The Financial Conduct Authority (FCA) is consulting on a new regulatory approach to cover “crowdfunding”. Crowdfunding is in essence a direct approach to investors for either equity investments in early stage companies, or loans to similar companies. It has become popular of late due to the emergence of various web-based platforms to collate the interests of many small investors, but can also be employed by companies to make direct approaches to investors. ShareSoc looked at one of the latter examples (Clear Books) in a recent newsletter and made some unfavourable comments on it.
Typically the new approaches bypass the normal regulatory oversight or intermediary processes although it has always been technically true that direct equity investors in private companies (e.g. by “business angels”) should only have been done by those persons who qualify as “sophisticated investors” or “high net worth” individuals. That was to ensure that they have sufficient business experience to judge the risks of such investments or sufficient wealth to absorb likely losses because it is generally accepted that such investments are very high risk! Indeed the FCA note in their consultation document that “most start-ups fail in the early years” and that all the investment capital is lost in between 50% to 70% of cases.
Unlike most private equity investments by professional investors, where an onerous “shareholders agreement” is put in place, because of the large numbers of investors and generally lax legal frameworks the investors in crowdfunding propositions are very open to being abused as minority investors in unlisted vehicles (although some platforms do have some additional protections for minority shareholders). Many of those who are putting money into crowdfunding propositions seem to be unaware of the dangers. And because of the ease and speed of the investment processes used by these platforms on the internet, investors may not be giving sufficient thought to them before committing. To spell out the risks even more clearly this is what the FCA have to say in their consultation document (para 2.32 onwards of the document available from: www.fca.org.uk/news/cp13-13-regulatory-approach-to-crowdfunding) :
No dividends and equity dilution
Investors in unlisted shares in a start-up or young company, even if the company remains a going concern, face the risk of never receiving a return on their investment if those controlling the company decide not to issue dividends. And, if the business is sold or becomes listed, investors may find their share in the profits is reduced if the value of shares is diluted by subsequent issues of new shares. Investors need to understand that they will have almost no control over these decisions.
No secondary market
After purchasing unlisted equity in a company, even if it remains a going-concern, investors will usually find there is no, or only a limited, secondary market for their investments. Consumers investing in such equity need to understand that they will probably have to wait until an event occurs, such as the sale of the company, a management buy-out or a flotation, before
getting a return. Consumers should realise that, in the event of their death, ownership of these investments will probably need to be transferred to their beneficiaries.
They also warn about crowdfunding of loans where some web sites compare the interest rates available from them to those on “deposits” with large financial institutions, i.e. they are not comparing like with like because the risk of default on the former are much higher.
The FCA is proposing to establish new regulations for loan-based crowdfunding platforms and peer-to-peer lending. It will include regulatory capital requirements and rules to ensure loans can continue to be managed if a firm goes bust, to regulate how client money is managed and establish a dispute resolution system.
As regards equity investment they propose to restrict the direct offering of shares or debt securities in unlisted companies to:
- retail clients who are certified or self-certify as sophisticated investors, or
- retail clients who are certified as high net worth investors, or
- retail clients who confirm that, in relation to the investment promoted, they will receive regulated investment advice or investment management services from an authorised person, or
- retail clients who certify that they will not invest more than 10% of their net investible portfolio in unlisted shares or unlisted debt securities (i.e. excluding their primary residence, pensions and life cover)
Where advice is not provided, the FCA will expect firms to apply an appropriateness test before selling promotions for unlisted equity or debt securities. This is to ensure that only those clients who have the knowledge or experience to understand the risks can invest.
Now some commentators have alleged that these new rules for equity investment (although they are not much different to what went before in the UK, even if they were widely ignored, and are indeed more relaxed), will have an inhibiting effect on the fund raising of start-up companies and will frustrate the desire of investors to put money into these ventures. But the other point of view is that there seem to be many “snake-oil” propositions out there that inexperienced investors are being sucked into. Should investors, even small retail ones, be protected from their own stupidity or inexperience is of course the perennial question to consider.
ShareSoc will be making a submission on behalf of our Members to the consultation so if you have any views on this subject please let us know. But submissions are required by the 19th December so please tell us soon.