Where angels fear to tread? Crowd-sourced equity funding

On 4 August 2015, Treasury released its consultation paper outlining the Federal Government’s proposed crowd-sourced equity funding (CSEF) framework. The proposed lifting of regulatory impediments to CSEF in Australia has the potential to be a game-changer for start-ups and small business as well as a boost for FinTech.

Treasury’s consultation paper reflects the commitment to CSEF made in the 2015-16 Federal budget. As part of the Growing Jobs and Small Business package, the Government confirmed its intention to introduce a legislative framework to facilitate CSEF.

While this legislative initiative is to be welcomed, potential issuers and intermediaries will need to be careful in navigating the framework in order to realise its full potential.

This follows on from developments in relation to CSEF which have been gathering momentum over the past year. Different CSEF framework options have been explored in the Corporations and Markets Advisory Committee’s report (May 2014), the Financial System Inquiry (FSI) final report (November 2014) and Treasury’s discussion paper (December 2014) as well as a variety of industry publications.

These recent consultation papers and reports have recognised the significant potential for CSEF to stimulate innovative start-up and other small-scale enterprises through digital funding sources. Funding for these types of enterprises has traditionally been more challenging when compared with established and large corporates.

As noted in the FSI interim report, interest rates on loans to small and medium size enterprises are generally higher than those for large business loans. Approval rates are also much lower for loans to new ventures, reflecting the perceived levels of risk associated with such lending.

As a result, start-ups and small businesses have traditionally turned to family sources as well as venture capital and angel investors to secure funding. In addition, new institutional models such as Reinventure (backed by Westpac) and incubator spaces (Stone and Chalk and Fishburners) have emerged to support start-ups, particularly in the FinTech space. While these initiatives are providing an exciting boost to the local start-up landscape, CSEF has the potential to provide a further dimension by expanding the funding options and facilitating digital access to capital from a wide range of investors. 

What is crowdfunding?

A range of crowdfunding models have emerged globally. Crowdfunding facilitates fundraising for projects or businesses whereby small amounts of money are contributed by each member of the “crowd” through an online intermediary. In general terms, the main models break down into:

  • Social crowdfunding, which involves:
    • donations by the crowd for no financial return but where a connection is established with the recipient, e.g. charitable causes; or
    • rewards-based programs where the contributors to causes or business initiatives receive a non-financial return, e.g. music and clothing.
  • Commercial crowdfunding, which involves:
    • equity, where the crowd invests in an issuer with the result being that the members of the crowd then become shareholders; or
    • debt, where lending is facilitated between individuals, based on credit data and a loan matching platform.

Debt-based models have already become a feature of the Australian investment landscape through peer-to-peer lenders such as SocietyOne and RateSetter. While these operators have relied on the existing regulatory framework to establish themselves, their equity-based cousin, the CSEF, has faced regulatory impediments.

Current regulatory impediments

Regulatory impediments to the development of CSEF solutions in Australia include that proprietary companies are not permitted to have more than 50 non-employee shareholders and face prohibitions (subject to limited exceptions) on making public offers of equity. These impediments mean that proprietary companies cannot access the large numbers of investors which would typically be targeted under a CSEF offering.

Although operating as a public company may avoid some of these impediments, this company form may not be appropriate for small businesses who are looking to avoid the associated costs and compliance requirements such as reporting and corporate governance.

In addition, while public companies can offer shares to the public (outside exemptions such as sophisticated, professional investor or small scale offers), the work involved in preparing the requisite disclosure documents for these offers can be expensive and time-consuming.

Accordingly, calls have been made to change the regulatory regime to facilitate CSEF offerings.  The response from Treasury has sought to balance the need to reduce compliance costs for issuers and intermediaries with providing for appropriate levels of investor protection and education. The result in the consultation paper is a proposed framework for public companies, but which explores how the framework may be extended to include proprietary companies.

The proposed framework for public companies is outlined in the table below:

HDY-Insight-September-2015-Crowd-Sourced-Equity-Table.jpg

Navigating the proposed regulatory framework

While the legislative outline proposed in Treasury’s consultation paper is to be welcomed, potential issuers and intermediaries will need to be careful in navigating the framework in order to realise its full potential.

On the basis of the outline released in the consultation paper, issuers and intermediaries will need to obtain advice on and work through the following key issues:

  • The role of the intermediary will need to be carefully considered so it is not exposed to unviable levels of commercial risk, including exposure to claims if investments in the underlying issuer lead to investor loss. In particular, intermediaries will need to understand clearly their role and obligations in respect of undertaking prescribed checks on the issuer.
  • Intermediaries will need to introduce systems to meet their obligation to monitor compliance with the proposed investment caps for retail investors.
  • Issuers will need to ensure they have the systems and accounting processes in place to ensure compliance with the public company exemption requirements, which are based around annual turnover and asset thresholds. 
  • Prospective intermediaries will need to consider the Australian financial services licensing implications arising from providing the service. New entrants will need to assess whether to make an application or rely on exemptions from licensing. Existing operators may be able to rely on a current licence or may need to seek a variation.
  • In designing the tailored CSEF disclosure document and other information, issuers and intermediaries will need to consider how they may be made suitable for the digital environment but also compliant with financial services laws more generally. In addition, they will need to consider adjacent legal requirements for engaging with individual investors such as privacy laws and anti-money laundering rules.
  • Issuers may need to consider the likelihood of investor activism. The small lot allocation contemplated by a CSEF program should mitigate against large block shareholdings which could be leveraged to convene meetings and exercise control. However, unless a non-voting or economic interest only option emerges through the draft legislation, the framework appears likely to provide investors with voting rights through the issue of ordinary shares.

The CSEF legislation is intended to be introduced to Parliament in the Spring parliamentary sittings of 2015. Draft legislation will be released beforehand providing issuers and intermediaries with the opportunity to work through the above regulatory and commercial considerations with regard to the fine detail before it is finalised.

There is accordingly the potential for the framework and legislation to change during the course of this process. However, the overarching principle and speed of this new regime is exciting.

It has the potential to create significant fundraising options for start-ups and small business, together with new commercial opportunities for intermediaries equipped to support those offerings. 

Jon Ireland

I constantly strive for technical excellence and commercial outcomes that add real value for my clients.

Jon Ireland Partner

Jon has extensive experience in corporate and financial services law, specialising in complex transactions, funds management and investment distribution. Jon also advises on regulatory issues relating to the use of technology in financial services.

Jon provides advice to leading Australian and international financial services clients on the full range of corporate, commercial and regulatory issues facing these businesses. He has considerable experience advising them on establishing, buying into, selling and restructuring their businesses.

Jon regularly advises on funds management issues including fund structuring, disclosure, investment management and outsourcing arrangements. He has particular expertise in the area of investment distribution and has advised on key projects for platform operators and advice providers.

Recently, Jon has advised on the establishment of a fully digital investment platform, the negotiation of a material outsourcing arrangement for a global investment bank and a scheme modernisation project for a leading Australian fund manager. Jon has also recently advised on the establishment of the Australian operations of a global diversified financial services business, including regulatory and corporate issues related to its expansion.

Jon's clients value his advice on recent law reforms, including around product disclosure statements and the digital provision of financial services. Jon is consulting to the Committee for Sydney and is a regular participant on Financial Services Council working groups.

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