BRUEGEL POLICY CONTRIBUTION

ISSUE 2014/09 AUGUST 2014 IMPROVING THE ROLE OF EQUITY IN EUROPE'S CAPITAL MARKETS

KAREN E. WILSON AND MARCO TESTONI

Highlights

• Crowdfunding is a growing phenomenon that encompasses several different models of financing for business or other ventures. Despite the hype, is still the smallest part of the crowdfunding market. Because of its legal framework, Europe has been at the forefront of equity crowdfunding market development.

• Equity crowdfunding is more complex than other forms of crowdfunding and requires proper checks and balances if it is to provide a viable channel for financial interme- diation in the seed and early-stage market in Europe. It is important to explore this new channel of funding for young and innovative firms given the critical role these start-ups can play job creation and economic growth in Europe.

• We assess the potential role of equity crowdfunding in the overall seed and early-stage financing market and highlight the potential risks of equity crowdfunding. We describe the current state of play in this nascent industry, considering both the innovations Telephone introduced by market operators and existing regulation. Currently in Europe there is a +32 2 227 4210 [email protected] patchwork of national legal frameworks related to equity crowdfunding and this should be addressed in a harmonised way. www.bruegel.org Karen Wilson ([email protected]) is a Senior Fellow at Bruegel. Marco Testoni ([email protected]) is a Research Assistant at Bruegel. BRUEGEL POLICY CONTRIBUTION EQUITY CROWDFUNDING Karen E. Wilson and Marco Testoni 02

IMPROVING THE ROLE OF EQUITY CROWDFUNDING IN EUROPE'S CAPITAL MARKETS

KAREN E. WILSON AND MARCO TESTONI, AUGUST 2014

1 INTRODUCTION to directly connect funders with those seeking funding, without an active intermediary. Crowdfunding is increasingly attracting attention, Crowdfunding platforms assume the role of most recently for its potential to provide equity facilitators of the match. funding to start-ups. Providing funding to young and innovative firms is particularly relevant given While people tend to talk about crowdfunding in their importance for job creation and economic general, the crowdfunding phenomenon encom- growth (OECD, 2013; Haltiwangner et al, 2011; passes quite heterogeneous financing models. Stangler and Litan, 2009). In addition, at a time There are four main types: when banking intermediation is under pressure (Sapir and Wolff, 2013), it is important for Euro- • Donation-based, in which funders donate to pean Union policymakers to further explore alter- causes that they want to support with no native forms of financial intermediation. But expected compensation (ie philanthropic or questions remain about the appropriateness of sponsorship-based incentive). crowdfunding for providing seed and early stage • Reward-based, in which funders’ objective for equity finance to new ventures and how this funding is to gain a non-financial reward such market could be developed and regulated. as a token gift or a product, such as a first edi- tion release. While there is growing hype around crowdfunding, • Lending-based (crowd lending), in which fun- there are also many wrong perceptions. The bulk ders receive fixed periodic income and expect of crowdfunding is for philanthropic projects (in repayment of the original principal investment. the form of donations), consumer products often • Equity-based (usually defined as crowdinvest- for creative ventures such as music and film (in ing), in which funders receive compensation in the form of pre-funding orders) and lending. Equity the form of fundraiser’s equity-based revenue crowdfunding, sometimes called crowdinvesting or profit-share arrangements. In other words, is relatively new and currently comprises the the entrepreneur decides how much money he smallest part of the crowdfunding market. How- or she would like to raise in exchange for a per- ever, it is currently more active in Europe than in centage of equity and each crowdfunder other regions. receives a pro-rata share (usually ordinary shares) of the company depending on the frac- 2 GROWTH OF CROWDFUNDING tion of the target amount they decide to commit. For example, if a start-up is trying to Crowdfunding can be defined as the collection of raise €50,000 in exchange for 20 percent of its funds, usually through a web platform, from a equity and each crowdfunder provides €500 (1 large pool of backers to fund an initiative. Two percent of €50,000), the crowdfunder will fundamental elements underpin this model and receive 0.20 percent (1 percent of 20 percent) both have been enabled by the development of of the company’s equity. the internet. First, by substantially reducing transaction costs, the internet makes it possible The four models vary in terms of complexity and to collect small sums from a large pool of funders: level of uncertainty. The donation-based model is the crowd. The aggregation of many small the simplest. Legally the transaction takes the contributions can result in considerable amounts form of a donation. The risk is that the project does of capital. Second, the internet makes it possible not achieve its declared goals, but the backer does BRUEGEL POLICY Karen E. Wilson and Marco Testoni EQUITY CROWDFUNDING CONTRIBUTION 03 not expect any material or financial return from the has been North America (and mostly the US where transaction. Equity crowdfunding is the most com- the concept of crowdfunding started) with 60 plex. From a legal standpoint, the funder buys a percent of the market volume, followed by Europe, stake in the company, the value of which must be which has 36 percent. estimated. Moreover, the level of uncertainty in equity crowdfunding is much greater compared to Equity crowdfunding is the smallest category of the other models because it concerns the entre- the overall industry and had a CAGR of about 50 preneur’s ability to generate equity value in the percent from 2010 to 2012. Most of that growth company, which is extremely difficult to assess. was through European crowdfunding platforms Overall, these complexities pose problems that because legal barriers currently prevent the devel- are distinct and more fundamental than those of opment of equity crowdfunding in the US (see Box the other crowdfunding models. These complexi- 2 on page 11). As a result, Europe is currently the ties require special attention from policymakers, leading market for this financing model (see fur- as this Policy Contribution will discuss. ther discussion in section 4).

In general, crowdfunding is experiencing While in Europe equity crowdfunding is growing, exponential growth globally. In the period 2009- the understanding of its risks and opportunities is 13, the compound annual growth rate (CAGR) of still limited. We first assess the potential role of the funding volumes was about 76 percent with equity crowdfunding in the overall seed and early- an estimated total funding volume of $5.1bn in stage financing market. Second, we point out the 2013. In terms of geography, the biggest market potential risks of equity crowdfunding. Third, we Figure 1: Worldwide funding volumes ($millions) (left panel); geographical distribution (% of volumes, 2012) (right panel)

6000 1.24% 0.03% (South America) 2.86% 0.002% (Africa) 5100 5000

4000

2661 35.51% 3000 60.35%

2000 1470

1000 854 530 North America Europe Oceania 0 2009 2010 2011 2012 2013 (est.) Asia South America Africa Source: Bruegel on the basis of Crowdfunding Industry Report 2013 (Massolution). Figure 2: Funding volumes by category ($ millions) (left panel); CAGR 2010-12 (right panel)

3000 400% 4% 350% 2500 Equity 14% Reward 300% 2000 Donation 250% 37% 1500 6% Lending 200% 4% 150% 1000 6% 49% 2% 100% 44% 500 55% 50% 40% 38% 0 0% 2010 2011 2012 Reward Lending Total Equity Donation Source: Bruegel on the basis of Crowdfunding Industry Report 2013 (Massolution). BRUEGEL POLICY CONTRIBUTION EQUITY CROWDFUNDING Karen E. Wilson and Marco Testoni 04

describe the state of this nascent industry con- ners, and aims at investments in firms in early sidering both the innovations introduced by to expansion stages. The source of capital market players and existing regulation. Finally, we pooled into funds is predomi- discuss the implications of our analysis for policy. nately institutional investors. Venture capital firms typically invest around $3m and $5m per 3 THE SEED AND EARLY-STAGE FINANCING round in a company. MARKET The contributions of angel investors and venture Equity crowdfunding is receiving attention from capital firms are not limited to the provision of policymakers as a potential source of funds for finance. They are actively involved in monitoring start-ups, a segment of the economy that has lim- the companies in which they invest and often pro- ited access to finance. Young firms have no track vide critical resources such as industry expertise record and often lack assets to be used as guar- and a valuable network of contacts (Gorman and antees for bank loans. In addition, information Sahlman, 1989; Baum and Silverman, 2004; Hsu, asymmetries make it difficult for investors to iden- 2004). tify and evaluate the potential of these firms. The importance of angel investors has increased Traditionally there have been three sources of in recent years given the difficulties young inno- equity funding for young innovative firms: vative firms face in securing finance from other founders, family and friends; angel investors; and channels (Wilson, 2011). As a result of the finan- venture capitalists. cial crisis, banks are even more reluctant to fund young firms because of their perceived riskiness • The most common source of funding for new and lack of collateral (Wilson and Silva, 2013). ventures is the founders’ own capital, even if Meanwhile, venture capital firms are focusing that is funded through credit cards. Family and more on later-stage investments and have left a friends sometimes also provide finance to the significant funding gap at the seed and early entrepreneur in the first phases of develop- stage. Angel investors, particularly those invest- ment of the start-up (seed stage). ing through groups or syndicates, are active in this • Angel investors are experienced entrepreneurs investment segment and thus help to fill this or business people that choose to invest their increasing financing gap. own funds into a new venture. They typically invest in seed and early stage ventures with Equity crowdfunding departs from the models of amounts ranging from $25,000 to $500,000. traditional angel investors and venture capital Angels invest not only for the potential finan- firms because transactions are intermediated by cial return, but in many cases to give back by an online platform. Some platforms play a more helping other entrepreneurs. active role in screening and evaluating companies • Venture capital is considered ‘professional’ than others (see section 4). Also, their role during equity, in the form of a fund run by general part- the investment and post-investment stages can Figure 3: The equity crowdfunding process

Investment stage Selection and valuation Investment Post-investment Exit

Shares online all Finds new Entrepreneur Submits application relevant sources of information capital

Performs more Mentors and Screens Posts pitch Platform vetting and monitors the applications online releases funds company

Assess company Can participate Sell shares to Crowdinvestors and decide on and monitor the funding company new investors

Source: Bruegel. BRUEGEL POLICY Karen E. Wilson and Marco Testoni EQUITY CROWDFUNDING CONTRIBUTION 05 vary dramatically. While there is a great deal of Another characteristic that equity crowdfunding variation among the approaches adopted by the has in common with angel investors is that finan- different platforms (Collins and Pierrakis, 2012), cial return is not the sole motive for an investment. equity crowdfunding platforms generally follow Crowdfunders might also derive social and emo- the phases described in Figure 3. tional benefits from financing a company. In other words, they are likely to be motivated to provide Platforms usually charge companies a fee, typi- funding to a company to be connected with an cally 5-10 percent of the amount raised, plus entrepreneurial venture that shares their own sometimes a fixed up-front fee. Some platforms values, vision or interests. A survey of Seedrs2 also charge fees to investors that are either fixed users revealed that the three top motivations for or a percentage of the amount invested or a per- investors to fund start-ups are the desire to help centage of the profit for investment. For example, new businesses get off the ground, the ability to charges entrepreneurs 5 percent plus exploit tax reliefs3, and the hope of achieving a £1,750 fee for successful fund raising. meaningful financial returns (, 2013). charges entrepreneurs a €250 registration fee plus 5 percent of the amount raised and charges In terms of investment preferences, venture cap- investors 2.5 percent of the amount invested. itals tend to concentrate on technology-based Seedrs charges entrepreneurs 7.5 percent of the companies, which typically are high-risk/high- amounts raised and charges investors 7.5 percent return investments. Angel investors tend to invest of the profits from the investment. in a wider range of sectors and geographies, cov- ering some investment segments in which ven- To understand how equity crowdfunding can com- ture capital typically would not invest (Wilson, plement the market incumbents in seed and 2011). Because the crowd might encompass early-stage finance, we have to consider charac- quite heterogeneous investment motives, the teristics such as investment size, investment investment spectrum of equity crowdfunding can motives, the risk/return profile, the investment be even broader. For example, Seedrs users have model and investor characteristics. invested in sectors as diverse as food and drink, high-tech, art and music, fashion and apparel, real Figure 4 shows the funding per project in equity- estate and many others (Seedrs, 2014). The fact 1. Nevertheless, this based crowdfunding. Compared to the other that crowdinvestors derive also non-financial ben- distribution might not sources of finance described above, we can see efits from the investment implies that they might reflect simply the that equity crowdfunding mostly operates in the also be willing to accept higher risks or lower investment preferences of the crowd. Legal constraints financing segment covered by angel investors1. returns than an investor seeking to maximise currently provide upper financial returns (Collins and Pierrakis, 2012). limits to the capital that can Figure 4: Funds paid out per equity-based be raised from non- project (2011) Unlike venture capital and angel investment, qualified investors. See section 4. 30% equity crowdfunding requires entrepreneurs to publicly disclose their business idea and strategy. 2. Seedrs is an equity 25% This early information disclosure might be harmful crowdfunding platform based in the United 20% for firms with an innovative business model that Kingdom. It allows users to 15% can be easily imitated (Hemer, 2011; Agrawal et invest as little as £10 into al, 2013; Hornuf and Schwienbacher, 2014a). the start-ups. In the first 18 10% Therefore, crowdfunding might be most beneficial months since its launch in July 2012, Seedrs collected 5% for start-ups that can protect their intellectual cap- more than €6.8 million ital through means other than secrecy, or for start- through 56 funded 0% ups whose business is not particularly innovative. campaigns and counted more than 29,000 users. <$10,000 >$250,001 Another common element shared by business 3. In particular, the Seed Enterprise Investment $10,001-$25,000 $25,001-$50,000 angels and crowdinvestors is that neither type of $50,001-$100,000 $100,001-$250,000 financing model necessarily involves an active Scheme (SEIS) launched by Source: Bruegel on the basis of Crowdfunding Industry the UK government in April Report 2012 (Massolution). financial intermediary that makes the investment 2012. BRUEGEL POLICY CONTRIBUTION EQUITY CROWDFUNDING Karen E. Wilson and Marco Testoni 06

decisions. Venture capital firms pool financial the average distance between a revenue-sharing commitments from institutional investors into crowdfunding platform's entrepreneurs and funds and then select a portfolio of companies investors was approximately 3,000 miles (4,828 over time in which they invest. For angel investors km). According to their study, only 13.5 percent of and crowdinvestors, the decision to finance a the investors provided funds to entrepreneurs company is ultimately made by the individual within 50 km. investor. Some equity crowdfunding platforms pool the funds of the crowd into an investment Table 1 summarises the key characteristics of vehicle and act towards the company as the rep- equity crowdfunders, angel investors and venture resentative of the interests of the crowd. However, capitalists, highlighting their similarities and dif- even in this case the platform does not act as a ferences. financial intermediary in portfolio management for the crowd, and the decision to invest in a specific Overall, equity crowdfunding can provide a com- company is taken by the individual investor. plementary channel through which start-ups can obtain finance. In addition, equity crowdfunding While angel investors are typically high net worth can provide some advantages by fully exploiting individuals who are sophisticated investors, the potential of the internet. crowdinvestors are individuals that might or might not have experience and knowledge of financial For example, crowdfunding allows a start-up to markets and early-stage financing. Moreover, gain online visibility in the first phases of its devel- while angel investors tend to invest locally, crowd- opment. As crowdinvestors are also potential con- investors might invest in start-ups that are quite sumers, an entrepreneur can benefit from distant from them. Agrawal et al (2011) show that crowdfunding through early advertisement of its Table 1: Key characteristics of equity crowdfunders, business angels and venture capitalists Equity crowdfunders Business angels Venture capitalists Background Many different backgrounds, Former entrepreneurs Finance, consulting, some many have no investment from industry experience Investment approach Investing own money Investing own money Managing a fund and/or investing other people’s money Investment stage Seed and early stage Seed and early stage Range of seed, early-stage and later-stage but increasingly later-stage Investment instruments Common shares Common shares (often due Preferred shares regulatory restrictions) Deal flow Through web platform Through social networks Through social networks as and/or angel groups/networks well as proactive outreach Due diligence Conducted by individual, if at Conducted by angel investors Conducted by staff in VC firm all, and sometimes by the based on their own experience sometimes with the platform assistance of outside firms (law firms, etc.) Geographic proximity of Investments made online: Most investments are local Invest nationally and investments most investors are quite (within a few hours’ drive) increasingly internationally distant from the venture with local partners Post investment role Depends on the individual Active, hands-on Board seat, strategic investor, but most remain pas- sive. Some platforms repre- sent the interests of the crowd Return on investment Financial return important but Financial return important but Financial return critical. The VC and motivations for not the only reason for not the main reason for angel fund must provide decent investment investing investing returns to existing investors to enable them to raise a new fund (and therefore stay in business) Source: adapted from Wilson (2011). BRUEGEL POLICY Karen E. Wilson and Marco Testoni EQUITY CROWDFUNDING CONTRIBUTION 07 products and by obtaining information on poten- average individual is not aware of the risks. tial market demand and product preferences (Agrawal et al, 2013; Hornuf and Schwienbacher, The characteristics of crowdfunding can make 2014a). This early assessment of demand could investments in seed and early-stage companies help to reduce inefficient investments in start-ups even riskier. Information asymmetry problems with weak business potential. common to seed and early-stage financing are exacerbated in equity crowdfunding. Below we Compared with traditional angel investing transac- describe some of the issues that might arise in tions that rely mostly on word-of-mouth, crowd- each phase of the investment. funding can improve the efficiency of the market by enabling faster and better investor-company Selection and valuation matches. Moreover, geographical factors that might affect traditional forms of seed and early-stage Before investing in a company, business angels financing might be less important in crowdfunding and venture capitalists routinely perform due dili- (Mollick, 2013a; Agrawal et al, 2011 and 2013). gence to assess the potential value of the firm. This can be costly in terms of time and resources. Finally, the crowdfunding industry is well-posi- However, evidence shows that due diligence is a tioned to benefit from the so-called 'big data' par- major determinant in achieving returns on the adigm (Agrawal et al, 2013). Being online-based, investment (Wiltbanks and Boeker, 2007). This crowdfunding deals leave data trails on investors, expense is often justified in light of the consider- entrepreneurs, companies and deals, unlike angel able size of such investments. Because their investment and even most venture capital trans- investments are relatively small, crowdinvestors actions. Through time, the analysis of this data have less incentive to perform due diligence. could enable crowdfunding platforms to provide Moreover, individual investors have the possibil- better matches between investors and compa- ity of free-riding on the investment decisions of nies and maximise the correlation between the others. This implies that the crowdfunding com- crowd and product demand. munity may systematically underinvest in due diligence (Agrawal et al, 2013). 4 RISKS IN EQUITY CROWDFUNDING Crowdfunders also likely lack the expertise and Seed and early-stage financing can be high risk skills to perform adequate due diligence. Since but with the hope of a high return. Eurostat data4 everyone is able to join, the crowd often includes show that in EU the one-year survival rate for all non-professional investors, who do not have the enterprises created in 2009 was 81 percent, while knowledge or capabilities to properly estimate the the five-year survival rate of all enterprises started value of a company. 4. Business demography in 2005 was only 46 percent. Despite the statistics, available at: expertise of professional investors, the risk of Finally, company valuation performed by a crowd http://epp.eurostat.ec.europ investing in start-ups remains high. Shikhar might be affected by social biases and herding a.eu/statistics_explained/in Ghosh, senior lecturer at Harvard Business School, behaviour5. Evidence suggests that a crowdfun- dex.php/Business_demog- raphy_statistics. analysed data from more than 2,000 US der’s investment decision might be affected by companies that received venture financing and those of the other investors (Agrawal et al, 2011; 5. However, valuation per- formed by the crowd might found that about 30-40 percent of them fail, while Kuppuswamy and Bayus, 2013). Moreover, dif- also benefit from the so- more than 95 percent fail to generate the expected ferent studies have found that both the crowd and called ‘wisdom of crowds’ return on investment (WSJ, 2012). There is a entrepreneurs are typically initially overoptimistic (Surowiecki, 2005). Accord- misconception about success rates and returns about potential outcomes (Mollick, 2013b; ing to this theory, a crowd could make efficient invest- on investment in start-ups (Shane, 2008) and the Agrawal et al, 2013). ment decisions because individual decision-making errors could cancel each ‘Despite the expertise of professional investors, the risk of investing in start-ups remains high. other out on the aggregate There is a misconception about success rates and returns on investment in start-ups and the level (Hornuf and Schwien- bacher, 2014a; Agrawal et average individual is not aware of the risks.’ al, 2013). BRUEGEL POLICY CONTRIBUTION EQUITY CROWDFUNDING Karen E. Wilson and Marco Testoni 08

Investment less incentive to provide active support to the company because the return for their action is Equity crowdfunding often relies on standardised lower (Agrawal et al, 2013). However, if too many contracts that are provided by the portal. However, investors choose to become active, it could be equity investment into seed and early-stage firms excessively costly for a small firm to manage a often requires tailored contracts to align the inter- crowd of investors that want to participate. This is ests of the entrepreneur to those of the investor. particularly relevant considering that the venture For example, venture capital and business angels has limited ability to select its crowdinvestors. use various covenants in their contracts, such as anti-dilution provisions that protect against down- Moreover, high information asymmetry also char- rounds6, tag-along rights7 that facilitate exit oppor- acterises the post-investment phase, thus limit- tunities, and liquidation preferences that secure ing the monitoring potential of the crowd. One of higher priority in the distribution of value (Hornuf the elements contributing to the increase in infor- and Schwienbacher, 2014a). Moreover, in order to mation asymmetry is geographical distance reduce risk exposure and increase control over the between funders and the entrepreneur. While this entrepreneur’s behaviour, seed and early-stage characteristic enables backers to attain access to investors often split their investments into a wider pool of entrepreneurs (and visa-versa), it tranches that are conditional on the attainment of also entails higher monitoring costs. Literature defined milestones. All of these mechanisms are suggests that distance increases the costs that an difficult to replicate in the crowdfunding setting. investor must bear in order to monitor the venture (Grote and Umber, 2007). This is in line with the Another strategy applied by venture capitalists observation that venture capital funds invest pre- and business angels is to invest in a portfolio of dominantly in firms close to them (Lerner, 1995). companies in order to diversify their risk. Equity crowdfunders might be able to replicate this strat- Finally, the lack of repeated interactions reduces egy given that crowdfunding platforms expose the potential of reputation as a mechanism to them to a variety of projects. However, non-pro- incentivise the entrepreneur to behave in line with fessional investors might not be aware of the the interests of the investor (Agrawal et al, 2013). importance of this strategy and could potentially In other online marketplaces, such as eBay, concentrate all their investments in a single ven- participants have a low incentive to misbehave ture. For example, Seedrs statistics show that 41 because, if they do, they might, in effect, be percent of investors hold only one company in prevented from participating in the market in the their portfolio (Seedrs, 2014). future because of the feedback and ratings mechanisms. Since sourcing equity finance Moreover, crowdfunders might not be able to par- through the internet is often a one-time event for ticipate in follow-on investment rounds. The fail- an entrepreneur, the incentives for behaving ure to do so might mean that the investor’s shares correctly are lower, which can lead to potential get diluted, thus reducing their chances to attain a fraud. More active crowdfunding platforms screen 6. A round of financing in positive return from the investment. companies. However, not all platforms have the which investors purchase stock from a company at a same standards. lower valuation than the Post-investment support and monitoring valuation placed upon the Exit company by earlier As we have described, business angels and ven- investors. ture capitalists not only provide finance to start- The lack of adequate monitoring is particularly 7. A contractual obligation ups, but are also actively involved in increasing worrisome in a setting in which investments often used to protect a minority shareholder. If a majority the value of the company. While the crowd could take 5-10 years or more to produce a return, if any. shareholder sells his or her potentially provide active support to the venture, Crowd investors might not appreciate that long stake, then the minority there are reasons to believe that this support can periods are necessary for these investments to shareholder has the right to be less valuable than that provided by traditional either succeed or fail, or that most of these invest- join the transaction and sell seed and early-stage financiers. Given their typi- ments are unlikely to yield any return. Moreover, his or her minority stake in the company. cal small level of investment, crowdfunders have equity investments are mostly long-term illiquid BRUEGEL POLICY Karen E. Wilson and Marco Testoni EQUITY CROWDFUNDING CONTRIBUTION 09 assets. Therefore, it is important that non-profes- 5 CROWDFUNDING PLATFORMS AND THE sional investors are adequately informed about REGULATORY ENVIRONMENT the illiquid characteristics of this asset class. The issues we have raised demonstrate the greater For equity investments to provide a return to exposure that equity crowdfunding market has investors, a positive 'exit' must take place at some compared to other forms of seed and early-stage point. This can be through an initial public offering investment. In particular, adverse selection prob- (IPO) or, as more often the case, through a merger lems could increase the cost of capital up to the or acquisition (M&A). Unfortunately, these posi- point at which only low-quality ventures will even- tive exits became increasingly rare during the tually choose to seek financing through crowd- financial crisis. In Europe, EVCA data (2013) funding, while high-quality ventures will continue shows that only 15 percent of venture capital exits to secure venture capital or angel investor financing in 2012 (in terms of number of companies) were (Agrawal et al, 2013). Competition between plat- through trade sales, and even fewer, 5 percent, forms and between the crowdfunding industry and were IPOs. These numbers are clearly lower than traditional financing is pushing platforms to design pre-crisis (2007) figures that pointed to 22 per- innovative solutions to avoid the unintended con- cent of exits through trade sales and 8 percent sequence of creating a ‘market for lemons’. through IPOs. Overall, the main limitation of equity crowdfund- For angel investments and equity crowdfunding ing is that it allows a non-professional investor, investments, the path to a positive exit can be who might lack the incentive and/or capabilities to longer and even less likely. IPOs and M&As do not adequately assess and monitor a start-up, to happen by chance. Venture capitalists and the make an investment. Efforts to address this limi- firms themselves often have an exit strategy in tation to date have included the introduction of an mind from the beginning and proactively work intermediary between the crowd and the company towards making it a reality over a long period that is able to perform these tasks, or the reduc- (Wilson and Silva, 2013). tion of the crowd to only qualified investors.

In conclusion, the lack of adequate pre-invest- The first approach involves the provision of an ment screening and due diligence, weaker invest- active intermediary that could act as a represen- ment contracts and poorer post-investment tative of the interests of the crowd in performing support and monitoring can make the risk associ- due diligence and monitoring start-ups. Following ated with equity crowdfunding significantly higher this trend, many platforms are active in performing than the risk usually borne by business angels due diligence, while others operate a nominee and and venture capitals. Moreover, while the poten- management system in which they represent the tial for fraud is exacerbated in the equity crowd- interests of investors with the crowdfunded busi- funding setting, information asymmetry makes ness (eg Seedrs). Another example is provided by investments in the start-ups of even well-inten- platforms such as MyMicroInvest in Belgium, tioned entrepreneurs riskier, since the compe- which allows investors to co-invest with an expe- tence of the entrepreneur and the quality of the rienced business angel. In this case, the crowd business plan cannot be properly assessed. benefits from the financial contracting skills and from the post-investment monitoring of an expe- While there are some successful equity crowd- rienced active investor. While this approach pro- 8. www.antabio.com. funding cases (such as the biotech start-up vides some benefits, it also entails some risks: by 9. http://blog.seedmatch.de/ Antabio8 in France, which succeeded in producing leveraging the investment decisions of a business 2013/08/16/betandsleep- a positive return for its investors) and failure cases angel, this mechanism may increase the risk stellt-den-geschaeftsbetrieb- (such as the liquidation of betandsleep9 or propensity of the angel, thus biasing his or her ein/. sporTrade10 in Germany), the industry still lacks a investment decisions. 10. https://www.com- sufficient track record to assess its ability to panisto.com/en/news/vorl% create value for both investors and entrepreneurs. A second approach is to reduce the crowd, by C3%A4ufige-insolvenz-der- sportrade-gmbh-article- limiting the investment to a restricted group of 469. BRUEGEL POLICY CONTRIBUTION EQUITY CROWDFUNDING Karen E. Wilson and Marco Testoni 10

people, possibly accredited investors, each From a legal standpoint, equity crowdfunding is contributing more capital than the average crowd currently possible in some jurisdictions by exploit- investor. In this case, crowdinvesting would more ing exemptions to existing securities regulations closely resemble angel investor groups than the (Hornuf and Schwienbacher, 2014b). Securities typical crowdfunding model. Examples of this laws generally require an issuer to register with model are CircleUp and FundersClub in the US or the national securities authority and to comply based in Ireland, whose offers are with strict reporting standards in order to gain restricted to accredited investors. Other examples access to the general public. These requirements are platforms that impose high investment are prohibitively expensive for small firms, which minimums, thus reducing the crowd to a few are the typical beneficiaries of crowdfunding. investors. Finally, some platforms (such as Seedrs and Crowdcube in the UK) require crowdinvestors In the EU, exemptions as defined in national regu- to pass a test before investing in a company, to lations pertaining to prospectus and registration certify that they are sufficiently aware of the requirements, allow start-ups to gain access to the investment risk. general public through equity crowdfunding (Hornuf and Schwienbacher, 2014b). Exemptions The efficacy of these measures needs to be evalu- include the maximum amount that can be offered ated and appropriate policies should take into to the public, the maximum number of investors account these assessments. Moreover, while the to whom the offer is made, the minimum contri- market gives incentives to platforms to adopt the bution imposed on investors and whether the offer best practice, some platforms could deviate from is made to ‘qualified’ or ‘accredited’ investors. the best practices because of lack of long-term While these exemptions to existing securities leg- vision, incompetence or other hidden interests islation allow small firms access to the general (Griffin, 2012). The financial crisis showed that public for financing, they also imply weaker pro- leaving the financial market to self-regulate can be tections for investors. costly. Many of these crowdinvestors could lose their money before the market has time to self-cor- EU member states have adopted different practices rect and force out inadequate platform models. on whether the equity crowdfunding platform must register as an investment intermediary or obtain a Crowdfunding platforms have an incentive to build bank license. For example, in Germany, crowdin- a good reputation by securing attractive deals for vesting platforms explicitly stating that they do not their crowds, since in the long run reputation provide any investment advice or brokerage serv- results in market-share gains. Apart from this rep- ice have no obligation to provide any documenta- utational incentive, platforms differ in the struc- tion in terms of advisory records or to act in the ture of fees they derive from the deals. As interest of the investor (Dapp and Laskawi, 2014). described in section 2, most of the platforms As a result, most German platforms are not regis- derive revenues as a percentage of the amount tered as investment intermediaries (ECN, 2013). In raised, while only a few (eg Seedrs) derive mone- the UK, platforms are regulated by the Financial tary benefit from a successful exit by imposing a Conduct Authority (FCA) (ECN, 2013; Hornuf and fee as a percentage of investor’s profits. This typ- Schwienbacher, 2014b). In France, equity crowd- ical fee structure implies that platforms derive funding platforms such as Wiseed, Anaxago, monetary incentive to close deals while there are Finance Utile and SmartAngels are registered as only reputational incentives to provide success- financial investment advisers, since their activities ful deals in the long run. If long-run reputational consist of advice in providing financing (ECN, 2013; incentives are lower than short-term monetary Hornuf and Schwienbacher, 2014b). incentives, conflicts of interest could arise and platforms might downplay investment risk to the Finally, national corporate laws can also have an crowd in order to secure deals. In light of this effect on equity crowdfunding (De Buysere et al, potential conflict of interest, a supervisory body 2012; Hornuf and Schwienbacher, 2014b). For for crowdfunding platforms is probably desirable. example, because they are relatively inexpensive in most countries, closely held company types BRUEGEL POLICY Karen E. Wilson and Marco Testoni EQUITY CROWDFUNDING CONTRIBUTION 11

(eg private limited liabilities companies) are the formalities, such as notarial intervention, which typical entity type chosen by start-ups. However, increases the costs for start-ups. in many countries these company types have lim- itations or might be prohibited from offering equity Despite the harmonising role played by Directive to new investors. Even when allowed, equity trans- 2010/73/EU (Box 1), the EU remains a patchwork actions for these kinds of companies often require of different regulations. This lack of uniformity

Box 1: EU legislation Prospectus Directive 2010/73/EU of 24 November 2010 (amending Directive 2003/71/EC) states that exemptions to publishing a prospectus apply if at least one of the following conditions is met: • The offer is addressed solely to qualified investors; • The offer is addressed to fewer than 150 natural or legal persons per member state, other than qualified investors; • Investors purchase securities for a total consideration of at least €100,000 per investor; • The denomination per unit amounts to at least €100,000; • Or the offer of securities represents a total consideration of less than €100,000 over a 12-month period. The Directive also states that national regulators can raise this threshold up to €5,000,000. Accordingly, this threshold varies among member states. For example, in Italy innovative start-ups complying with the law can offer securities of up to €5,000,000, while in Germany this value is set to €100,000 (see ECN, 2013, and Hornuf and Schwienbacher, 2014b, for an overview of the leg- islation in different EU member states).

Box 2: US legislation In the US, as a general rule, securities offered to the general public must be registered with the Secu- rities and Exchange Commission (SEC). A notable exemption to this rule are offers made to accred- ited investors – individuals with a net worth of at least $1,000,000 or who have income of at least $200,000 – who are supposed to be able to ‘fend for themselves’. Apart from this, US legislation pre- viously allowed for few exceptions, making equity crowdfunding practically inoperable (Griffin, 2012). The situation changed on 5 April 2012 when President Obama signed into law the Jumpstart Our Business Startups (JOBS) Act. Under this act, issuers are not required to file a registration state- ment with the SEC or at the state level if: • The amount raised does not exceed $1,000,000 during a 12-month period; • The transaction is conducted through a broker or funding portal registered with the SEC; • The amount sold to a single investor does not exceed the greater of either $2,000 or 5 percent of the annual income or net worth of such investor if either the annual income or the net worth of the investor is less than $100,000, and 10 percent of the annual income or net worth of such investor if either the annual income or net worth of the investor is equal to or more than $100,000. In any case, the maximum aggregate amount sold to a single investor shall not exceed $100,000; • The issuer discloses the required information to potential investors. In particular, if the aggregate target offering amount is equal to or below $100,000, issuers must provide their most recent income tax returns and financial statements, which must be certified by the principal executive officer of the issuer. For issues of more than $100,000 but less than $500,000, financial state- ments must be provided and reviewed by a public accountant, who should be independent from the issuer. Furthermore, the accountant must use professional standards and procedures for the review. For issues of more than $500,000, audited financial statements must be provided by the issuer. Despite the approval of the JOBS Act, this new regulation is still not active, as the SEC has not yet implemented the specific rules. As a result of this delay, so far equity crowdfunding deals have not taken place in the US and existing crowdinvesting portals adopted structures similar to angel-invest- ing networks, where only accredited investors can participate. BRUEGEL POLICY CONTRIBUTION EQUITY CROWDFUNDING Karen E. Wilson and Marco Testoni 12

inhibits the development of a pan-European alongside professional investors. However, also in industry by making cross-border deals more diffi- this case, the platform should take significant cult, and highlights the lack of consensus on steps to protect the interests of the crowd from the whether equity crowdfunding could be welfare- misbehaviour of other investors. Finally, in order enhancing or not. to monitor potential conflicts of interest of plat- forms, supervision by national security authori- 6 CONSIDERATIONS FOR POLICYMAKERS ties is important.

Crowdfunding can be an additional tool for provid- Crowdfunding currently is a highly deregulated ing seed and early-stage equity finance to new market with little legal protection provided to fun- ventures. However, policymakers should proceed ders. In the EU, some member states have intro- with caution by carefully assessing the risks of this duced ad-hoc legislation for crowdfunding, while new financial intermediation tool. We argue that the some others will introduce new laws soon. The challenges that equity crowdfunding poses are dis- European Commission is currently studying tinct and more complex than those posed by other equity crowdfunding, along with the other forms forms of crowdfunding. As we have outlined, the of crowdfunding, to assess its risks and opportu- risks also differ from other forms of seed and early- nities. In this regard, the Commission started a stage equity finance, such as angel investing and public consultation late in 2013 and published a venture capital. Equity crowdfunding can open up Communication in March 2014 (EC, 2014). At this additional channels for new ventures to access stage, the Commission’s efforts are focused on finance at a time when securing funding is difficult, increasing awareness of the opportunities and but the risks, including those related to investor risks of crowdfunding, spreading best practice and protection, need to be addressed. improving the general understanding of this grow- ing phenomenon. The Commission is also explor- These risks could result from potential fraudulent ing the potential of a ‘quality label’ to spread good activities of start-ups or platforms or, more likely, practice and build user confidence. poor investment decisions made by unsophisti- cated investors. The current legal framework Being based online, equity crowdfunding has the mainly addresses this issue by reducing the expo- potential to contribute to a pan-European seed sure that individual investors can have to riskier and early-stage financial market to support Euro- assets. The goal is to make sure that the investor pean start-ups. However, in order to maximise this is able to bear a potential loss. However, as the benefit, harmonised policies to address equity equity crowdfunding volumes continue to grow, crowdfunding models should be adopted in this solution does not prevent the potential loss of common by all member states. This approach significant amounts of capital. would maximise the benefits of equity crowd- funding and help to reduce the risks. We urge the Overall, the legal framework should not allow a Commission to work with member states to crowd of investors, who might lack the incentive address the current patchwork of national legal and/or the expertise to invest in a start-up, to do frameworks, which constitute an obstacle to the so without adequate intermediation and protec- development of this nascent model of funding tion. If the crowd is made up of non-qualified across Europe. investors, we argue that there should be at least one participant that legally represents the inter- Finally, legislators should take a holistic approach est of the crowd in the investment in a business. in assessing the regulatory burden on the indus- This participant could be the crowdfunding plat- try. Corporate law in many countries imposes lim- form. The crowd could also be allowed to co-invest itations or prohibits closely held company types –

‘Crowdfunding can be an additional tool for providing seed and early-stage equity finance to new ventures, but policymakers should proceed with caution by carefully assessing the risks of this new financial intermediation tool.’ BRUEGEL POLICY Karen E. Wilson and Marco Testoni EQUITY CROWDFUNDING CONTRIBUTION 13 the typical legal form chosen by start-ups – from In conclusion, all types of crowdfunding can pro- selling equity to new investors. These provisions vide significant and new sources of funding for are another significant obstacle to the develop- many types of organisations, ranging from chari- ment of equity crowdfunding. Corporate laws ties to companies. Equity crowdfunding, however, should be harmonised and should take into is more complex and requires the proper checks account this new financing channel for start-ups. and balances if it is to provide a viable channel for In addition, other financial regulations which might financial intermediation in the seed and early- interact with and have an impact on the market stage market in Europe. should be assessed.

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