Posted: Friday 17 February 2012

Crowdfunding – lifeboat or iceberg?

By Austin Flynn

A client came to see me recently to say that she was hoping to use crowdfunding to raise growth equity for her early stage technology company. For those of you who may not have heard of it, crowdfunding (as the name would suggest) is the new(ish) way for a community of like-minded people to network and pool their money (and knowledge) and has grown from the increasingly connected and online world in which we live; it seems to blend a combination of the internet, online micro-payment systems and social networking. The concept started as a means of raising money for one-off good causes, often charitable, but is now being seen as a means of raising growth capital for businesses.

I had to admit to my client that I’ve never been involved in a crowdfunding deal (show me a lawyer who has) although I’ve been involved in dozens of ‘traditional’ private equity deals over the years. The traditional route is tried and tested, the documentation is becoming more standardised than ever, and those of us who operate in that sector know the pros and cons and understand the tempo of a private equity transaction.

Being an inquisitive sort of chap, I told my client that I would go and do some research. However, the idea of crowdfunding did immediately raise some potential concerns. Although many lawyers would have you believe otherwise, the job of a lawyer is not to find problems and obstacles; having said that, it is one of the jobs of a lawyer to look out for icebergs, and I thought that I may have spotted a few in the hazy distance:

1. once the company places its advertisement on a crowdfunding website, confidentiality is lost. Sufficient information has to be given for investors to be able to make an investment decision, and that level of information may require some sensitive information to be made public;
2. the traditional private equity market is quite heavily regulated and my first impression was that crowdfunding may well breach the Financial Services and Markets Act 2000 (FSMA). Without wishing to bore you (or even myself), FSMA contains rules to protect investors (on the basis that the value of investments may go down as well as up) and it’s hard to see at first glance how crowdfunding could comply with those rules; and
3. in a traditional equity investment, the company knows the identity of the investors; the investment documentation contains mechanisms for managing the relationship between the company and its investors, including decision-making, board representation, investor access to ongoing financial information and share transferability. How that might work in a crowdfunding investment is also hard to fathom at first glance.

Since the meeting with my client I’ve spent some time attempting to educate myself on the finer points of crowdfunding but I’m not sure that I’m any the wiser. Various commentators have spotted the same icebergs as I spotted but not suggested any workable means of steering around them. Having said that, completed crowdfunding deals are reported (although not in any detail). The agreement that I reached with my client is that if people start pledging cash for her business, we’ll see at that stage what documentation the crowdfunding co-ordinator requires, and take it from there. Experience suggests that while it can be hard to raise equity, it’s sometimes wiser to turn it down than to end up in bed with the wrong investor, or with the wrong documentation in place. After all, the relationship between a company and its investors is not a one-off transaction and can last for years. Going back to my icebergs, I won’t see my client holed below the line.

By way of postscript, I also noticed that Darlington Football Club is attempting to rescue itself from administration by raising money using crowdfunding. Those of you who have read my blog before will know that I support Sunderland AFC, by far the greatest of the football clubs in North East England, but nonetheless I wish Darlo all the best and hope that crowdfunding can provide a lifeboat.

2 Comments

• Naz replied on 20 Feb 2012 at 12:59

  Interesting article Austin.

  I like the concept of crowd funding but I wonder whether part of the issue with its slow uptake in the UK is to do with how it is perceived by many.

  Until recently, it mainly has been used as more of a charitable effort for people to play their part in making something they care about happen. The football club you mention being a good example of this (i.e. they're hoping the fans will bail them out).

  Until the mindset of people starts to change, many might want to avoid using crowdfunding as it gives the impression that the idea is not of merit through normal means, and so requires charitable effort to continue.

  Nonetheless it is a new method of raising funds and is definitely worth exploring further.

  Understanding the legal issues involved is key to knowing whether it can potentially become a suitable vehicle to securing the initial capital required for startup companies in the near future - and in particular how it could impact those which may need subsequent rounds of investment through the more traditional channels. Startups need to explore all opportunities and in some instances crowd funding may be the way to go.

• Shahida replied on 4 May 2012 at 15:33

  Hi Austin,

  I appreciate the sentiment which reflects that of many in the legal world as this could be fraught with many difficulties for the investor and company owners alike. However, the JOBS Act in the US has just recently passed a law that will make it easier for firms to raise investment (in particular through crowd funding) and I can only imagine the UK FSA will follow suit with some regulatory offering in the not too distant future. In the meantime, there are some 'innovative' workarounds in the UK.

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