the opportunity for the development of market solutions in respect of equity CF. We review the range of market mechanisms that have been deployed in the UK and other jurisdictions to overcome the contracting problems inherent in equity CF. We suggest that these hold out promise, and that an initially permissive regulatory approach, open to learning from market developments yet with a credible threat of intervention should markets fail to protect funders, is justified. At the outset, it should be emphasised that as the CF industry is in its infancy, our analysis and conclusions must be regarded as preliminary.