Crowd Sourced Equity Funding – A New Funding Source for Social Enterprise

The rise of Crowd Sourced Equity Funding is indicative of increasing interest from the general community to be personally involved in social and caused related enterprises but it needs to be opened up by Governments to enable it to reach its full potential, writes Alan Greig  from Employee Ownership Australia Ltd.

On 4th August, the Federal Government announced yet another review into “crowd sourced equity funding’” (CSEF) in Australia  (see the “Consultation paper on regulatory framework for small proprietary companies and crowd sourced equity funding”) – with the welcome addition that this one would be focussed on  the needs and involvements of proprietary companies in CSEF.

The review states: “The Government is making it easier for small businesses to access the capital they need to grow and thrive by removing obstacles to crowd-sourced equity funding. A key element of the paper is a proposal to extend CSEF to proprietary companies.”

“Of particular interest to many of the small businesses and entrepreneurs I have visited over the past few months is the debate around the limit of 50 non?employee shareholders for proprietary companies and the ‘small scale offerings’ exception to the disclosure requirements”.

This is the third review into CSEF in the past two years, an indication perhaps of over-caution. Since the take-off of CSEF around the world in 2010, most economies have simply gone ahead and made it happen, with the most noticeable example being the new “regulation-lite” system introduced into New Zealand, where up to $2 million per project can be raised without the usual, costly “offer documents” applying.

While the reviews go on, soliciting investors in securities via internet based CSEF platforms remains illegal under Corporations law in Australia (except where the “20/12 rule” applies, ie: small numbers of ‘informed investors’ being asked to invest, but less than 20 of them per project in any 12 months).

In the light the developments elsewhere – and the impact that CSEF is having on tech start-ups, local enterprise development and social enterprise (and of course the jobs being created in the process) – it is important to have a look at the issue of “in whose interests” is the policy now being developed and why the stalling in this country (on the time being taken, see the Pro Bono Australia News article in May, 2015 “Progress on Crowd-sourced Equity Funding Too Slow?”.

The CSEF debate in Australia has become particularly out of step with community participation in ‘caused based’ investing. The conflicting issues with our regulatory settings are easy to identify.

1. CSEF is about offering ‘the crowd’ the chance to invest a small amount of funds into the shares of a small business or social enterprise, through an on-line platform upon which the ‘share offer’ is placed.

2. The offer can be put to ‘the crowd’ at minimal cost and without the need for the expensive and complicated disclosure documents prescribed currently under Corporations Law (a Prospectus for instance).

Or as it is being referred to overseas, CSEF offerings are lawyer free, people powered, often ‘cause related’ investments  – especially those directed at community renewable energy projects –  looking for the financial backing that conventional, institutional sources find too hard to do, through either size or risk, or just plain bias. So let’s look at the problems inhibiting development here.

Firstly, a proprietary company under our Corporations Act must not have more than 50 shareholders and must not offer shares to the general public, or undertake any fundraising activities that would require the issue of a disclosure document.  There are over two million such companies in Australia, making up the vast majority of all registered companies – with the vast majority of them being classed as “small”.

This limitation on the number of shareholders places on proprietary companies the need to convert to public companies if they wish to go ‘public’ with a share offer. Converting to a public company imposes very significant additional governance, reporting and disclosure requirements, with the need to prepare audited financial statements being just one.

The Government’s review statement indicated that expanding the number to ‘100 shareholders’ may be an option. For the social enterprise sector however, this may not be enough. With the social enterprise landscape around the world increasingly being made up of small scale companies looking for ‘patient capital’ in the form of equity, then making a ‘public offer’ of a stake in the business to ‘the crowd’ is becoming a cheap and viable route for raising needed funds to be used for early–stage start-up.

Let’s look at the evidence on this. The most comprehensive data on CSEF can be found in the excellent Nesta research report “Understanding Alternative Finance” which has analysed/surveyed the nine new forms of ‘alternative finance’ that are developing in the UK, including CSEF.

This study shows that there has been a 410 per cent growth in the value of CSEF investments over the years 2012, 2013 and 2014, from £4 million in 2012 to £84 million in 2014, with £199,000 being the average total investment per CSEF project (ie: about AU$400,000), and with the average number of funders being 125. There were 188 CSEF offers covered in the survey with around a total of 23,000 investment transactions.

Only two-thirds of these investors invested more than £1,000 (the average being £1600), with sixty–two per cent of all investors having no previous investment experience. The majority were therefore new ‘retail investors’ and mostly on the young side at that. Notably, the other 38 per cent of investors were those classed as ‘professional investors or high net-worth individuals’ who tend to hold higher amounts in larger ‘portfolios’ of projects. Half of all CSEF investors also plan on investing more in 2015. In terms of doing social or environmental good, this attracted 46 per cent of all investors, with another 33 per cent targeting local business as being the major attraction.

Importantly, since securing CSEF funding, 70 per cent of the businesses invested in have increased turnover and 60 per cent have increased employment.

What do we learn from this? The key issue is to ensure that CSEF in Australia is an enabler of “mass participation” by the community in investing in cause related local business and social enterprise. It should not simply become a ‘lawyer-free’ exercise in reducing costs for the professional investors and high net worth individuals mentioned above.

There are increasing concerns that the CSEF debate is becoming captured by the platform entrepreneurs, the wealthy investors who are presently their main ‘customers’ and the technology start-ups which are pressing the ‘need for investment’ issue.

These concerns can be seen in the proposal to have the upper limit on ‘regulation-lite’ CSEF investments set at $25,000 per investor. Compare this for instance with what is prescribed under the ‘pro crowd’ JOBS Act in the US (the law which legalised CSEF in the US, called Jump Start Our Business Start-ups Act  ) which is set at $2000 per investor.

Of course, with the higher the limit being set, the greater will be the need for externally regulated disclosure, licensing, pre-approval etc. requirements, all of which will add significant cost and complexity to what should be a simple process of access to a platform allowing ‘ordinary men and women of Australia’ – basically you and I – to invest a small amount of funds in our favourite businesses (whether local, social or cause based).

The Nesta report indicated that it is ‘connectivity with the issue’ that appears to be driving many people towards CSEF investment, with investors focusing more on altruistic reasons or general benefits for providing funding, rather than any expectation of financial return to them – and with the internet becoming the most likely way of finding such CSEF “investment opportunities”.

So how to keep CSEF open to the broad community?

Here are some suggestions for each of the three participants in the system:

1. Those companies making the offer/issuing shares

Firstly, Corporations law must be amended to allow for a minimum of 100 shareholders in a proprietary company as the Minister has suggested – and preferably more (my preference would be 200 to meet the caps mentioned below). The shares on offer must be new, ordinary shares. For ‘regulation-lite’ CSEF, there will need to be a cap on investment both per investor and per project, with trends looking like $5,000 per investor (with another cap, like $20,000 in total per investor per annum), with a total of no more than $1 million required for each offer.

CSEF offers seeking greater amounts would be subjected to existing Corporations law disclosure requirements. Lending to purchase shares would be prohibited and it would be incumbent on those making the offer to ‘fairly’ disclose basic information about the offer (perhaps through a template offer information statement). There would be continual updating about any changed conditions or adverse events. If the offer is a cause related one, then potential social impacts should add quality to the offer. Of course, prohibitions on misleading or deceptive promotion and advertising would remain.

2. The internet platform providers (known as intermediaries)

Of course, the key issue here is whether – and how – such providers would be appropriately licensed. It may be too big a step to demand of them an AFSL licence, as this might narrow the field to the highly “professionalised” and count out community owned platforms. But nevertheless, some due diligence and background checks should be undertaken by providers on those involved in making the ‘share offer’.

To undertake this, platforms will likely need to registered with ASIC and they will need to manage and report compliance with any of the limits/caps that any new CSEF law may want to enforce. This may also mean some form of pre-registration of investors and some form of ‘approved sponsor’ for each project. It would be useful also for providers to have standardised ‘offer information statements’ available to be issued with each offer made (see 1. above).  Fees of course will need to be disclosed up front, as would dispute resolution if and when required.

Those providers offering the best ‘connectivity’ between investors and those making the offer would be expected to lead the development of the ‘market’, with quality ICT communications systems being stimulated accordingly.

3. The crowd who are investing

The problems associated with potentially increased risk (especially through fraud) can only be tackled in two ways (i) through the low limits placed on investors (both in terms of the amount per project and total investments in any 12 month period), so that CSEF investors are not encouraged to risk the greater part of their savings and (ii) making it clear through constant acknowledgement the higher risk nature of CSEF investments and that they are subject to lower disclosure requirements than other investment offers.

On the other hand, investors themselves will likely be demanding payment systems that are more transparent and more “localised” (subject to prescribed neighbourhoods, as some in the US are, where people are known to each other and identify with the project, thus maximising accountabilities), with perhaps systems offering “public feedback” (like eBay). Investor reporting responsibilities will also have to be clear and perhaps signed up for.

In conclusion, for social enterprise, CSEF will enable substantial funding beyond the current philanthropic and Government sources currently being accessed. It will substantially increase seed funding for start-ups, along with patient capital for the more creative and innovative projects which might have a much longer time-frame for breaking even.

CSEF will no doubt evolve over time –  as will the regulatory framework –  with it hopefully becoming a lot cheaper and easier as worries about ‘fraud’ and ‘villains’ are seen to be largely unrealised.

CSEF must become something for everyone, not just the well-off ‘investing community’. This will happen only so long as those balanced limits and conditions are applied with regard to fraud and increased risk.

A more supportive approach to CSEF could really encourage ordinary people to ‘get back’ to investing in their local economies, with this becoming potentially the major source of funds for social enterprises and community owned businesses in future.

The rise of CSEF is indicative of increasing interest from the general community to be personally involved in social and caused related enterprises. It needs to be opened up by Governments to enable it to reach its full potential. Making a submission to the latest of the Government’s CSEF reviews would be one way of bringing to notice this potential.

About the author: Alan Greig is a Board member Employee Ownership Australia Ltd, a Director of The Mercury Centre Cooperative Ltd and Co-ordinator of the Social Enterprise Legal Models Working Group. He is not a lawyer, so the above represents opinion only.