The future position of Equity Crowdfunding in the European Capital Market Union

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1 The future position of Equity Crowdfunding in the European Capital Market Union Ondřej Dusílek Czech Republic October 2015 Abstract: The main goal of this paper is to analyze equity crowdfunding as a new possibility of SMEs financing. The first part of the research describes the current development of equity crowdfunding and compares it with other alternative finance channels. The article further analyzes business models of crowdfunding platforms, and motivations for investors and start-ups to invest or raise finance through these platforms. Different regulation of equity crowdfunding in European countries is a crucial obstacle for the cross-border development within the EU, and therefore, the research also drafts the main points of common future European regulation regarding equity crowdfunding. The report is concluded with a proposal of the complex market infrastructure in the European Capital Market Union, including a platform for equity crowdfunding. Key words: alternative finance, equity crowdfunding, peer-to-peer lending, capital market union. I. Introduction In recent years, there has been huge development of a new business sector called financial technology, also known as FinTech, based on using software to provide financial services. This development also launched alternative finance markets such as crowdfunding and peer-to-peer lending. Whilst donation- and rewards-based crowdfunding has continued to grow steadily in recent years, the equity and loans-based sectors should continue exponential growth as they have exhibited in the past few years. From a risk and regulatory point of view, one of the most interesting forms of investment distribution is equity crowdfunding. Moreover, the evolution of crowdfunding platforms has created an important economic and regulatory issue which should be solved in the future Capital Market Union. As a participant of the City of London Corporation Fellowship Programme, the author of this paper decided to focus mainly on the UK s alternative finance market and especially

2 on the equity crowdfunding market, which is the most developed in the world. The aim of this paper is to compare alternative finance markets within the EU, discuss the impacts of regulatory changes on an EU level and finally incorporate equity crowdfunding into the capital market infrastructure. The author would like to thank the City of London Corporation for support, and all interviewees for excellent cooperation and helpful remarks, especially to: Jason Pope and Richard Taylor (Financial Conduct Authority), Alysia Wanczyk (Seedrs), Gonçalo de Vasconcelos (Syndicate Room), Michael Wong (Crowd Financial), Richard Williamson (CrowdBnk) and Hannes Takacs (European Bank for Reconstruction and Development). II. Alternative finance diversity Over the last few years we have seen the growth and development of new alternative finance instruments mainly in US and Europe. The simplest to distinguish of these alterative finance channels, according to future obligation, is peer-to-peer lending and crowdfunding. These two main streams can be compared with the difference of investments to bonds and shares. On the other hand, from regulatory point of view, it is more important if there is a potential future financial reward (as in the case of peer-topeer lending or equity crowdfunding), or if there is not any financial reward (for example a reward or donation crowdfunding). The special case of alternative financing is peer-topeer factoring (trading with invoices). The most important forms of alternative financing are descried in the table below. Figure 1. Main models of alternative financing Peer-to-Peer Consumer Lending Reward-based Crowdfunding Peer-to-Peer Business Lending Equity-based Crowdfunding Community Shares/ Microfinance Donation-based Crowdfunding Debt based transactions between individuals; most are unsecured personal loans. Backers have an expectation that recipients will provide a tangible (but non financial) reward or product in exchange for their contribution. Debt based transactions between individual/institutional investors and existing businesses who are mostly SMEs. Sale of registered security by mostly early stage firms to investors. Microfinance refers to the lending of small sums to entrepreneurs who are often economically disadvantaged and financially marginalised. No legally binding financial obligation incurred by recipient to donor; no financial or material returns are expected by the donor.

3 Invoice Trading Firms sell their invoices or receivables to a pool of individual or institutional investors. Debt-based Securities Lenders receive a non collateralised debt obligation, typically paid back over an extended period of time. Similar in structure to purchasing a bond, but with different rights and obligations. Certainly, if we compare the value of the alternative finance market with the standard financial market based on the banking sector and capital market, the difference is really enormous. This disproportion can raise a question of whether or not it makes sense to analyze or regulate such an insignificant business sector, but what is more important than total value is the annual growth and development. The value of an alternative market in Europe has more than doubled every year and this trend should at least continue for the next several years. For instance, according to estimations of the UK Crowdfunding Association, the UK alternative finance market is expected to be worth around 4.4 bn by the end of the year 2015 if current growth continues. This signals that the alternative finance market will be an important part of the whole financial system and should not be ignored by analysts, regulators and politicians, and fortunately is not according to the Green Paper of the European Commission regarding the plan to create the Capital Market Union. Figure 2. Value of alternative finance market in the UK and Europe (mil EUR) UK The rest of Europe In terms of total alternative finance market volume by individual European countries in 2014, according to the research of University of Cambridge and EY, the UK is an undisputed leader with a sizeable 2,337m. France has the second-largest online alternative finance industry with 154m, which is only 6% of the UK s share. Then is 1 Robert Wardrop, Bryan Zhang, Raghavendra Rau and Mia Gray. University of Cambridge and EY. Moving Mainstream - The European Alternative Finance Benchmarking Report (February 2015).

4 Germany 140m, followed by Sweden ( 107m), the Netherlands ( 78m) and Spain ( 62m). However, if ranked on total volume per capita, Estonia takes second place in Europe after the UK ( 36 per capita), with 22m in total and 16 per capita. From the perspective of instruments, peer-to-peer lending and factoring has the largest share followed by equity crowdfunding. Other forms of alternative finance are from a volume and also regulatory point of view, almost negligible. The UK is a dominant player for all forms of alternative finance, except reward and donation crowdfunding, but these types of crowdfunding are not significant. Figure 3. Comparison of alternative finance in 2014 (mil EUR) 2 mil EUR 2014 UK France Germany the rest of Europe Peer-to-Peer Business Lending Peer-to-Peer Consumer Lending Invoice Trading Equity-based Crowdfunding Community Shares/ Microfinance Reward-based Crowdfunding Debt-based Securities Donation-based Crowdfunding The superiority of the UK s market is also confirmed by the number of alternative finance platforms. There are over 60 platforms in the UK and over 30 in Germany, France, Spain and the Netherlands. On the other hand, it is necessary to mention that many of these platforms are established only for reward and donation crowdfunding. Despite this fact, there are over 30 equity and debt crowdfunding platforms in the UK, 2 Robert Wardrop, Bryan Zhang, Raghavendra Rau and Mia Gray. University of Cambridge and EY. Moving Mainstream - The European Alternative Finance Benchmarking Report (February 2015).

5 and there exists a question of whether or not this current quantity is still useful, or if this status creates pressure on consolidation. Figure 4. Distribution of alternative finance platforms in Europe 3 In the case of volume purely invested through equity crowdfunding platforms, over 90 % of fund raising is done in three countries of the EU (the UK, France and Germany), and almost 60 % of investments were made through the UK s platforms. According to statistics of the UK Crowdfunding Association, London alone sees an average of 12 projects going live on crowdfunding platforms every day. Figure 5. Comparison of equity crowdfunding in 2014 (mil EUR) UK France Germany the rest EU 3 Robert Wardrop, Bryan Zhang, Raghavendra Rau and Mia Gray. University of Cambridge and EY. Moving Mainstream - The European Alternative Finance Benchmarking Report (February 2015).

6 III. Successful stories in the UK There are several reasons which can explain the UK s dominance regarding the alternative finance market and especially in the case of equity crowdfunding. The first pillar is the developed capital market that includes market infrastructure, sophisticated investors, venture funds and business angels. The increasing FinTech sector of start-ups supported by incubators, accelerators and associations, is a crucial factor in the growth of the alternative finance market. A perfect example is Level39 established in Canary Wharf, which is Europe s largest accelerator for technology businesses, innovating in the finance, retail and future cities sectors. Another cross-sector organization that aims to accelerate the UK's leading position in global financial services is Innovate Finance, with the City of London Corporation as the leading sponsor serving as a single access point to the full financial services and technology ecosystem, and connects their members to policymakers, regulators, investors, customers and educators. The UK Crowdfunding Association plays a key role for self-regulation and promotion through publishing a code of practice that is adopted by UK crowd funding businesses and explaining all crowdfunding businesses in the UK to the public, press and policymakers. A reasonable regulatory approach set by the FCA is also an important advantage in comparison to other European countries. The last, but not the least attribute supporting investments to start-ups are government tax relief schemas. EIS (Enterprise Investment Scheme) and SEIS (Seed Enterprise Investment Scheme) are each designed to help SMEs raise finance by offering tax relief on new shares in those companies. For the investor, it s a tax efficient way to invest in small and early stage companies. The most successful UK crowdfunding platform, Crowdcube, has 180,000 registered potential investors and the average investment is almost 3,000 GBP. For example, via this platform the company JustPark was financed in 2015 by more than 2,500 investors from dozens of countries, and the offer had to be stopped before the deadline because the total amount invested reached the regulatory maximum 3.7 mil GBP (5 mil EUR is the limit for an investment offer without a prospectus). Sugru, another company, has similar data with a maximum single investment of 1 mil GBP. There are other interesting crowdfunding platforms like Seedrs and Syndicate Room, with different approaches. Via Seedrs, for example, every investor can invest into foreign start-ups from other European countries while Syndicate Room offers investment opportunities that are backed by an angel investor. In September 2015, Syndicate Room took another step and introduced the possibility for investors to participate in an equity round that is already funded, which

7 means the guarantee of a successful pitch. This way of investment is labeled by the platform as the Lift Round. Regarding examples of profitable investments via equity crowdfunding platforms, there was a successful AIM (London stock Exchange) IPO of wine maker Domaine Chanzy. Another successful exit is E-Car Club, where investors receive a multiple return on their investments via Crowdcube. Sixty three investors helped E-Car Club, the UK s first entirely electric car sharing club for businesses and communities to raise 100,000 in 2013, and two years later they received a return on their investment following the sale of the business to Europcar. IV. Investments through equity crowdfunding - main models and differences Equity crowdfunding is when investors buy shares in a company and become part owners. Investors make a return on their investment either by being paid a dividend, or by selling their shares at a later date when the company value has increased. The most likely exit strategy for start-ups is an acquisition or an initial public offering (IPO). The board of the company will decide whether or not to pay a dividend and how much, and in addition if and when to sell the business. This tends to be a riskier form of investment as there is no guarantee of the amounts or timescales for returns. One of the important aspects for investors is different share classes. Very often companies do not offer A shares (the same as founders have), but other classes limited voting-rights or dividends; or at least a minimal limit of investment to receive A shares. On the other hand, start-ups and SMEs can raise money easily through crowdfunding platforms and also receive additional values from a campaign. For example, through the process of crowdfunding it is possible to measure market readiness for the product, involve others in the design and development process, capture customer response and feedback and finally, promote the final product and engage a market and audience. There are three basic strategies of how to invest through crowdfunding platforms. The first option is a direct investment in equities of selected high growth start-ups and early stage businesses. The second possibility is an indirect investment through a venture fund cooperating with the crowdfunding platform. This option very often needs higher initial investment. Several companies also offer their bonds (called mini-bonds) with a fixed interest rate, but certainly direct investments in start-ups are the most popular on crowdfunding platforms. After the investment to equities, the investor receives a share

8 certificate from the company, and when this process is finished the crowdfunding platform does not play any role which leaves just the direct relationship between the investor and the company. This standard structure is called a direct holding model. But some crowdfunding platforms offer an indirect holding model. It is based on a nominee structure (a form of trustee), and the platform acts as a legal shareholder on the behalf of investors. This structure can be charged by crowdfunding platforms, but on the other hand, the platform provides full custody services for investors. The business model of equity crowdfunding platforms is mainly based on a success fee paid by companies raising finance. Success fees are between 3% % of total funds processed, and are charged only in the case that a pitch is funded as was planned. To offer a pitch through a crowdfunding platform is very often free of charge for start-ups, but there can be administration and corporation fees. For instance, several platforms have a fixed fee per successful pitch and also an enhanced EIS/SEIS service fee. On the other hand, in almost all situations investors do not pay any fee. Only in the case of nominee holding can there be a fee based on the profit that the investor makes on an investment from dividends, or due to a successful exit, and this fee can reach 10% of the investor s profit. V. Regulation of equity crowdfunding and complete market infrastructure in Europe The European Commission has declared to support crowdfunding because of the benefits that crowdfunding provides for the financing of SMEs and start-ups. Beyond this declaration, a growing number of countries (the UK, France, Spain, the Netherlands, Germany etc. - the largest crowdfunding markets) are implementing specific national crowdfunding regulations which are not harmonised. Other countries (e.g. the CEE region), believe that the current regulation of capital markets (mainly MiFID, eventually AIFMD), is sufficient and there is no reason for a specific regulation. The result means a divergence of regulatory requirements for equity crowdfunding platforms (license as a crowdfunding platform, as an investment firm or no license), for investors (possibility to invest and how much) and companies (marketing restrictions, prospectus requirements). Therefore, it is becoming difficult to develop cross-border crowdfunding business and for crowdfunding platforms from abroad to enter into the European market. This evolution goes against the goal of establishing a single European market and promoting equity crowdfunding. The main barriers of cross-border crowdfunding can be divided into direct obstacles which can be minimized during a few years, and more comprehensive indirect obstacles which will need deeper integration and law harmonization within the EU. Direct obstacles are connected

9 with the common regulation of crowdfunding platforms regarding requirements and surveillance, investor protection, prospectus directive and free movement of issuers. Indirect obstacles to cross border capital flows are more complicated, included are divergences of insolvency law, corporate law, taxation and tax relief and securities law of individual European countries. The European Commission s plan to build a Capital Market Union could be a promise of how to dismantle all direct obstacles (for example the EC will review the current prospectus regime through public consultation), and at least to reduce several indirect barriers. One of the key principles of this green paper should be to create a single market for capital for all 28 Member States by removing barriers to cross-border investment within the EU. In addition, it should foster stronger connections with global capital markets. The main outcomes should be to identify the actions that are necessary to achieve improving access to financing for all businesses across Europe (in particular SMEs), and diversifying the sources of funding from investors in the EU. Moreover, the European Commission is also focused on alternative means of financing and they worry that peer-to-peer lending and crowdfunding could have great potential in contributing to the financing of the economy, but there is limited evidence of cross-border activity. Currently the Commission is gathering on member state approaches to the regulation of crowdfunding, and the preliminary results suggest that the diverse national regulatory strategies may encourage crowdfunding activity locally, but may not be compatible in a cross-border context. 4 This gives a very strong signal for future harmonization of equity crowdfunding regulation. The stable and growing common capital market needs a reasonable regulatory approach to all pillars of the market infrastructure. Given the situation when one part is overregulated and another part is not harmonized at all, this can cause imbalances and jeopardize competition among ways of financing. Figure 6. Main pillars of the market infrastructure Crowdfunding Business angels Venture funds ELTIFs Start-up Custody CSDs Custodians Nominee holding Private markets SME MTFs Exchanges Traders Market 4 European Commission. GREEN PAPER - Building a Capital Markets Union (2015).

10 VI. Conclusion The alternative finance market is here and growing, that is a fact. The current value of this market is probably not so significant for many national regulators, but on the other hand the pace of this growth is meaningful and should not be underestimated. At the top of the pyramid of alternative financing is equity crowdfunding. This is because there is a potential financial reward without a specific period time, and also the highest risk for investors. More than half of start-ups go bankrupt which means, for investors, a loss of the whole investment. However, there are also cases when the value of shares was multiplied by fifty and more. Due to the short term history of start-ups or SMEs that raised money, with only few successful exits and without relevant SMEs exchanges or multilateral trading facilities it is impossible to calculate any average rate of return or percentage of defaults. It will take at least an additional 3-5 years to receive relevant statistic data. The last few months show that there is a huge demand for interesting start-ups and their projects. Every day there are more than three new opportunities to purchase shares of startups or SMEs through more than 30 equity crowdfunding platforms, and the trend is increasing. These numbers could raise a relevant question - how many crowdfunding platforms can be profitable? On the other hand, this issue should be decided by the market and not by regulators. The future of equity crowdfunding in Europe will be influenced by several factors including the regulation of crowdfunding, the number of future successful start-ups exits and defaults, the support of national governments and the other well-functioning pillars of capital market infrastructure. The main goals of harmonized equity crowdfunding regulation should be the minimization of cross-border barriers within the EU, easy access to financing for SMEs and the protection of retail investors. It seems that the current direction of the European Commission building the Capital Market Union is promising. The support of local governments can be provided through tax relief, European or local programs and direct investment policy (e.g. ELTIFs). Certainly, other functional parts of the capital market are crucial for sustainable development of equity crowdfunding. One part of the whole infrastructure is a private market due to the possibility to sell shares that are not traded regularly. One good example of a private market is Asset Match, which is an online marketplace to buy and sell shares of the private companies. Liquid SME MTFs (multilateral trading facilities), exchanges and custodians are also an important part of the infrastructure in the case of smooth and successful exit, or growth via IPO. All these aspects will increase the confidence of retail investors regarding equity crowdfunding, and willingness to invest into shares through crowdfunding platforms.

11 Bibliography: European Crowdfunding Network, Review of Crowdfunding Regulation. Interpretations of existing regulation concerning crowdfunding in Europe, North America and Israel (2014). Robert Wardrop, Bryan Zhang, Raghavendra Rau and Mia Gray. University of Cambridge and EY. Moving Mainstream - The European Alternative Finance Benchmarking Report (February 2015). Financial Conduct Authority. A review of the regulatory regime for crowdfunding and the promotion of non-readily realisable securities by other media (February 2015). Financial Conduct Authority. The FCA s regulatory approach to crowdfunding over the internet, and the promotion of non-readily realisable securities by other media Feedback to CP13/13 and final rules (March 2014). Daniela Peterhoff, John Romeo, Paul Calvey. Towards better capital markets solutions for SME financing (2014). Eleanor Kirby and Shane Worner. IOSCO. Crowd-funding: An Infant Industry Growing Fast (2014). European Commission. GREEN PAPER - Building a Capital Markets Union (2015).