Crowdfunding: the threat for bankers
PUBLISHED: 27 Mar 2013 00:05:00 | UPDATED: 27 Mar 2013 15:57:37PUBLISHED: 27 Mar 2013PRINT EDITION: 27 Mar 2013
ASIC commissioner Greg Tanzer, who has been monitoring the crowdfunding market for the past year, says that based on overseas experience the potential for fraud on pledge and reward sites is real and, when it occurs, it is “extremely damaging for investor confidence in the market affected by it”. Photo: Paul Jones
James Eyers
An Australian-based website established by Alan Crabbe and Rick Chen in 2010, Pozible helps projects find capital. So far it has facilitated about $8 million worth of fund-raising.
Crowdfunding is a recent phenomenon that may define the future of capital raising for entrepreneurs and small businesses. The model is simple and has become possible with the arrival of social media and connected online networks. Those seeking capital post a description and a fund-raising target on a crowdfunding website, where sponsors pledge small amounts to help the project take flight. It’s an all-or-nothing system: if a project fails to reach its target, pledged amounts are cancelled. Rewards are typically offered to attract support.
This is known as “pledge” crowd-funding, but raising equity through these platforms is also on the cards, forcing bankers to consider yet another threat to their position as capital intermediaries.
The genesis of crowdfunding is crowd-sourcing, where the small online contributions of many people further a larger goal, such as creating comprehensive encyclopedia Wikipedia or computer operating system Linux.
Now, however, the online crowd – which is becoming increasingly sophisticated as networks of friends and professional colleagues circulate ideas in niche areas – is being harnessed by artists and capital-starved small businesses and entrepreneurs, liberating them from constraints imposed by their traditional lenders.
As The New Yorker contributor James Surowiecki argued in his 2004 book, The Wisdom of Crowds, groups can often make better decisions than individuals.
And for innovators unable to win support for projects from banks or angel investors, crowdfunding is a more democratic forum for floating ideas and raising early stage capital.
The movement is attracting the attention of those entrusted to oversee more traditional capital-raising forums. NYSE Euronext chief executive Duncan Niederauer raised it at the CGI America conference last June.
“If done properly,” he said, “[crowdfunding] is the future of how small businesses in this country will be financed.”
Anything is possible
The Queensland Literary Awards was one of 1903 projects launched on Pozible in 2012, of which 53 per cent reached their fund-raising targets. A total of $5.8 million was pledged through the site last year, giving year-on-year growth of 465 per cent. Globally, crowdfunding sites raised $US2.8 billion in 2012, according to an estimate by Massolution, a consultant in the space, double the level of 2011.
In the US, the leading crowdfunding site, Kickstarter, which launched in April 2009, raised $US145 million last year – more than the entire sum the US federal government spent through its National Endowment for the Arts agency. Over the past five years, Kickstarter has raised $US429 million; 89,049 projects have been launched through the site and 43.6 per cent have hit their targets. Its largest project to date is the Pebble smartwatch, which displays information pulled from a smartphone using Bluetooth, which raised more than $US10 million from almost 70,000 people last year. (The company offered the watch, which would retail for $150, to all those pledging a minimum of $115, effectively using Kickstarter as a pre-ordering platform.) Both Kickstarter and Pozible earn a 5 per cent service fee from successful projects (and nothing from unsuccessful ones).
Pozible’s Crabbe says that while crowdfunding has been built on connecting musicians and filmmakers with capital, it will “move more mainstream” and to the point where anyone with a business idea will be able to turn to it to gauge its long-term viability. “I think we’re still in the early days of a much bigger trend,” he says.
Crabbe met Pozible co-founder Chen after advertising on the Gumtree website for a travel companion for a road trip from Sydney to Noosa. “As it turned out, we had common interests and decided we could benefit by working on a project together,” Crabbe says. They created FundBreak in 2010, changed the name to Pozible and launched internationally in 2011. Its most successful raising is small entertainment company IRL Shooter, which crowd-funded a live-action, zombie-shooting game, Patient Zero, raising $234,000 in August. Online news site New Matilda also funded its relaunch through Pozible, raising $175,000 in late 2010.
Low barriers to entry and the potential of the market are encouraging other sites to enter the space. In the US, Indiegogo and RocketHub are well established, while in Australia, iPledg is still waiting for its first large project after launching in January 2012. Over its first year of operation, iPledg successfully linked 20 projects with funding, mostly for community and sporting groups and charities at around the $2000 level; the largest was more than $26,000. In its first year of operation, iPledg helped raise almost $100,000.
iPledg co-founder Andy Tompkins says the crowdfunding business was not possible before the arrival of social media and low-cost payment systems such as PayPal. “Now all of that has come together, crowdfunding is starting to take off,” he says. Tompkins, a chartered accountant, emigrated to Australia in 2010 from England via South Africa and became a panel member on the Queensland government’s Mentoring for Growth program, where he met many entrepreneurs struggling to borrow.
He met business partner Bryan Vadas on one of the panels and the two launched iPledg. Tompkins says the relatively benign levels of fund-raising in its first year is a function of many projects not using social media effectively and not properly understanding how to structure their rewards. But he expects the market to become more sophisticated and volume to grow.
Not surprisingly, given the combination of fund-raising and the internet, crowdfunding is attracting attention from global regulators and legislators. Last August, the Australian Securities and Investments Commission issued guidance to website operators, reminding them that under Australian corporations law they cannot facilitate the raising of equity capital without a licence.
Neither Pozible nor iPledg has sought to be licensed and the “pledge and reward” models they offer do not require their platforms to be registered with the regulator, as their transactions do not involve financial products as defined by the law.
ASIC commissioner Greg Tanzer, who has been monitoring the crowdfunding market for the past year, says that based on overseas experience the potential for fraud on pledge and reward sites is real and, when it occurs, it is “extremely damaging for investor confidence in the market affected by it”.
ASIC says fraud has not been a problem domestically, in the pledge and reward area, and Pozible and iPledg say they are not aware that any fraudulent projects have used their platforms. Both were in close contact with ASIC before the release of the guidance and have been developing processes to monitor and vet projects to ensure the potential for deception of sponsors is reduced. iPledg has introduced quality controls such as requiring photo identification from project sponsors to ensure they are real persons; in addition, to have a project on iPledg, the project creator must have a verified PayPal account, meaning that PayPal has confirmed the user’s identity. “It’s certainly not foolproof but we’re doing as much as we can in terms of checks and balances to avoid [deception],” Tompkins says.
Crabbe says Pozible vets, reviews and performs basic due diligence and, in some cases, gives advice to ensure projects comply with regulations, laws and extensive project guidelines. “We have a responsibility to ensure the long-term viability of crowdfunding for creative projects,” he says, “and also for creating a safe and reputable marketplace.”
Role of regulation
While Australia’s regulator has warned of the potential pitfalls of equity crowdfunding, the US is set to open its doors. As here, US crowdfunding, including through Kickstarter, has been the pledge and reward type, as equity raising is governed by strict securities laws. This is about to change.
US President Barack Obama’s Jumpstart Our Business Startups Act (JOBS Act) establishes a tailor-made legislative regime which seeks to protect investors providing equity to companies over the internet while relieving issuers from strenuous disclosure requirements. The act was passed last April with overwhelming bipartisan support. The Securities and Exchange Commission is still finalising its rules, a necessary step before the law comes into force.
Under the new law, small US businesses will be able to raise up to $US1 million in equity capital in any year by selling shares online without needing to register with the SEC and produce a prospectus, with its attendant costs. Before they can take advantage of this exception, crowdfunding sites will have to register with the US government. A range of investor protections have been included, such as a yearly aggregate limit on the amount each person may invest in projects, linked to net worth or annual income. Project sponsors will have to lodge financial statements for offers greater than $100,000 and audits of financial statements for offerings greater than $500,000.
Equity crowdfunding is also gaining momentum in other jurisdictions. In the Netherlands, Symbid offers equity crowdfunding, alongside a pledge model, via a co-operative structure. In Britain, new regulations will allow investors to provide equity directly to small businesses through Crowdcube.
Each jurisdiction that is moving on equity crowdfunding has studied Australia’s corporate law, given the Corporations Act has a specific provision – section 708 – that exempts small-scale offerings from strict prospectus requirements. Offerings of $5 million in a 12-month period can be made without a prospectus, as long as 20 investors or fewer participate. Such offerings are made via the Australian Small Scale Offerings Board, facilitated by an ASIC class order made in 2002. In the past seven years, ASSOB has assisted about 176 companies to raise $132 million. For most businesses it is an option of last resort when attempts to borrow from the banks or other sources have failed.
Issuers on ASSOB pay a fee of just less than $5000 for ASSOB legal and accounting staff to prepare streamlined offer documents and put them on the platform. Its regulations require regular reporting by directors on insolvency and lodging of company announcements. Only investors registered with ASSOB can participate in the capital raisings, to ensure rules against solicitation are not breached.
Paul Niederer, ASSOB’s chief executive, says nearly 6 per cent of companies that have raised money through ASSOB have gone on to list on a stock exchange, while about 40 per cent have been sold to other companies and 86 per cent are still registered as an entity with ASIC. There have been no incidents of investors being defrauded, he says, and ASSOB passes on any issues with possible director misrepresentations to ASIC to deal with under the existing corporations law.
The limit of 20 investors makes the potential market a very small crowd and ASIC does not see ASSOB as a crowd-funder. Nevertheless, as other jurisdictions consider models for equity crowdfunding, ASSOB has been getting global coverage as an example of a platform that allows a crowd, even though a small one, to provide equity to small businesses without offer documentation.
Niederer says pressure to increase the 20-investor limit is likely to grow in Australia. “I think [section 708] has been very smart legislation,” he says, “but the way the world’s going, I think there’ll be a push to open [the 20 investor limit] up so that smaller amounts can be invested. People can go and put a thousand dollars in the pokies and nobody cares. If they want to have a punt on a company that’s in a niche that they love, they should be able to put $1000 into that company, and do it in a way that’s relatively easy – but have the assurance that some safeguards are in place.”
ASSOB would raise five times more capital than it does if the 20 investor limit was increased to 100 investors, Niederer says, because in most offerings, many potential investors wish to contribute small amounts of capital but companies are forced to reject these amounts because the investor limit forces them to the larger offerings.
ASIC’s Tanzer says any change to the existing law to open equity crowdfunding up to a larger crowd is a matter of policy for the government and says there has been “no clamour” by market participants for changes to be made. Should such a change be considered, he urges caution, saying the limit of 20 investors is important and similar to limiting the number of shareholders in an Australian proprietary limited company.
“The policy thinking behind that is that, if you have a relatively small number of people, they’re in a position to be much more familiar with the business,” he says. “It’s the type of thing you see in families or communities. We have the exemption for a very good reason – equity fund-raising is quite a different animal [to pledge and reward crowdfunding] and it periodically entitles investors to a better level of disclosure and requirements of those that offer to them. That protection has been built up over years, due to problems with fraud.”
Banks pushed out of the limelight
The extraordinary arrival of pledge and reward crowdfunding and the potential for equity to be raised in a similar way throws down a challenge to bankers as it reflects growing disintermediation in investment markets. While it is too early to declare that crowdfunding will take the reins from the banks, which have dominated equity capital raising, things appear to be moving in that direction. Tompkins reckons the more entrepreneurial banks and private equity players will ultimately take strategic stakes in equity crowdfunding platforms.
Technology and social media might also counter regulatory fears that investors might be duped, as the crowd self-regulates using the sites themselves, dissecting the online history of potential project promoters. Forums on the crowdfunding websites provide a safety mechanism that can weed out untoward behaviour by those seeking funding as the online community asks questions and provides feedback. Sources such as Facebook or LinkedIn can also provide insight into trustworthiness.
“They say the wisdom of the crowd will become more and more important,” Niederer says. “I don’t know what form it will take but in 10 years the wisdom of the crowd will enable people to make judgments about entrepreneurs, just like eBay, which gives sellers a rating.”
Pozible’s Crabbe and iPledg’s Tompkins both recognise the younger generation in Australia seems to be more risk-seeking and willing to contribute small amounts of funding to Australian start-ups that excite or interest them. They believe the time has arrived for a policy debate on whether the carve-out in section 708 of the Corporations Act is sufficient, or whether Australia should examine broader changes along the lines of other countries.
“The current regulations in Australia make it expensive, time-consuming and very restrictive to publicly promote an investment offering,” Crabbe says. “Technologically, a great deal has changed since these regulations were put in place and I hope the government is already working to make it easier for start-ups and new business to raise the funding they need to get off the ground.
“Countries like New Zealand, the US and Britain are leading the way with changes to their security and investment laws and this will give new [their] start-ups and small businesses an edge over their Aussie counterparts.”
Tompkins says the process leading to the US JOBS Act took three years and Australia should be examining the international trends and finding the common ground on its direction.
Given the substantial mark Kickstarter has made in the pledge and reward space, Tompkins believes the impact when the JOBS Act comes into force could be significant. “I would be too scared even to try to punt a number on what could be done from an equity perspective – it could be huge,” he says.
“The Australian Securities Exchange and the banks aren’t even aware of the potential of crowdfunding as yet, but they should be having many a restless night in the coming years as equity crowdfunding grows.”
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James is Capital editor based in our Sydney newsroom. 
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