Why slow and steady approach to crowdfunding may pay off

The Murray report has suggested a cautious approach to regulation around crowd sourcing, which offers both opportunities and risks. Image sourced from www.shutterstock.com

The Financial System Inquiry has taken a “slow and steady” approach to financial crowdfunding, despite perceptions that Australia is lagging behind in this area.

While acknowledging the wide range of global crowdfunding models, the report focuses on securities-based crowdfunding such as crowd-sourced equity funding (CSEF) or debt, and peer-to-peer lending (P2P), recommending:

Graduate fundraising regulation to facilitate crowdfunding for both debt and equity and, over time, other forms of financing.

The aim is to eventually have a holistic regulatory setting that can facilitate internet-based financing, including crowdfunding.

For the moment, it will be an “adjust-as-you-go” approach with the regulations, but the focus will be on disclosure requirements of issuers and protection of retail investors. Since CSEF has far more regulatory requirements than P2P, the inquiry recommended a consultation on CSEF regulations, leading Treasury to immediately release a discussion paper on CSEF.

The government’s measured approach is justified if we realise we are looking at the tip of a very huge iceberg.

Crowdfunding is a whole new market with its own ecosystem. Just like we have emerging markets, frontier markets and so on, this financial crowdfunding market is expected to disrupt financial intermediation similar to what Amazon did to bricks-and-mortar bookshops.

Tagging on keywords like collaborative finance, fintech, platforms, algorithms, networks, engagement, equity slices, social validation and momentum-investing, this market is projected to reach US$93 billion by 2025 and an astonishing US$300 billion once the developing countries release their crowd.

With the new market comes new asset classes such as venture capital for retail investors. Take the case of Australian entrepreneurs Dan Joyce and Jared Mooring, now living in London, who pitched their venture My Mate Your Date (MMYD) on the UK equity crowdfunding platform Crowdcube with a target of reaching £130,000 representing 20% equity by 21 December 2014.

The project was pitched on the platform around 29 October 2014 (according to its Facebook entry). By 9 December MMYD had raised £110,550 (representing 85% of funds) from 97 investors, with the largest investment being £20,000.

The pitch’s links to MMYD’s Facebook and Twitter, the stream of messages, “likes”, and “shares” and “comments” matter as much as the financials and key data. The social validation of a venture can make a casual observer become a curious investor, and then a self-appointed brand ambassador, passionately following the firm as it grows and into a possible IPO. This is the power of a networked, engaged crowd.

The returns in these ventures are clearly much more than financial which explains the rush by even banks and large companies to back these ventures. SocietyOne Australia is backed by Rupert Murdoch and James Packer as well as Westpac’s Reinventure Group.

Financial crowdfunding is a brilliant solution for the small and medium-sized enterprises’ funding gap issue, as well as for the economy’s innovation and industry competitiveness agenda, while delivering along the way the gift of efficient risk-return transactions to the crowd. That’s a lot of wins and doesn’t justify the slow approach.

But, here’s why one needs a steady approach too - new market, new risks. Recently, Aurora Labs, a Perth-based startup that launched on Kickstarter on 23 September 2014 cancelled the campaign on 9 October despite receiving $304,755 from 122 backers - three times its $100,000 target - due to the company’s concerns over protecting its intellectual property (IP).

Aurora had failed to understand Kickstarter’s disclosure requirements:

When a project involves manufacturing and distributing something complex, like a gadget, we require projects to show a prototype of what they’re making, and we prohibit photorealistic renderings.

The funders want as much detail as possible, while the issuer wants to protect IP. Questions around what “showing a prototype” really means and the level of detail required in its disclosure, need to be addressed.

Other risks such as cross-jurisdictional/cross-border complexities, securitisation of unsecured loans, and a lack of disclosures of “real” returns have been highlighted in recent reports from Infodev/World Bank and the International Organization of Securities Commission.

We also need to understand the “real” business model of these Fintech companies. LendingClub debuted this week on the New York Stock Exchange under the ticker symbol LC with a highpoint value of US$5.7 billion, but rose to more than US$9 billion on the first day of trading. Is it a “fin” or a “tech”? It is being valued as a technology company.

We are back to the question: “What’s this fintech’s business model”? Well, that explains the “understand before you regulate” perspective of the inquiry. After all, we don’t need a regulation that turns out to be a lemon.