Background

The last 20 years have seen it become increasingly difficult for private investors to access IPOs, as the regulators have placed a series of hurdles in the path of advisors that have made it uneconomic, and quite frankly more trouble than it is worth, to offer new issues to retail clients.

During the same time period, a far more significant trend has been the emergence of the internet. The established financial sector has been one of the slowest and least innovative in its approach to the internet. The most significant innovations (e.g. PayPal, Wonga and Bitcoin) have come from new players, and other innovative new developments (e.g. e-Gold) have fallen foul of regulators running scared of parallel financial channels.

On development that has emerged strongly over the last decade, and is in my view set to revolutionise financing during the next few years, is Peer-to-Peer funding (“P2P”), or as it is commonly referred to, “Crowdfunding”.

Crowdfunding

The premise of Crowdfunding is not new; the original building societies and cooperatives were established on essentially the same basis, that of collecting together a large number of small contributions in order to finance larger loans or businesses within a particular community. But the internet separates the “community” from any geographic boundaries and reduces the friction of transaction costs and overheads.

The earliest Crowdfunding sites were in the personal lending sector: Zopa, established in 2005 has 49,000 “lenders”, who have lent a total of £713m during that time; RateSetter, established in 2010 has 657,000 registered users who have lent a total of £456m in that time. These were followed by commercial lenders, including Funding Circle, which focuses on conventional loans and MarketInvoice, which focuses on invoice discounting. More recently, equity Crowdfunding has begun to grow rapidly, notably CrowdCube and Seedrs.

Crowdfunding initially existed a regulatory twilight zone but, as of April 2014, this changed. Equity Crowdfunding offers fall within the Financial Promotion Rules (FPR), and are promoted to restricted groups unless a full prospectus or s21 offer is produced. However at the time the new regulations came in, the FCA added a new investor exemption to the long established High Net Worth and Sophisticated Investor categories for Crowdfunding sites, that of “Restricted Investors”, with all three categories having to pass an “appropriateness test” before they can invest.  Restricted Investors must self—certify that they will not place more than 10% of their investible wealth in equity Crowdfunding and other non-realisable investments Donation and reward based Crowdfunding (Kickstarter and Indiegogo being the leaders in these areas) remain outside the regulated arena as the involve no ongoing financial arrangement.

Concurrent Crowdfunding sites are rapidly delivering to the finance world what eBay has done over the last 20 years for small dealers in physical goods; it has democratised opportunities for the smaller operator by producing a low cost, efficient, trustworthy and standardised route to market and reduced the transactional friction of high fixed costs.  During 2014 the different types of Crowdfunding are estimated to have raised over £1.5bn, split as follows:

• Business Lending – £749m
• Personal Lending – £547m
• Invoice Finance – £270m
• Equity Crowdfunding – £84m
• Others – £91m (primarily reward based, donation based and community share (social enterprise) issues)

2014 has seen the first integrations of Crowdfunding into the UK public equity markets.  Firstly, in September, Chapel Down, the ISDX quoted wine producer, raised at total of £3.95m, £1.7m by way of a regular institutional placing through FinnCap and £2.25m via an equity Crowdfunding on Seedrs. Secondly, Mill Residential REIT did an AIM IPO in December, raising a total of £2.5m, £1m by way of a regular institutional placing through Sanlam and £1.5m by way of equity Crowdfunding through Syndicate Room.

Much has been made over the concerns regarding the first “big failure” of a crowdfunded company, and there is no doubt that there will be many failures; it is the nature of the smaller company beast.  The primary counterbalances to these fears are twofold.  Firstly because Crowdfunding allows for small holdings (typically the minimum holding is just £10 per company), investors tend to spread their holdings widely and invest modest amounts in each, giving the benefit of diversification.  Secondly, the investment process is invariably passive. Under the FSA/FCA Retail Distribution Review (RDR) it is extremely difficult for Crowdfunding to be promoted to retail investors by advisers so there has been no “hard sell”, which, let’s be honest, is invariably the source of financial scandals.

Opportunities & Threats

Among our competitors, FinnCap has made the greatest strides in this area as they actively target the Crowdfunding market. 

There is a natural symbioses between a small cap corporate finance adviser like Allenby and the Crowdfunding platform providers.  They provide an alternative and complementary source of investors to our normal directory of institutions and private client brokers. Now that the platforms have been brought within the FCA umbrella there is no fundamental reason not to use them; we face no additional regulatory burdens than when we go through traditional routes.

However, just as importantly as providing a potential source of additional investors for companies that we would have already have brought to AIM, they also provide a potential for additional advisory work.  We see many potential clients that are not yet suitable for AIM but are looking to raise funds, and there is no reason why we should not advise them in relation to a pre-IPO financing that includes Crowdfunding. Equally, those companies that successfully progress their businesses once they have attracted capital through Crowdfunding are a potential source of advisory and broking work for the future.

So does Crowdfunding pose a threat to us?  As an activity it surfs on the top of two seemingly contradictory but significant trends:

• The simplification and standardisation of transacting increasing amounts of business online; and
• Increasing levels of regulatory oversight and complexity of rules.

My view is that these two may not be as contradictory as they at first appear.  The aspect that brings them together is standardisation: both online commerce and financial regulators thrive on standardisation.  The FCA rules are full of exemptions, building blocks and reduced requirements based around standardisation of charges and documentation.  AIM admissions are a very expensive process, but is this because “we” (I include nomads, accountants, lawyers and AIM Regulation in “we”) make it such to we can charge more? Standardised terms are becoming increasingly popular in the VC arena, and the BVCA have model documentation for early stage financing rounds freely available on their website.

Both the risk and the opportunity is therefore can the AIM (or possibly an alternative such as ISDX) process become cheaper and more efficient, just as Crowdfunding has proved to be, by following such an approach, and can Allenby be at the forefront of such an approach? If I was a betting man, my money would be on the smaller companies end of the junior public markets looking like that within the next 5 years.

This in turn will be exacerbated by continual elimination of investor advice from the small cap sector.  As I suggested earlier, the big “scandals” within the sector have tended to be when unsophisticated investors have been actively sold investments by commission earning brokers/advisers, so I think the regulators have taken the view that if they eliminate the investor advisory element, the scandals will dissipate. I attended a conference last year on alternative financing routes where Baroness Kramer answered questions on Government policy in the area.  What was clear was that wished to encourage entrepreneurial growth through such funding mechanisms, but they did not wish to see it become either the next miss selling scandal or another route for the financial sector to make supernormal profits. This very much favours a promotion by PR rather than a promotion by active selling approach.

Summary

My conclusions and predictions are as follows:

• Crowdfunding (in all its forms) will become an increasingly important source of finance for businesses, but at the same time the lines will be blurred with traditional financing routes as those participants engage with the Crowdfunding platforms;
• Regulatory concerns will be addressed by a combination of simplicity, standardisation, lower costs and passive marketing;
• Crowdfunding platforms will connect into the public markets to provide future liquidity and regulatory oversight of the secondary market;
• There will be significant opportunities for small company advisers to embrace but this will take an evolution of mind sets; and
• Nobody has a leading position, but moves are being made by our competitors.