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Improving the Role of Equity Crowdfunding in Europe's Capital Markets

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Improving the Role of Equity Crowdfunding in Europe's Capital Markets BRUEGEL POLICY CONTRIBUTION ISSUE 2014/09 AUGUST 2014 IMPROVING THE ROLE OF EQUITY CROWDFUNDING 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, equity crowdfunding 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 venture capital 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.
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