Crowdfunding as a Modern alternative to Start-Up Financing: Considerations for African Countries towards Regulation

By Andrew Wandera

Why Cowdfunding?
In this age of disruptions, start-ups with untested products frequently find it difficult to raise capital. Start-ups have greatly defined themselves as drivers of innovation and job creation hence the need for policy makers need to address any funding gaps that arise in start-up financing. With the aid of the internet, a new form of financing start-ups has evolved known as crowdfunding. This form of financing involves raising capital from a several individuals each of whom contributes a certain amount to the desired capital. This has been facilitated by the internet that has eased the dissemination of information without limitations as to geographical locations.

The availability and growth of crowdfunding is very exciting for start-ups although it is accompanied with uncertainties for those providing the funding. Most of the funders on these crowdfunding platforms are unsophisticated investors with limited capacity to assess the prospects of start-ups which high risky ventures hence higher chances of making uninformed investment choices. The need to help start-ups raise capital and the need to protect the interests of the investors on crowdfunding platforms raises important concerns to be addressed by regulators. The evolution of crowdfunding offers a modern alternative to the challenges of start-up financing and I will highlight some of the challenges below.

One of unfortunate facts is that most start-ups fail, so it is a risky endeavor to invest in. In most cases the profitability of the venture is based on future estimates of market size, opportunism and future production. Such uncertainties emphasize the problems with structuring any financing arrangement. The realities of raising finance set in when funders have exhausted their personal savings and personal credit facilities. Since start-ups do not have liquid assets to offer as security and do not generate steady cash flow to pay interest, they are unattractive for corporate debt financing.

In consideration of venture capital and business angels who are very much involved in the ecosystem of start-up financing, their investment model is designed to accommodate particular challenges of start-up financing and desire to take control rights of the start-up in order to influence decision making. As much as venture capitalists have revolutionalized financing of these high risk but potentially high reward projects, their expertise is short in supply and their investment model requires geographic proximity for the investor to participate in decision making. Another form of financing that would be considered by start-ups would be raising capital by making public offer which involves significant costs associated with compliance of securities laws. Such requirements of compliance put raising capital from regulated markets far beyond the reach of start-ups. With all the above constraints to financing start-ups, crowdfunding offers a better alternative to meeting the demands of start-up financing to access outside finance.

The rise and prominence of crowdfunding is greatly associated with funding of charitable projects and social causes. In this case funders would make monetary contributions to such projects without expectations of any returns other than the satisfaction of knowing the project would be pursued and implemented. It is upon that background that entrepreneurs noticed that significant amounts of money were being raised on the crowd hence the evolution of crowdfunding forms that focus on funding of start-ups and other commercial projects.

The nature of crowdfunding creates a contractual relationship between an individual investor and the entrepreneur. The contract created is on terms offered to individual investors by the entrepreneur with the assistance of a crowdfunding platform that establishes a marketplace of crowdfunding offerings. Since this article is on start-up financing, my focus will be on the nature of relationship created under equity crowdfunding and reward crowdfunding.

Reward crowdfunding model promises funders a tangible or nonfinancial return on their investment and with most startups the reward commonly promised is the product of the start-up when it’s ready. In contrast, an equity crowdfunding model enables investors to buy shares in the start-up.

The Realities of Equity Crowdfunding
Equity crowdfunding is a good response to combat challenges of early stage start-up financing and it’s promising to be a major form for start-up financing. However what is not certain in this model is investor (funder) protection. In consideration of the fact that crowdfunding platforms attract different funders on the crowdfunding platform, most crowdfunding investors lack the sophisticated expertise about prospects of the business projects they back which makes them vulnerable to making uninformed and poor decisions. More so when they make these investments their stake in participating in the decision making of the start-up is not guaranteed which may necessitate them to incur agency costs after the investment is made.

The accuracy of the pricing on equity crowdfunding platforms is also questionable since price formation and the considerations informing a price is a preserve of the issuer. In equity crowdfunding the prices do not reflect available information in the markets and investors have no opportunity to analyse the prices in relation to public available information and events. Therefore the market price is the best available estimate of the securities’ value on the crowdfunding platform.
The issuer under equity crowdfunding literally offers the securities directly to retail investors without any “bookbuilding” process as required under an initial public offering. The crowdfunding platform offers information about the company’s self-produced valuation, the percentage of equity it represents based on the valuation, the business plan and the target amount expected from the crowd. As the campaign progresses, information about how much the crowd has already committed and how many investors have already committed to the funding is also made available to the crowd.

With the availability of the information of how much has been committed and how many investors are backing the project, a crowd that is largely characterized by non sophisticated investors is likely to make decisions of their investment based on the number of backers on a given project without making individual analysis about the prospects of the project. This will then result into herding which may cause losses to the investors in the long run. The practice on an equity crowdfunding platform is that the price never reacts to changes in response to demand and never reflects informed investors’ bids.
Herding has become a notion that determines a project’s success meeting its funding targets. This explains why momentum is important to the success of crowd funding projects; in that if a significant number of funders can back the project then others will also join on the basis that the earlier investors made the right judgment. Therefore it is common for projects which do not get initial support to meet their funding targets.
During herding, funders as a group tend to attach great significance to the decision taken by early arrivals of funders that back the project hence the uninformed decision- making. Herding consequently results into misallocation of resources and over investment in projects for which prospects are weak. On the other hand some projects which have strong prospects may end up being underinvested.

Another factor which may also inform the decision of the funders is the amount of time for which an offer has remained open. If an offer has remained open and has not attracted reasonable investment, it is most likely that funders considering it will assume that the number of persons who have passed it over is large and so it won’t be worthy to invest in. Furthermore, most of the initial investors will be friends and family of the founders of the project whose decision to invest is most times biased with favour; if such conduct is coupled with herding then the decision of the funders to invest will be greatly misinformed.

The Realities of Reward Crowdfunding
As earlier explained, reward crowdfunding involves raising finances from a start-up’s prospective customers who are promised units of the product in return for their funding and the start-up contracts directly with the funders. The founder of the project makes available information about the nature and quality of the product and prospects of its delivery to the funder. This creates a risk sharing contractual relationship between the funder and the entrepreneur.
In this case the funders accept to fund a project largely because of its innovative character even when they are not certain of the success of the project. The conviction that they (funders) are part of something bigger informs their decision to invest and share the risk with the founders (start-up). Clause 5 of Kickstarter a popular reward crowdfunding platform terms of use provide an example of the structuring of the risk-sharing between the funder and the start-up. The clause is to the effect that the date listed on each reward is the creator’s estimate of when they will provide the reward and it’s not a guarantee to fulfill by that date. An obligation is also imputed on the entrepreneur under clause 4 of the terms of use of Kickstarter makes it a sole responsibility of the entrepreneur to fulfill their reward obligation. To fulfill this responsibility, the entrepreneur is under an obligation to update the backers about what work was done or is being done, how the funds are being used and what may prevent them from finishing the project as planned if any.

It is therefore important to understand that reward crowdfunding platforms are not online stores. Once a person backs a project on the platform, the person should understand they are helping to create something new but not ordering for something that already exists. Therefore the risk that something can prevent the creator from finishing the project should be borne in the funder’s decision as they back a project on the platform.

Benchmarking the Regulatory regime of Crowdfunding in UK and US: Lessons Africa Crowdfunding Association and African States
As crowdfunding continues to be a promising alternative to start-up financing, the regulators in Africa are taking a wait and see approach. The Africa Crowdfunding Association is however making commendable efforts of lobbying for crowdfunding legislation in African countries towards creating a more cohesive industry structure in Africa that protects investors and democratizes access to capital for all African start-ups.

As Africa moves towards regulating crowdfunding, it is important to draw lessons from UK’s regulation of crowdfunding especially equity crowdfunding which has proved a success over the years and US which is a leader in the provision of finance for innovation. The two countries have taken different approaches to regulation of crowdfunding which explains why United Kingdom has thrived in equity crowdfunding and United States has on the other hand thrived in reward based crowdfunding.

Regulation of Equity Crowdfunding in the United Kingdom and United States
Under the European Union’s Prospectus Directive, there is a permissive exemption that grants member states the discretion to regulate smaller offerings to the public amounting to 5 million Euros by a single firm in a 12-month period. The UK fully implemented this exemption to facilitate crowdfunding by exempting the issuers from the obligation to prepare a prospectus. This initiative saves start-ups a significant cost in meeting compliance requirements.

The Financial Conduct Authority authorizes the platforms offering equity crowdfunding in the UK because they carry out financial promotions and arrange deals in investments. In 2014 the Financial Conduct Authority introduced specific investor protection rules for equity crowdfunding platforms. The rules impose an obligation on the crowdfunding platforms to ensure that the financial promotions offered on the platform are fair and not misleading and to assess whether crowdfunding securities are appropriate for an investor client. The platform must also determine whether the investor has the necessary knowledge and experience to understand the risks involved in investing. This explains the common practice of most equity crowdfunding platforms that requires investors to answer automated tests about the nature of equity crowdfunding investments.

The Financial Conduct Authority of then introduced restrictions on the extent to which individuals may invest in equity crowdfunding. Therefore Equity Crowdfunding may only be offered to sophisticated investors or retail investors who certify that they have not invested and will not invest more than 10 percent of their net assets in non – readily realizable securities.

In regards to the United States, Title II of the JOBS Act of 2012 commenced the regulation of crowdfunding by requiring the US Securities and Exchange Commission to lift the ban on general solicitation to accredited investors. This therefore meant that entrepreneurs could use public means like the internet to solicit investments in their business provided that they prove that the investor is accredited. Pursuant to Title III of the JOBS Act, the US Securities and Exchange Commission (SEC) adopted the “Regulation Crowdfunding” which came into force in May 2016.
Title III of the JOBS Act also has investor protections which require the issuer to raise not more than $1 million in a given year, an issuer to make available their financials for review by an independent public accountant if raising between $100,000 and $500,000 and must be audited if raising more than $500,000. Regulation Crowdfunding sets out conditions for issuing which include conducting equity crowdfunding transactions through an intermediary registered with the SEC either as a broker or as an entity called a “funding portal” which must ensure that investors understand the risks involved.
The intermediaries must also have reasonable information that the issuer on their platform is in compliance with relevant regulation and should not allow access to issuers they believe may present potential for fraud. The officers and partners of the intermediary are also prohibited from taking any financial interest in issuers using the services of the intermediary to avoid conflict of interest.

In addition to the above requirements, there is also a requirement for mandatory disclosure. Equity Crowdfunding issuers in the United States file an extensive list of disclosures with the SEC and make them available to potential investors through the crowdfunding platform. These disclosures include financial statements for previous two years or the period since formation, whichever is shorter and a narrative discussion of the start-up’s historical results, liquidity and capital resources. Having completed an equity crowdfunding issue, the issuer is under an obligation to file annual reports with the SEC.

From the above appreciation of the two regulatory environments, it is evident that the United States imposes a burdensome regulatory regime for equity crowdfunding than does the United Kingdom. This explains why the UK’s equity crowdfunding platforms are thriving in the whole of Europe and beyond because the regulatory regime puts into consideration the unique needs of start-ups.

Regulation of Reward Crowdfunding in the UK and US
Contracts created under reward crowdfunding are undertakings to provide future services or to transfer title to future goods. In this case the funder bears part of the risk of business failure. Important to note is that under this contractual relationship, the funder should be aware that the contract can’t be settled by cash and there is no option for the funder to receive a return on investment that varies with the profitability of the business. With such a contractual relationship, reward crowdfunding offerings cannot be classified as financial instruments or securities.

It’s on the above understanding that explains why reward crowdfunding is not regulated as a public offer by the Financial Conduct Authority in the United Kingdom or as a securities offering by the United States Securities and Exchange Commission. Therefore such offerings are subject to general contract law and consumer protection laws.

In the United Kingdom, the Consumer Contracts (Information, Cancellation and Additional Charges) Regulations 2013 provides consumers with right of unconditional right to cancel. This right means that a consumer purchasing under a distance sales contract has an unconditional right to cancel the contract within 14 days of receipt of the goods and the supplier must reimburse the amount paid by the consumer. This means that start-ups offering products or services as rewards should be aware of the non-waivable rights of the funder in the event that the funder is not happy with the product or service.
In addition to that, the Unfair Trading Regulations 2008 make it a criminal offence of strict liability for sellers (read entrepreneurs) to make misleading statements or to omit material information in relation to consumer contracts. The implication of this provision is that costs of producing materials describing the reward crowdfunding offer will increase so as to avoid criminal liability.

The above provisions make reward crowdfunding unattractive to start-ups in the United Kingdom. This is so because the provisions do not put into consideration the unique nature of a reward crowdfunding contract that is characterized by risk- sharing between the funder and the start-up.
As earlier explained that reward crowdfunding is subject to contract law, in the United States contract law is a matter of state law. However it’s notable that all states have adopted the Uniform Commercial Code which governs sales contracts. This code provides that for standard remedies for late delivery and delivery of goods not matching their description or fitness for purpose and allows parties to waive such protections by express contractual provisions.
Just like contract law, consumer protection laws are also subject to state laws. Therefore most crowdfunding platforms reflect in their terms of use the different consumer protection laws of the states where they are domiciled. Furthermore most states have laws that prohibit deceptive acts or practices in consumer transactions.
In regards to consumer protection, in the case of State of Washington v Altius Management LLC King County Superior Court, Washington State, 22nd July 2015; the Attorney General of Washington represented Washington state citizens who had backed the defendant’s Kickstarter campaign and successfully obtained a default judgment under Washington’s general prohibition of deceptive acts in consumer transactions against a firm that had failed to deliver rewards or make communication on the accountability of funds after running a successful finding campaign on Kickstarter. At the time, the Terms of Use of Kickstarter provided that the founders of commercial projects were required to offer a refund if they were unable to fulfill the rewards and the judge reasoned that failure to fulfill the rewards was a violation and it was regarded a deceptive act to defraud the consumer. With a clear appreciation of the Terms of Use of Kickstarter by then, it’s clear that the backers of the project did not bare any risk therefore such a term was not considerate to the risks involved in start-ups and did not put into consideration the nature of reward crowdfunding contracts that are characterized by risk-sharing.

Following the above developments, Kickstarter modified its Terms of Use to provided that non-delivery would not be a breach provided the founder can account for how the funds have been spent in pursuit of the project. The current position of the terms of use of Kickstarter reflects on the risk-sharing nature of reward crowdfunding contracts.

Conclusion
Having understood how the two countries have approached regulation of equity crowdfunding and reward crowdfunding, it’s my conclusion that the regulatory environment determines what thrives and what doesn’t. The low activity of reward crowdfunding in the United Kingdom can be largely attributed to the consumer protection framework that makes it difficult to establish a risk-sharing agreement for reward crowdfunding which is not the case in the United States.

On the other hand, the mandatory disclosure obligations imposed by Securities law in the United States make it expensive for start-ups to launch equity crowdfunding campaigns in the United States and the exemption on small offers in the United Kingdom makes it affordable and convenient for start-ups to launch equity crowdfunding campaigns.

Therefore as Africa Crowdfunding Association continues to lobby African states to regulate and improve crowdfunding for financing of start-ups, the above approaches should be considered depending on the successes on the above benchmarked jurisdictions so as to come up with a progressive regulatory environment.

Andrew Wandera is a 4IR Lawyer and co-founder of Enset Tech.