Feature: Attracting a crowd

Crowdfunding has been helping good causes and entrepreneurs raise much needed cash. Tony Featherstone outlines issues that boards should be aware of as it is increasingly embraced in Australia.

There has been much debate about the potential of crowd-sourced equity funding to transform capital raising for start-up ventures and create a more vibrant entrepreneurship ecosystem in Australia. Less considered is crowdfunding’s opportunities and threats for boards.

Crowdfunding typically involves funding a project by raising small amounts of money from a large group of people, via the internet. The best-known global proponent, Kickstarter, last year raised US$480 million from three million people worldwide for almost 20,000 projects.

Entrepreneurs believe crowdfunding principles could be used to raise equity capital from small investors. Governments worldwide are racing to develop models to allow crowd-sourced equity funding and regulate a complex, fast-moving area.

Any regulatory change could be far-reaching. “This form of capital raising has a unique set of features that Australia has not had to deal with before,” says John Kluver, executive director of the Corporations and Markets Advisory Committee (CAMAC). “It will require a new regulatory regime to provide an appropriate corporate structure to support crowd-sourced equity funding.”

Crowdfunding has mostly involved artists raising funds for creative projects, social ventures raising funds for projects, or fledgling businesses attracting contributions to develop new products. Rewards, donations and pre-payment funding is a far cry from crowdfunding equity issuance, which would promote offers to the general public rather than sophisticated investors and possibly benefit from exemptions around disclosure and financial reporting.

By formalising and extending the “friends, family and fans” investor base, crowd-sourced equity funding could allow budding entrepreneurs to raise funds from investors worldwide, and get ventures off the ground. A start-up entrepreneur, for example, might seek $30,000 to develop a new smartphone application, and receive an average $30 from 1000 investors. Also, the entrepreneur could use crowd-sourced equity funding to develop a deeper relationship with investors, who comment on the application’s development, champion the idea to their peers via social media, and provide proof there is a market for the concept.

With real-time validation from crowdfunding, start-ups would have a stronger base to approach “angel” investors or venture capitalists in subsequent funding rounds. Alternatively, a start-up entrepreneur could attract well-known investors to seed their idea before taking it to the public through crowdfunding. In time, established private businesses might use crowdfunding as a capital-raising mechanism to top up other funding sources, meaning it could be on the radar of some boards.

Dr Terry Cutler, the principal of consulting firm Cutler & Company and president of CSIRO Chile, says equity crowdfunding is an exciting development for Australia. “It goes to the core of the perennial problem facing start-up entrepreneurs: lack of capital. I just hope the government does not regulate crowdfunding to death before it gets going.”

Nobody doubts equity crowdfunding’s long-term potential if the federal government develops the right regulatory settings that balance investor protection with the capital raising needs of start-ups, and the internet’s unique characteristics. But the CAMAC September 2013 review of the regulatory implications of crowd-sourced equity funding was criticised in some quarters as heavy-handed. Commissioned by the former Labor government, the CAMAC review attracted more than 40 submissions.

As Company Director went to press, it was unclear when or how the federal government would respond to a review that potentially has significant implications for company directors.

CAMAC is being closed as part of the government’s cost-cutting measures. It has not received feedback on its report from the government. The report is being watched closely by countries, such as Canada, which is expected to launch its own proposals in 2015. Genuine equity crowdfunding has not yet started in North America, has been confined to limited categories of investors in the UK and has being going for only a few months in New Zealand.

“The CAMAC review was so out of touch with the real-world of entrepreneurship that it is not funny,” says Cutler. “Any regulation of equity crowdfunding should be incredibly light-touched. The danger is that the government might take regulatory principles from other capital markets, rather than taking time to understand what it is that needs to be regulated.”

Cutler likens crowd-sourced equity funding to other peer-to-peer internet platforms, such as the accommodation-matching service, AirBnB, or the car-ride-sharing service, Uber. Here, the platform’s reputation effectively self-regulates the market and keeps both sides of the transaction honest through rating services.

“From the mid-1990s on, governments have been cautious about over-regulating emerging activity on the internet – an approach that has paid off,” says Cutler. “They recognised these markets must be allowed to develop and that you cannot take regulatory principles from offline markets and apply them to the internet. Unfortunately, that seems to be happening with Australia’s approach to equity crowdfunding regulation.”

Cutler prefers New Zealand’s regulatory model for crowd-sourced equity funding, which is perceived as having a lighter touch compared to CAMAC’s proposal. It started in April and the first intermediaries for crowd-source equity funding, PledgeMe and Snowball Effect, were licensed in late July. These platforms connect small companies seeking equity capital and small investors who want to buy their shares.

Andrew Macpherson, of law firm Macpherson Greenleaf, said in a recent presentation to the Commercial Law Association of Australia: “The CAMAC report is a helpful consideration of the issues, but proposes a too-restrictive regime for equity crowd funding.”

The New Zealand approach places a greater onus on the licensed intermediary, in conjunction with the issuer, to determine the level of disclosure required by companies raising funds through equity crowdfunding. Moreover, the intermediary can have a financial interest in companies it promotes. New Zealand companies are limited to raising no more than $2 million from the public in any 12-month period.

Although CAMAC proposes a similar $2 million issuer cap, it puts more onus on the company, and by default its board, to disclose information to investors.
Kluver says: “It is important that companies and their boards have a clear and precise idea of what must be disclosed in the capital raising offer for equity crowdfunding. A standard disclosure template would assist directors in this regard, while also providing more disclosure protection for investors and helping them to compare offers”

Kluver believes intermediaries must be more than merely a matching service. “Similar to the New Zealand approach, we believe the intermediary must be licensed, to ensure that they have the skills and accountability to carry out their tasks.” he says. “It is important that intermediaries undertake some due diligence vetting of issuers that they will host on their websites, given that retail crowd investors have no real capacity to do so. You can’t rely only on the internet to assess issuers because in most cases there will be no ratings for the companies.”

Kluver adds: “You are asking small investors to invest their money in typically unproven start-up companies that may have no market record, may not have experienced management, and where there is no independent assessment of its prospects.”

CAMAC believes that, unlike the New Zealand approach, permitting intermediaries to have a financial interest in companies promoting their platforms could send the wrong message to investors: that an issuer is worthwhile simply because the intermediary has invested in it. “There are very significant consumer protection issues to deal with. If there are no due diligence and other controls, fraud or misleading conduct of various types could emerge,” says Kluver.

Unlike New Zealand, which has no investor limits, CAMAC suggests caps on how much retail investors could invest through equity crowdfunding: $2,500 per company per year, and no more than $10,000 a year. While CAMAC does not propose any sanction on an investor who breaches the caps, these investment limits constitute a formal recognition of the financial risks for investors that are inherent in this form of capital raising.

Understanding the New Zealand approach is critical. It has been among the first countries out of the blocks on crowd-sourced equity funding and has taken a more aggressive approach compared to the UK and US. There is a push for Australia to follow New Zealand’s lead, given its recent success in fostering innovative start-up companies. The Australian government has little time to waste in creating a regulatory framework for equity crowdfunding. There is a risk that some promising Australian start-up ventures could incorporate in New Zealand to access a more favourable regulatory regime. There could also be a regulatory rush to the bottom, if other countries introduce lax rules to attract equity crowfunding and start-up ventures seeking it.

Amid this debate, directors might think crowd-sourced equity funding is mostly an issue for start-ups that typically have no board. That it true, to a point. A 20-something entrepreneur seeking $30,000 to develop a venture, for example, is a world away from boards.

At this stage, donation-based crowdfunding may be more relevant to directors of not-for-profit enterprises that are increasingly expected to incorporate social crowdfunding techniques into fundraising strategies. Private companies or community groups that have a strong social purposes could also use equity-based crowdfunding to deliver projects. CAMAC has indicated that there is scope to loosen its recommendations for social ventures, in time.

Moreover, there is no evidence that the Australian public is eager to invest in unknown start-up ventures, via equity crowdfunding. Contributing a small amount to help a struggling musician record his or her next album and receiving an advance copy, is completely different to buying shares in a speculative start-up venture that may not even have a product on the market.

Paul Niederer, CEO of the Australian Small Scale Offerings Board (ASSOB), says equity-based crowdfunding will only replicate a fraction of the success of rewards-based crowdfunding. “There is no evidence of extreme momentum in equity-based crowdfunding anywhere in the world. You cannot extrapolate the success of rewards-based crowdfunding to equity crowdfunding.”

Niederer says: “The idea of thousands of investors worldwide backing an unknown start-up is appealing, but it will not happen for the vast majority of companies. Every now and then, a company will come along that captures the imagination and attracts a large number of ‘fans’ as investors. They will be the minority.”

Niederer cites the experience of UK investment crowdfunding site, CrowdCube, launched in 2011. It has raised £34.5 million for 139 businesses and its investment platform showed 35 investable opportunities in early August – a small amount in the scheme of things.

The ASSOB platform, which matches start-up and early-stage companies with investors, has raised $140 million for around 300 companies in Australia in the past eight years. Niederer believes the federal government should extend exemptions in the well-established small scale offerings area, allowing companies to raise funds from 100 sophisticated investors in 12 months, rather than the current 20.

“This is a simple change to make,” says Niederer. “It recognises that most of the equity capital for a start-up venture comes from people known to the founders or the firm’s employees. The ‘crowd’ can be used to top up funds, but regulators should be making it easier for companies to attract a larger base of retail investors known to the entity and those supporting them. We need a 100/12 rule, not the 20/12 rule.”

ASSOB’s research shows an average 667 people “visited” each capital raising offer on its platform. Of that, 202 people downloaded the offer and became “followers” and 16 of that group invested. About half of them were retail or unaccredited investors and their average investment was $30,000.

“We are talking very small numbers of retail investors in capital raisings for small companies,” says Niederer. “Rather than thinking about it from the investor’s view, regulators should ask: what can we do to help empower small companies to raise capital. They should extend what we already have – a small scale offerings market that is currently the world’s largest equity crowd-based platform – rather than create a new regulatory system.”

Steve Johns, a partner at law firm Norton Rose Fulbright, says crowd-sourced equity funding is unlikely to form a big part of the Australian economy. “My view is it will help fill a niche for capital-seeking start-ups. I’m optimistic on crowdfunding’s long-term potential, but do not see it becoming a mainstream capital-raising technique for companies.”

On balance, the evidence points to slow take-up for equity crowdfunding in Australia, assuming new regulations are passed. Interest could initially spike as hundreds of exciting Australian start-ups clamour for funds and retail investors find they can quickly and easily contribute small amounts to a venture that could be the next Facebook or Twitter. And quickly wane if the first generation of crowdfunded start-ups disappoints investors with returns, if unsophisticated investors become disgruntled by quick capital losses or if fraud emerges.

But nobody knows for sure how crowd-sourced equity funding will play out in the next few years. The internet is the perfect vehicle to match small start-up companies with small investors, and give them a level of emotional, behavioural and rational connection in a business that can never be replicated by hard-copy prospectuses or PowerPoint presentations.

Boards should watch regulatory developments in crowdfunding for several reasons. Chief among them is equity crowdfunding’s potential to boost the number of promising start-ups that can be acquired by larger companies. Cutler says: “More and more large companies are sourcing their innovations through the acquisition of start-ups and other early-stage companies. They need to watch this space closely.”

Moreover, CAMAC’s review, if embraced by government, could create issues for boards that have so far had little consideration. In fairness, CAMAC’s brief was to consider regulatory models for crowd-sourced equity funding, not how any changes would affect boards. But directors would be affected by any moves to change the rules on raising capital. Central to CAMAC’s recommendation is the concept of a specially created exempt public company status for ventures that use crowd-sourced equity funding. CAMAC realised that the law, as it stands, would not balance the need of issuers, intermediaries and investors in this market.

Section 708 of the Corporations Act 2001 has an exception for small-scale offerings (the 20/12 rule) that says a disclosure document is not required if more than $2 million is raised in any 12-month period from no more than 20 investors. And the proprietary company structure, which requires a lower level of financial reporting and disclosure compared to public companies, has a ceiling of 50 non-employee shareholders.

A venture that successfully uses crowd-sourced equity funding could have hundreds, possibly thousands, of small shareholders. If the proprietary company 50 shareholder ceiling was lifted to accommodate this increased number of shareholders, private companies could have a much larger public shareholder base, without the disclosure, governance and reporting requirements of a public company.

Kluver says: “CAMAC believed that supersizing the proprietary company structure to allow for sharply higher shareholder numbers would be detrimental to the interests of the investing public. Equally, to force start-up companies with a larger shareholder base to have the full range of public company reporting obligations could be too onerous in the early stages of their development.”

He adds: “The exempt public company structure proposed by CAMAC would effectively relieve corporate controllers from a considerable burden of public company reporting requirements, for a limited period. After a maximum of five years, the exempt public company would revert to a full public company and the organisation would have to prepare audited accounts for the earlier period, thereby ensuring full financial accountability.”

Under CAMAC’s proposal, there could be different classes of shares for the venture’s founders, investors sourced through crowdfunding, and other investors. For instance, crowd investors could be offered non-voting or limited voting shares, allowing founders to retain control of their venture. “However, the venture would have to make it clear to crowd investors whether or not the shares on offer to them have any voting rights to decide the board composition, dividend policy or other fundamental issues,” says Kluver. “Crowd investors should not be misled as to the rights, or lack of rights, attached to their shares.”

Kluver believes that unduly light regulation could undermine equity crowdfunding in the long run to the detriment of worthwhile issuers. “If there is significant fraud or people lose their money due to poorly communicated offers, investors could become very disillusioned and spread their negative reaction quickly via social media. The key is to develop a regulatory framework that protects investors, helps worthwhile companies raise capital and does not create unintended consequences in other parts of the regulatory framework.”

“Directors should be glad CAMAC delivered such a thoughtful, balanced proposal. Entrepreneurs and innovators who say CAMAC’s approach is too restrictive, or that investors should rely on the online market to self-regulate, may not have considered the issue from the perspective of company directors and their legal requirements.”

Johns says it is not clear what level of disclosure will be required with crowd-sourced equity funding or what protection will be afforded to directors in capital-raising offers. “At a macro level, CAMAC’s proposals make plenty of sense,” he says. “But it’s not until you get into the detail that you realise there could be very significant implications for directors of organisations that raise equity through crowdfunding.”

Crowdfunding for not-for-profits
Directors who want to understand the power of crowdfunding should look to the not-for profit (NFP) sector. Some social ventures are starting to raise significant funds for projects and social crowdfunding sites, such as Chuffed.org, are doubling in size every three months.

This year Chuffed helped Edgar’s Mission, a Victorian sanctuary for rescued farm animals, raise $162,400 from almost 1800 people in 14 countries. Edgar’s target of raising $50,000 in 60 days was smashed within three days, a new Australian record for NFP crowdfunding.

Chuffed expects to raise $1 million for social ventures within its first year of operation, for about 200 projects. It is receiving a dozen or more approaches from NFPs each week to run campaigns and expects to be self-funding within 12 to 18 months, given its rapid growth.

“I would guess that fewer than 1,000 of the 600,000 or so NFPs in Australia have tried social crowdfunding,” says Chuffed founder Prashan Paramanathan (Twitter @pparaman).

“Smaller NFPs have been using crowdfunding over the past couple of years to raise donations and I would expect larger NFPs to use it before long. Crowdfunding is just such a powerful way for NFPs to raise funds from people who support the cause.”

Chuffed, itself an NFP, plans to expand in Asia and believes social crowdfunding could be used by for-profit enterprises with a social purpose. “We think there is a lot of potential for organisations to use social crowdfunding platforms to help their community,” says Paramanathan.

“For example, a co-operative or mutual organisation could use crowdfunding to raise funds from the community to buy a particular community asset that’s closing, and keep it in local hands.”

Schools can also use social crowdfunding platforms to raise funds for projects from their community of parents and other stakeholders, Paramanathan says. The Queensland government in August backed down on its initial objection to a school using third-party crowdfunding platforms to raise funds, in what could pave the way for more schools to use crowdfunding.

Paramanathan says there is no greater risk of fundraising fraud from crowdfunding compared to traditional approaches. “We vet campaigns that use our platform, and those that are unlikely to meet our criteria self-regulate and don’t actually start. The higher transparency of the internet tends to be the best form of regulation.”

He says the federal government needs to harmonise state-based fundraising rules because social crowdfunding quickly crosses state and even international borders. “Some of our campaigns have raised funds from people all around Australia and overseas. State-based fundraising rules in an online world are completely outdated.”

Cutler & Company principal Dr Terry Cutler says crowdfunding is tailor-made for the NFP sector. “If I was on a NFP board, I would watch this space very closely and ask if the organisation is taking advantage of crowdfunding to supplement other fundraising activities. Crowdfunding has been very successful in the arts because people who feel a strong emotional connection to a project are more committed to make donations.”

Cutler adds: “There is a great link between social crowdfunding, social networking and building a community of engagement around the NFP’s objectives. In time, it will change how NFPs think about fundraising and how individuals think about giving and getting involved.”