I first became interested in crowdfunding when I wrote my University dissertation on the legislative framework in the UK and US at that time. Broadly speaking I was attempting to give a view on whether the legislation was fit for purpose (to surmise, it wasn’t) and could accommodate the growth in demand for crowdfunding. I have followed the growth of Crowdfunding since then, which in 2017 had grown to an estimated £6.2bn in the UK, according to the Cambridge Centre for Alternative Finance.
I have been most pleased by the growth of its use by Small and Medium Sized Enterprises (SMEs) and start-ups seeking external investment. The UK is heavily reliant on SMEs, who made up 52% of all private sector turnover in 2018 and 60% of all private sector employment. The number of start-up businesses in the North East (where I and many of my WBD colleagues are based) is growing at one of the fastest rates in the country – there were 45,498 start-up businesses in the North East at the end of the 2017/18 financial year, an increase of 20.8% compared to the previous year.
These companies are more and more often looking at Crowdfunding as a method of solving a perceived lack of external financing (known as the ‘funding gap’) available for such companies. Whilst the factual evidence surrounding the existence of the ‘funding gap’ is not conclusive, the rules on alternative external funding can be hugely important to such businesses, potentially unlocking the investment to get them through those “touch and go” initial years.
In the UK the Financial Conduct Authority (FCA), regulates two forms of crowdfunding:
- Loan-based crowdfunding – usually called peer-to-peer (P2P), where investors use lending platforms to lend money directly to consumers or businesses; and
- Investment-based crowdfunding, where investors can invest directly in businesses by buying investments such as shares or debentures.
The FCA has recently launched various consultations on changes to the FCA Handbook to reflect the developments in the crowdfunding sector. The Treasury and BEIS have also focused their attention on the sector, undertaking an inquiry in 2018 on the state of SME finance, with particular consideration of crowdfunding. These enquiries have often focused on similar themes, such as:
- whether there should be more explicit rules around governance arrangements, particularly on areas such as credit risk assessment and risk management;
- what happens if a crowdfunding or P2P platform fails;
- whether such platforms should evaluate investors’ knowledge and experience before permitting investments; and
- evaluating the mandatory information that platforms need to provide to investors.
Importantly, the FCA has, following these various reviews, confirmed its proposals for new rules and guidance coming into force on 9 December 2019. They are introducing a package of rules and guidance to improve standards, seeking to find an “appropriate balance between advancing policy objectives and enabling future innovation in products and services”. These rules, whilst targeted at the P2P and Crowdfunding platforms themselves, could have an impact on the extent to which SMEs rely on some form of crowdfunding to raise money, and such companies should be taking notice.
What is changing?
The changes introduced by the new rules extend the application of the marketing restrictions that currently apply to investment-based crowdfunding platforms to loan based crowdfunding. In particular the FCA is to tighten the nature and extent of the due diligence each platform undertakes in respect of prospective borrowers, in order to better assess their credit risk. The platforms will need to provide more information to investors of how the loan risk is assessed and to assist them in determining whether they able to properly make such investments.
Further to this, P2P platforms that communicate financial promotions directly to consumers will, from 9 December, only be permitted to direct such promotions to prospective investors that:
- are certified or self-certified as ‘sophisticated investors’ or are certified as ‘high net worth investors’;
- confirm before a promotion is made that they will receive regulated investment advice or investment management services from an authorised person, or
- are certified as ‘restricted investors’, i.e. they will not invest more than 10% of their net investible assets in P2P loans in the 12 months following certification.
What is the potential impact on SMEs?
These changes are clearly targeted at protecting potential investors and this is important if the crowdfunding market is to remain a reputable source of raising finance. Crowdfunding has understandably come under greater scrutiny since the FCA forced P2P investor Lendy into administration, and lessons should of course be learnt from this. Critics of the new rules have however raised the view that these regulations may put off investors who would otherwise have provided a source of financing to those companies that need it most, and restrict crowdfunding to institutional investors such as mutual funds, pension funds, banks and asset managers.
My view is that the additional hurdle of certification outlined above is not necessarily a significant barrier to prospective investors. The inclusion of the “restricted investor” criteria is an important one, without which the pool of prospective investors would become much smaller and crowdfunding would become far less accessible to new investors – certified high-net-worth investors and sophisticated investors are concepts generally seen as restrictive and it can often be difficult to find persons who are willing to certify as such. On the other hand a “restricted investor” simply needs to confirm that they will not invest more than 10% of their assets. The FCA has also stated in its policy statement on the new rules that investors can re-classify as sophisticated investors (thereby removing the 10% investment limit) when they have made two or more P2P/Crowdfunding investments over two years.
What is more difficult to assess is whether the due diligence each platform undertakes in practice in respect of prospective borrowers, in order to ensure compliance with the new regulations, will result in an increased burden upon prospective borrowers. A borrower will likely be required to work more closely with the platforms in the run up to their crowdfunding project and this could make crowdfunding less attractive to start-ups and SMEs, if it requires a greater allocation of their (already limited) resources