European Institute

Alternative financing portals are proliferating throughout the European Union as more and more investors put their toes in the water of a new generation of high-risk start-ups they hope become a Skype, Rovio or Storify one day. With interest growing exponentially, though, questions are emerging about the adequacy of investor protections that new national regulations plan to address. The challenge ahead is to implement such protections without burdening entrepreneurs with regulatory overkill.

“Crowdfunding” is one way small businesses are raising money. ^[1] Investors pool small amounts of money through Internet-based platforms to provide capital to the companies they select from the crowdfunder’s roster. They do so without transaction costs that would otherwise make small investments prohibitively expensive. With other investors, they share thoughts on portfolio strategies, technology trends, and assessments of pioneering firms’ prospects.

For capital-starved start-ups, crowdfunding answers an urgent need to obtain funding at perhaps the most difficult point -- getting the business off the ground. Venture capitalists and angel investors find that initial stage unattractive, typically seeking far more advanced businesses. Their reason: they want to “cash out” with a stock offering within a reasonably short timeframe.

Behind this financing vehicle is the belief that wisdom emerges from a crowd. "[U]nder the right circumstances, groups are remarkably intelligent, and are often smarter than the smartest people in them," as explained by New Yorker business columnist James Surowiecki in his book The Wisdom of Crowds. Those companies who attract the largest crowd of investors tend to succeed, as research by Wharton management Professor Ethan Mollick suggests.^[2]

Critics dismiss these investments as fool’s gold – a “lottery” says one -- for unwitting investors. Companies may only be a dream, without workers, revenue, or products/services ready to market. Rapidly evolving technologies may make today’s brilliant idea obsolete as a consequence of breakthroughs (for example, ultra high-definition television) or strategy changes by the standard setters, such as Apple. The risks are high and the success rate low.  One blogger questioned a crowdfunder’s operations, noting the high failure rate and the platform’s exaggerated information about companies “to sex up the offer.” Given their infancy, too, empirical data is lacking to say which widget works best.

Worldwide, crowdfunding industry has raised $2.7 billion in 2012, across more than one-million individual campaigns globally. In 2013 the industry is projected to grow to $5.1 billion, according to The Crowdfunding Industry Report by Massolution. ^[3] In the U.K. alone, alternative finance intermediaries raised almost £1bn in 2012, an increase of 91% from the previous year’s figure of £492m, according to another report.^[4]

The UK-based Seedrs, is one example. Launched in 2012, it acts as an agent on behalf of investors who choose the companies they want to invest in. Investors own ordinary shares in the companies but hold those shares with Seedrs, their nominee.   In December alone, Seedrs announced it raised £3 million.    More than 27,000 members are registered, providing £4.5 million for 51 deals in the 17 months since Seedrs began. Co-founder and CEO Jeff Lynn recently expanded access to Seedrs to include investors living within the European Economic Area. He joins others with rapid growth plans, such as Fundedbyme, which is operational in eight countries.

One company seeking funding via Seedrs is GlassUps, a Modena, Italy, based company is one, creating eyeglasses that show emails, news, scores, directions, heart rates, etc.^[5] Designed to be like regular glasses, the eyewear projects images at the center of the eye for ease of reading. As of mid-January, it had raised seven percent of the £100,000 goal.

One rival of Seedrs, another UK-based platform, CrowdCube, allows investors to buy shares directly in the start-ups. Since its founding in 2010, it has raised £16.6 million for 86 businesses through its 56,000-plus investors, with nearly three-quarters raised just last year. Funding averaged £226,000 ($370,000 per company) last year.

“There are many EU platforms, bigger or smaller, such as Anaxago, Fundedbyme, Seedmatch, Symbid, Companisto, WiSEED, SmartAngels, Invesdor, Innovestment, etc., “ said Oliver Gajda, chairman of the European Crowdfunding Network , “but all with their own niches or sometimes leading approaches.” The network has played a key role in developing the political and regulatory discourse in Europe regarding crowdfunding.”

Under European law, EU member states can allow the raising of up to €5 million ($6.8 million) through equity crowdfunding platforms – but they can also set the limit as low as €100,000. Germany and France, for example, set their limits at €100,000. The UK or Italy, for example, set their cap far higher at €5 million.

Neelie Kroes, Vice-President of the European Commission responsible for the Digital Agenda, publically announced the EU’s support for crowdfunding at LeWeb in December 2012. In a subsequent speech, she said, “[W] e can make crowd-funding more visible, and more accessible: so people are more aware of not just the funding itself, but also the vibrant start-up culture it supports.”^[6]

Last October, Commissioner Michel Barnier put on the table the need for greater investor protections. "Do we need a single European framework to support both those who develop crowdfunding platforms and to reduce the risks to those who make use of such platforms to finance projects?" he asked.^[7] The European Commission is preparing a communication on crowdfunding to be issued in 2014. ^[8] However, regulation on EU level is not yet being discussed and it remains unlikely before 2015.^[9] The European Securities and Markets Authority is working with national regulators to explore crowdfunding and the International Organization of Securities Commission is also developing “guidance” that may inform future regulation.

Of all EU member-states only Italy has already specific crowdfunding regulations. Some of the other member-states are now revising their regulation with regard to crowdfunding, such as the UK and France, or discuss doing so, such as Austria and Belgium. The U.K. Financial Conduct Authority, for example, plans to expand regulations to cover loan-based crowdfunding platforms from April 2014 onward. The regulator is requiring more information investors need to make decisions and will consider the platforms as “trustees” of the clients, according to the consultation paper. ^[10] Consumers "need to be clear on what they're getting into and what the risks of crowdfunding are," said Christopher Woolard, the FCA's director of policy, risk and research.^[11]

In the United States in October, the Securities and Exchange Commission proposed regulations that run hundreds of pages.^[12] Under these, small businesses could raise up to $1 million each year through crowdfunding without having to register with the regulator. All crowdfunding transactions would have to be conducted by a registered intermediary.