Crowdfunding - Legal, Financial, and Ethical Considerations

Josef Bergt
2023

Introduction

Crowdfunding has emerged as a disruptive financial mechanism that democratizes access to capital for various projects and enterprises. While it offers an alternative to traditional financing methods, it also introduces a plethora of legal, financial, and ethical challenges. This article aims to provide an analysis of crowdfunding, focusing on its different models, benefits, risks, and regulatory implications. The article concludes with key findings and core statements that encapsulate the complexities and nuances of crowdfunding as a modern financial instrument.

Crowdfunding, a term that translates to "crowd financing," is a financial model that leverages specialized internet platforms to present and promote various ventures or projects. The objective is to pool financial resources from a multitude of investors, colloquially known as the "crowd," to collectively fund these initiatives. Operators of crowdfunding platforms play a pivotal role in curating projects and enterprises, determining the nature and structure of the financing, and often conducting independent evaluations or "ratings" of the ventures. They act as intermediaries, bringing together capital-seeking enterprises or project owners (the borrowers) with investors (the lenders).

Crowdfunding is subject to the European regulatory regime under Regulation (EU) 2020/1503 on European Crowdfunding Service Providers (ECSPR). The European Regulation came into effect on November 10, 2021, establishing a harmonized regulatory framework across the European Union for the first time. Under the ECSPR, a maximum financing volume of EUR 5 million per project sponsor per year is stipulated. Beyond this threshold, the ECSPR authorization is not applicable. 

Types of Crowdfunding Models

Crowdinvesting

In crowdinvesting, the investor receives either a share in the future profits of the funded project or, if the investment is linked to securities, shares or debt instruments. Typically, crowdinvesting is realized through subordinated loans, characterized by the subordination of interest and repayment claims in the event of insolvency.

Crowdlending

Crowdlending usually involves an internet platform facilitating the conclusion of a non-subordinated loan agreement between a financial institution (the lender) and the project owner seeking credit (the borrower). The financial institution then sells the repayment claim from the loan contract to individual investors (the crowd), promising repayment with or without interest.

Donation-Based Crowdfunding

In this model, the public donates money for a specific project within a set timeframe without expecting any return.

Reward-Based Crowdfunding

Investors receive a symbolic, non-monetary reward, such as their name in the credits of a crowdfunded film or personal items from the artist whose work was funded.

Regulatory Focus

Given that neither donation-based nor reward-based crowdfunding offer financial returns, they are not classified as financial investments. Regulatory attention, therefore, primarily focuses on crowdlending and crowdinvesting models.

Advantages and Risks

Advantages for Borrowers and Lenders

Crowdfunding offers an additional avenue for enterprises to bridge financing gaps and test market viability. For investors, it provides an opportunity to support innovative ideas and projects that were previously inaccessible to private investors.

Risks and Considerations

Investors should be aware that they are not investing in the platform but in a third-party project that the platform has included in its offerings. The risk of total loss of invested capital is a real possibility, especially in the case of subordinated loans commonly offered in crowdinvesting. Investors usually have no say in the project and should scrutinize the contractual terms carefully. Furthermore, the duration of the investment depends on the specific project, and investors should assess whether they can afford to lock their capital for such periods.

Legal and Ethical Implications

Investor Responsibility

Investors bear the responsibility for choosing a product that aligns with their risk tolerance and investment objectives. They should not only compare various crowdfunding projects but also consider other forms of investment.

Transparency and Disclosure

Investors should be cautious if information about costs and fees is not provided or is not transparent. Even if providers and issuers are not subject to prospectus requirements, they are usually obliged to produce a Financial Investment Information Sheet, which should be carefully read by investors.

Cybersecurity Risks

Given that crowdfunding is primarily internet-based, investors should also consider the risks associated with online communications and ensure they have adequate IT security knowledge.

Key Questions Before Initiating or Investing in Crowdfunding

• Does the platform or project require authorization from the Financial Market Authority (FMA)?

The need for authorization depends on the type of investment (securities, investments, loans, others), the specific activity, and the financing volume.

• Does the platform or project require a capital market prospectus or other information documents?

This depends on the type of investment, the issue volume, and possible exceptions.

Types of Crowdfunding Service Providers

European Crowdfunding Service Providers (ECSPR)

• These providers are authorized to operate cross-border and offer loans and securities, as well as individual credit portfolio management. They are continuously supervised by the FMA respectively another national competent supervisory authority. Project sponsors must note that an investment basis information sheet must be created for offers on such platforms.

Licensed Security Firms under MIFID II

• These firms can operate a crowdfunding platform exclusively for financial instruments, particularly transferable securities, and above the EUR 5 million threshold where the ECSPR does not apply.

Rules for Credit Brokerage

• In the absence of a European alternative above the EUR 5 million threshold, national rules may apply. In general, for example, credit brokerage is considered a banking business under the applicable Banking Act, unless one of the exceptions applies.

Monitoring Financial Thresholds

It is crucial for platforms and project sponsors to ensure that the EUR 5 million total financing volume per project sponsor within 12 months is not exceeded. If this threshold is surpassed, the ECSPR authorization is no longer valid for services related to that project sponsor and its offers. For offers exceeding EUR 5 million, a license as an investment firm or credit institution may be required, and the obligation to publish a prospectus for the public offering of transferable securities comes into effect.

Verification and Oversight

Before engaging in any business transactions, it is advisable to verify whether a provider has the necessary authorization. This information can be found in the national supervisory authority’s company database. The European Securities and Markets Authority (ESMA) also maintains a directory of crowdfunding service providers for the entire European Economic Area, which should be consulted when using platforms from other member states.

Conclusion and Key Findings

Crowdfunding is a multifaceted financial instrument that offers both opportunities and challenges. While it democratizes access to capital, it also introduces a myriad of legal, financial, and ethical complexities that both borrowers and lenders must navigate carefully.

Source: BaFin on Crowdfunding and FMA Austria on Crowdfunding service providers

Executive Summary:

• Crowdfunding serves as an alternative financing model that complements traditional methods like bank loans, venture capital, and grants.
• The crowdfunding landscape is diverse, with different models such as crowdinvesting, crowdlending, donation-based, and reward-based crowdfunding, each with its unique set of advantages and risks.
• Regulatory focus is primarily on crowdlending and crowdinvesting due to their financial investment nature.
• Investors should exercise due diligence and be aware of the risks, including the potential for total loss of capital, lack of governance rights, and long lock-in periods.
• Monitoring financial thresholds is crucial for both platforms and project sponsors to ensure compliance with regulatory requirements.
• Legal and ethical considerations, such as regulatory oversight, investor responsibility, transparency, and cybersecurity, add another layer of complexity to crowdfunding.