Crowd-sourced equity funding

Crowd-sourced equity funding

In recent years, a number of innovative financing mechanisms have emerged globally that draw on the “crowd” to expand the funding options available.  Examples include peer-to-peer lending, rewards-based crowd funding and equity and debt crowd funding.

These new mechanisms complement the more established financing options available from professional investors focused on start-up businesses or other speculative ventures such as angel investing and venture capital.

Crowd funding is a method of funding which often utilises internet and social media platforms to raise funds in support of a specific project or business idea.  Investors who pledge funds typically receive some reward in return for their funds.  In some cases, the reward expected may be of minor value and is merely incidental rather than the purpose of the contribution.  In other cases, the reward may result in obtaining equity in the company or venture.

Readers may be aware of popular crowd funding platforms such as Kickstarter and Indiegogo.  On the back of the success of these well known platforms, numerous platforms have been created both globally and in Australia each taking a different approach to crowd funding and the projects in which they seek funds.   

What is crowd-sourced equity funding?

Crowd-sourced equity funding (CSEF) is a model of fundraising where an invitation for the provision of funds is accessed by the world-at-large and, in return for providing funds, investors take an equity stake in the company. 

Why has the take up of CSEF been slow in Australia?

To date, CSEF in Australia has had limited opportunities.  Commentators regularly propose that CSEF models in Australia have not enjoyed popularity as a result of the barriers created by regulatory requirements currently in place.  

CSEF in Australia is predominately regulated by the Corporations Act 2001 (Cth) (Corporations Act) – legislation that does not specifically contemplate crowd-sourced funding models (let alone CSEF) and the unique issues such arrangements raise.

Fund raising regulations

A key objective of CSEF models is to have access to as many potential investors as possible. However, under current Australian laws, a company seeking to raise money from the general public or which has in excess of 50 shareholders, must be incorporated as a public company.

Under the Corporations Act, public companies are subject to more stringent reporting, disclosure and administrative requirements.  These requirements may be restrictive, and even prohibitive, to small businesses and start-ups in search of funding.

As such, unless the company seeking to raise funds can viably incorporate as a public company, it is unlikely that CSEF would be a practical source of funds for such a company.

Public companies seeking to raise funds from the general public will be subject to Chapter 6D of the Corporations Act.  Chapter 6D prohibits the issue of any securities (such as shares or debentures) in a company to an investor, except under a prospectus or similar disclosure document (unless a prescribed exception applies).  As a generalization, the exceptions in effect limit the company to make offers to professional or sophisticated investors.

For ventures that do not require the raising of large amounts of capital given their scale or speculative nature, the regulatory hurdles created by the Corporations Act could prove to be the roadblock that stops a project from obtaining the funding it requires to get off the ground. 

Managed investment schemes

A managed investment scheme (MIS) is a scheme where:

• people contribute money (or money’s worth) to acquire rights to prospective benefits produced by the scheme;
• the contributions are pooled or used in a common enterprise to produce benefits including money or rights or interests in property; and
• members of the scheme do not have day to day control over the operation of the scheme. 

A CSEF arrangement is likely to be considered a MIS for the purposes of Chapter 5C of the Corporations Act.  Subject to certain exemptions, the operators of a MIS must register the relevant scheme with the Australian Securities and Investments Commission (ASIC), and operate through a ‘responsible entity’ – which will need to be a public company and hold an Australian Financial Services Licence (AFSL).  Applying for and holding an AFSL, in turn, raises additional disclosure and administrative requirements.

The need for the innovation and growth that can be fostered by making access to CSEF less difficult has been recognized by the government and steps have been taken to make regulatory change.

Regulatory changes on the horizon

On 7 December 2014, the final report of the Financial System Inquiry was released (which concerned, amongst other topics, CSEF).

The Treasury subsequently released a discussion paper on CSEF and invited submissions from the public with a deadline of 6 February 2015.  The discussion paper sought views on the following three options with respect to CSEF regulation:

• The Corporations and Markets Advisory Committee (CAMAC) model – the CAMAC model proposed several changes to the existing regulatory regime under the Corporations Act including the addition of a new public company category – known as the ‘exempt public company’ – providing relief from certain reporting and other requirements such as continuous disclosure and auditing for up to 5 years.  Exempt public companies may also raise up to $2m in a 12-month period with less disclosure requirements.  Participants running the website or other platform will be required to hold an AFSL.  The model proposes that investors are prohibited from investing more than $2,500 in 12 months to any single CSEF issuer and not more than $10,000 in 12 months to CSEF issuers in aggregate.  Intermediaries are not permitted to receive shares in an issuer undertaking CSEF using their website or platform.
• New Zealand model – New Zealand introduced reforms in 2014, which are similar to the CAMAC model.  However, there is no equivalent of the ‘exempt public company’ concept and therefore no relief for reporting and audit requirements. Under the New Zealand model, the required level of disclosure is variable in the sense that a specified minimum standard becomes more onerous as the level of investment or capital raised corresponding increase. Unlike the CAMAC model, there are no restrictions on intermediaries’ fees, other than those fees required to be disclosed.
• Status quo – maintain the current regulatory framework as is.

The CAMAC model appears to be the most heavily favoured model to base the changes to the regulatory regime on with respect to regulating CSEF.

Next step

In early February, following the closing of submissions, a roundtable was held between the Minister for Small Business and other industry members.

The Minister advised that any regulatory changes were at least six months away.

Lavan Legal comment

If either the CAMAC model or New Zealand model is adopted, in our view, businesses and investors will be greatly benefitted.

With less regulatory hurdles to overcome, businesses seeking funds by way of CSEF will have access to funds which:

• at least initially, may not require the issue of a complex disclosure documents in order to obtain; and
• will result in, arguably, less onerous conditions placed on the party obtaining the finance than through other means – such as debt financing.

Businesses will not be the only ones to benefit from an overhaul of the current regulatory regime.  For investors, taking an equity stake in a business at such an early stage may result in gains for the investor in excess of those that may be available by investing in the securities exchange.

However, risks for investors still remain.  Apart from the obvious risks of investing in a start up business, investors may face issues with liquidity as funds invested in a CSEF model may not have a liquid secondary market.  It is also possible that any equity stake in the company may be diluted as the company completes successive capital raisings as the company grows.

As more guidance is provided by the government with respect to CSEF regulatory overhauls, we will continue to keep you updated.  Keep watching this space.