The concept of crowdfunding has been making ripples in startup funding talks over the last few years, but as with any new phenomenon, it is interesting to consider whether this concept is as new as we think it is. If not, why did it not work before and what is different now? Before we start, for those of us who have been “trekking” in the Andes for the last ten years and don’t know what crowdfunding is, firstly: lucky you; and secondly: crowdfunding is when someone raises money for a project from a large number of people, promising something in return for the funding.
Contrary to word on the street, the concept of crowdfunding is not as new and shiny as we might think. In 1713, Alexander Pope decided to have Homer’s Iliad translated into English, which took translators more than five years and no doubt numerous sleepless nights. To fund all of this, Pope offered 750 people the opportunity to each pledge two gold guineas in return for a mention of the donation in an early edition of the translation. There are numerous other examples of crowdfunding over the last three centuries and the emergence of social media has brought with it endless possibilities when it comes to funding projects, businesses, adventures, charities, bravery or silliness – through crowdfunding.
One form of crowdfunding that has been in the limelight since it was first used by the U.S. based Grow VC Group in 2009, is equity crowdfunding. This is a form of investment crowdfunding (the other being debt crowdfunding), in terms of which an investor would fund a company or project in return for equity (i.e. shares) in the company that owns the project when it takes off. If you’re familiar with angel investment, this is a similar concept, but implemented on a bigger scale and with even less control by investors over investee companies.
This all sounds pretty exciting, especially if you’re good at creating new ideas and getting people excited about them. According to a report by Massolution, global Crowdfunding is expected to exceed venture capital as a funding mechanism for early stage companies in 2016. However, there are a few thorny issues around equity crowdfunding that might just spoil the party – none more so than the regulation of these transactions.
Since 2011, financial regulators in the UK, USA and elsewhere in the world have been trying to find ways to regulate equity crowdfunding without turning out the lights completely. Until recently, crowdfunding was allowed in these countries, as long as benefits other than equity are offered to the public. The essence of the conundrum for regulators when it comes to equity crowdfunding is that there needs to be a balance between the need to protect public investors and the need to promote capital raising activity that could stimulate the economy. This explains why all forms of crowdfunding are illegal in countries like Singapore. In 2013 the U.S. Securities and Exchange Commission (“SEC”) proposed a 500 page set of rules to regulate the offer and sale of securities through crowdfunded private offerings, which are now set forth in Title III of the “Jumpstart Our Business Startups (JOBS) Act”. As the rest of the world usually follows suit, we need to use this as an indication of what lies ahead from a South African perspective and very importantly, consider how these regulations were received worldwide.
The responses to the regulatory framework set in the USA and UK have been varied: some say the regulation is too strict; while others say that the regulation falls short of addressing the level of risk involved when offering equity to the public in this manner. One thing is certain, the regulation is likely to take the joy out of the process for managers of most equity crowdfunding platforms and it seems to have been designed this way. Michael Piwowar, the U.S. SEC Commissioner, told the Market Mogul that there are traps hidden in the new regulations which are expected to burden small investee businesses that don’t keep regulatory compliance as a top priority. However, considering the level of risk of financial fraud that investee companies and investors can be exposed to, extensive disclosure and financial reporting requirements are of paramount importance.
From a South African perspective, there are a few crowdfunding platforms that are starting to make suggestions that they intend to go the equity route. For the moment these initiatives will be clouded by the lack of certainty when it comes to the regulatory framework. What we do know, is that a South African equity crowdfunding platform will be deemed as an “offer of securities to be issued to any section of the public” in terms of section 95 of the South African Companies Act, 2008 (“the Act”). This means that unless the offering of securities falls within one of the exclusions listed in section 96 of the Act (such as “offers to persons whose ordinary business is to deal in securities”), the entity that owns the platform will be required to be a public company. The platform will therefore be regulated by all the disclosure, financial reporting, auditing and general governance requirements regulating public companies in terms of the Act and other financial legislation. Considering the extent of an equity crowdfunding platform’s public presence and risk involved for investors and investee companies alike, this level of regulation is inevitable. Cross-border equity crowdfunding activity will also need to comply with South African exchange control regulations, which may add another hurdle to those aiming to streamline the funding process.
The question is whether the regulation of equity crowdfunding will kill the initiative in its tracks. There is definitely a place for capital raising in this manner in the South African market, but creating a cost-effective platform that addresses the risks involved while still providing a streamlined alternative for capital raising will prove to be no small task.
