Crowdfunding: Introduction
Crowdfunding is the process of raising finance for the development of a product or the carrying out of an endeavour through a typically large group of small backers, the ‘crowd’, usually via a web platform (the crowdfunding platform) which permits entrepreneurs to promote their projects to the public. Crowdfunding operations follow a number of different business models.
Crowdfunding business models
There are four major recognized business models:
- Donation based: people give money to activities or products they want to support
- Rewards based: people give money to receive a reward, service or product (e.g. a limited edition version of the video-game they are backing)
- Loan based: people lend money to individuals or businesses in the expectation of a return in the form of interest and capital repayments
- Investment/Equity based: people invest directly or indirectly in in new or established businesses by acquiring shares or debt securities, or units in a collective investment scheme
Economic rationale
Crowdfunding can satisfy an important economic need; channelling finance towards small, innovative start-ups that may be perceived as too risky by financial institutions and may not have the maturity and infrastructure necessary to obtain finance via the IPO route. Facebook’s recent acquisition of Oculus Rift has underlined the potential that the crowdfunding model has as a catalyst for entrepreneurship and technological innovation.
Crowdfunding in Malta
Legal implications of crowfunding under Maltese Law
How does Maltese law treat crowdfunding? Theoretically, one would expect loan based and investment based crowdfunding operations to be regulated under the provisions of the Financial Institutions Act, 1994 and the Investment Services Act, 1994 respectively (we can set aside donation and rewards based operations for the purposes of this discussion, since they pose lower regulatory risks). The recent introduction by the MFSA of rules governing loan issuing collective investment schemes may also provide under potential regulatory heading under which certain crowdfunding operations could fall. However it is clear that the existing legislative framework pre-dates the development of crowdfunding as a viable source of finance, and therefore does not adequately address the specific concerns raised by the sector. This is a significant lacuna, since crowdfunding present some very particular challenges, and without a bespoke rulebook to address these challenges it may be difficult for the sector to flourish.
Challenges raised by the crowdfunding business model
Which special challenges does crowdfunding pose that such a rulebook should seek to address? A recent paper by the UK FCA identified a number of risks including the lack of a secondary market, the possibility of platform failure and the potential for conflicts of interest. However the key concerns are probably three:
- Suitability and appropriateness: financial regulation requires operators to assess the suitability and appropriateness of financial products to the needs of investors. In simple terms, this means that one should not promote a high risk product to an unsophisticated, retail investor. However, crowdfunding is almost by definition focused on high-risk / high-return opportunities. The rulebook will need to identify ways in which the market can remain accessible to the retail investors that are the backbone of the service while protecting such investors from taking imprudent risks with their money. A limit on the portion of their net worth that inexperienced investors may invest via crowdfunding could be prudent in this context.
- Public offer of securities: the offering of securities (such as shares and bonds) to the public is an activity which is subject to stringent regulation. While such regulation is healthy and necessary, it may not be proportionate to the circumstances of businesses seeking to raise finance through crowdfunding platforms. Our law already provides for a number of exemptions from the rules associated with a public offer of securities; any further flexibility would be welcome and helpful in this context.
- Investee due diligence: reputable crowdfunding operators already seek to carry out due diligence on investees that are promoted on their platform in order to protect their reputation. Sensible regulation should seek to formalize this market practice, but without raising the bar so high that crowdfunding becomes inaccessible to the technology start-up niche that is most in need of it.
The need for a Malta crowdfunding rulebook
The issuing of a ‘crowdfunding rulebook’ would be an important first step towards opening Malta up for such business, and would almost certainly serve to encourage growth in the area. Malta will not have been the first country to take steps to address the specific regulatory concerns raised by crowdfunding. The UK has published rules that came into force on the 1st of April. The US has revised its rulebook, with the JOBS act being designed to create certain exemptions in favour of crowdfunding. While this means that Malta will not have first mover advantage, it does mean that we can learn from the experience of other jurisdictions and bring to the market a compelling proposition.
