In the last few years, a source of financing for start-ups, known as crowdfunding, has become widely available. It involves raising capital from a large number of individuals, each of whom typically contributes a small sum. The internet has lowered the costs of crowdfunding by facilitating the dissemination of information about small projects, and its use has grown exponentially, with some $34 billion being raised worldwide through crowdfunding in 2015 alone.
While the availability of crowdfunding is clearly good news for entrepreneurs, its merits for those providing the funding are less certain. Because funders typically put only small sums into projects, crowdfunding may appeal to consumers without a sophisticated investment background. They are prone to base investment decisions on biases and herd behavior. That can cause them to lose money and funds to be allocated 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, we sketch a road map for the regulation of crowdfunding for start-ups.
We begin by considering the use of crowdfunding and the characteristics of typical crowdfunding contracts. One such contract—the “reward” model, which rewards funders with units of product—offers firms and funders the promise of reducing uncertainty by generating new information about consumer demand. By using the reward model, 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 the “equity” model, which allows funders to buy shares of stock, the shares’ value is based on estimates of future sales and the venture’s profitability, matters beyond the typical funder’s expertise. There is consequently a real peril that consumers (referred to as “retail investors” when they invest in the equity model) will simply back projects that early adopters have found attractive, which can lead to misallocation of capital.
We then review the regulation of crowdfunding in the UK (which largely reflects the implementation of EU law) and the U.S. Because crowdfunding is a novel practice, regulatory policy has tended to take the form of existing frameworks designed for other contexts. This has led to inconsistent, and sometimes misconceived, regulatory treatment.
Reward crowdfunding combines a start-up’s financial and product markets. The involvement of the product market means that EU consumer protection rules seem to apply in the UK, requiring among 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 who bear risk associated with the product’s completion. In contrast, few mandatory rules apply to consumer contracts in the U.S. This gives parties greater freedom to design reward-crowdfunding arrangements and is one reason that they flourish in the U.S. but are virtually non-existent in the UK.
Equity crowdfunding involves issuing securities to investors, and so is covered by securities laws, including disclosure requirements that are often prohibitively expensive for small firms. Despite the reduction of these costs in the U.S. through a special regime for equity crowdfunding that went into effect in May 2016, they are not low enough to encourage equity crowdfunding. In contrast, equity crowdfunding has flourished in the UK, where there is an exemption from disclosure obligations under the Prospectus Directive for small offerings. In our analysis, equity crowdfunding markets are sufficiently different from traditional securities markets to justify an exemption from mandatory disclosure rules.
Crowdfunding shares many of the problems of other 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. At this early stage of crowdfunding, we advocate permissive regulation that allows reward crowdfunding to fulfill its promise, and equity crowdfunding to benefit from market solutions. We review the range of market mechanisms that have been used in the UK and other jurisdictions to overcome the contracting problems inherent in equity crowdfunding and show why they hold promise at this early stage.
This post comes to us from professors John Armour and Luca Enriques at the University of Oxford. It is based on their forthcoming article, “The Promise and Perils of Crowdfunding: Between Corporate Finance and Consumer Contracts,” available here. A version appeared in the Oxford Business Law Blog.