Crowdfunding – an alternative financing option for SMEs

Written by Agnieszka Widuto

The economic and financial crisis has significantly reduced banks’ lending to businesses. This gap in financing, coupled with the rise of social media and interactive online platforms, has contributed to the increased popularity of crowdfunding as a possible alternative source of funding. In this context, the European Commission adopted a communication on unleashing the potential of crowdfunding in the EU, as part of efforts to improve the long-term financing of enterprises and encourage innovation. The fragmented nature of the regulatory environment on crowdfunding across Member States may, in certain cases, however, pose challenges to such efforts.

Types of crowdfunding

Finance through crowdfunding can generally be divided into two types: with and without financial returns. The non-financial models include donations or rewards. This means that the funders either expect no return or receive a non-monetary reward, often of symbolic value. Some typologies also include pre-sales, whereby contributors pay to develop and produce a new product that will be shipped to them later. The models offering a financial return include lending and equity crowdfunding. The lending model involves individuals providing funds in return for repayment of a loan (with or without interest), while the equity model entails shareholding or profit-sharing. Currently, crowdfunding with non-financial returns prevails and at US$1.4 billion represents over half of the funds raised through crowdfunding platforms in 2012 (see figure 1 overleaf). However, financial-return crowdfunding is expanding as well. Each type follows a different logic, and is potentially subject to a different set of rules.

Benefits and risks

Crowdfunding can improve SMEs’ access to finance and potentially remedy certain market failures, such as the insufficient supply of funding for start-ups and early-stage companies. Its particular design offers flexibility, cost-effectiveness and a high speed of raising funds. Entrepreneurs also gain a market-testing tool which allows them to estimate demand and gather feedback from potential customers. Benefits for contributors include civic or community engagement and, in the case of models with financial returns, an investment opportunity. In more general terms, as SMEs account for a large majority of EU businesses and jobs, the Commission estimates that crowdfunding has the potential to foster growth and job creation.

While crowdfunding can be a financing option for SMEs, it also entails certain risks. These include the risk of fraud, platform closure or failure, project default, cyber-attack, donor exhaustion, misleading advertising practices, legal uncertainty stemming from different legislation, liquidity risk (lack of exit options), and infringement of intellectual property rights. Some of these issues have already been addressed in a number of countries through regulation.

Crowdfunding in the EU

The European Commission recognised the potential of crowdfunding to complement traditional financing channels and indicated its intention to support it in its 2013 Green Paper on Long-term Financing for SMEs. A public consultation with stakeholders carried out later the same year fed into the communication on crowdfunding published in March 2014. While the Commission does not currently envisage taking legislative measures, it aims to explore the added value of EU action. This includes raising awareness, creating a European ‘quality label’ for platforms and developing best practices, notably through setting up the European Crowdfunding Stakeholder Forum, as well as assessing the EU and national regulatory frameworks.

The Commission also sees interest in exploring the possibility of matched (public and private) financing through crowdfunding, at both EU and national levels. Successful examples of supplementing public funds through this new financing form exist. Some possible future options include co-investment in projects alongside private contributors, loan guarantees to crowd-lending transactions, or direct contributions to crowdfunding platforms. Compliance with the state aid and competition rules must be ensured, especially regarding risk finance investments, transparency and accountability, as well as with the EU’s Financial Regulation, where applicable.

At present, regulations vary from country to country, from comprehensive to unregulated. At EU level existing rules could already be applicable to crowdfunding activities, especially those types aimed at providing financial returns, depending on the specific business model used. These rules include, among others, provisions related to financial transactions and payment service providers or intermediaries (Anti-Money Laundering Directive, European Payment Services Directive), protection of intellectual rights (Regulation on Unitary Patent Protection), consumer protection (Unfair Contract Terms Directive, Unfair Commercial Practices Directive), electronic commerce (e-commerce Directive) and investment (Prospectus Directive, MiFID, CRD IV, AIFMD). As crowdfunding has cross-jurisdictional implications – unless investors are to be limited by national boundaries – convergence of national regulatory approaches might also be an appropriate measure.

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