What is crowdfunding and what license is required for it

Crowdfunding is an alternative way of raising funds that allows individuals and legal entities to raise funds for their projects through special online platforms.

This method is usually used to finance startups, small and medium-sized enterprises, as it involves obtaining funds mostly from inexperienced small investors rather than from those who are well versed in investing and regularly engage in it. Another bonus for startups is that crowdfunding allows them to test interest in a project and build a community of stakeholders around it.

In general, there are three parties involved in the crowdfunding process:

• The project owner – an individual or legal entity whose project is placed on the crowdfunding platform to raise funds.
• Investors – individuals or legal entities participating in the financing of projects through the crowdfunding platform. In general, the use of the term “investors” in relation to such persons is considered correct in the context of only two types of crowdfunding – debt-based and equity crowdfunding, which we will discuss below. However, for simplicity, we will also refer to those who invest in other types of crowdfunding as investors.
• Crowdfunding platform operators (crowdfunding service providers) – persons who actually manage the respective platforms.

What types of crowdfunding exist?

Crowdfunding is divided into the following types depending on the terms and conditions of such financing and the instruments used:

• Donation-based crowdfunding. One of the peculiarities of this type of financing is that investors do not receive any property or other rights after donating funds, do not become creditors of the project and do not receive any kind of share in it. At the same time, in order to attract new investors, the project creator may offer some reward for financial contributions to the project, such as small symbolic gifts. Usually, this type of crowdfunding is used to raise funds for charitable and social projects, and among the popular platforms where it is carried out are GoFundMe, GiveForward, Kickstarter, CrowdFunder, Indiegogo and others.
• Rewards-based crowdfunding. Unlike the previous case, in this case, investors who invest in a project expect a certain non-financial reward for this, including the provision of certain goods or services after the project is implemented. Sometimes, developers differentiate the form or amount of reward depending on the amount of money that a person has provided through crowdfunding.? Examples of platforms for raising funds in this way include WhyDonate, Crowd2Fund, MiiMOSA, EcoCrowd and others.
• Debt-based crowdfunding. Financing in this case is somewhat similar to lending in a bank: investors invest in a project, expecting to get their money back with interest. It is this type of crowdfunding that is considered the most attractive and safe for investors because even if the project does not come to fruition and the developer goes bankrupt, such investors will be the highest priority for repayment from the business’s residuals. This type of financing can be carried out through several instruments: mini-bonds, invoicing, and P2P, each with its own advantages and disadvantages. Popular debt-based crowdfunding platforms include Rendity, Crowdestate, Winwinner, and others.
• Equity crowdfunding. This is also an attractive option for investors, as it involves individuals receiving securities in exchange for investments. Thus, investors receive a stake in the business that depends on the size of their contribution. Usually, equity and debt-based crowdfunding are the most difficult to implement, as they are subject to the most extensive legal regulation. For example, they are subject to rules on information disclosure, the availability of the necessary legal documents, holding annual shareholder meetings and creating annual reports, etc. Among the platforms through which equity crowdfunding can be carried out are primarily Wefunder and StartEngine.

How is crowdfunding regulated and by whom?

Crowdfunding is often regulated by national laws and regulations. For example, in the United States, there is the Jumpstart Our Business Startups Act (JOBS Act), Section III of which is dedicated to this type of financing. In particular, the JOBS Act establishes the following rules for equity crowdfunding:

• all transactions in connection with crowdfunding must be conducted online through an intermediary registered with the Securities and Exchange Commission (SEC);
• project developers may raise a maximum of $5 million per year through crowdfunding;
• the amount that individual non-accredited investors can invest in crowdfunding offers is limited;
• information disclosure requirements are imposed.

In the United Kingdom (UK) equity and debt-based crowdfunding are regulated by the Financial Services and Markets Act (FSM Act) but the Financial Conduct Authority (FCA) also oversees payment services provided in connection with donation-based and reward-based crowdfunding. For example, according to local regulation, companies may only promote crowdfunding offers to certain investors: either sophisticated investors or those who confirm their intention to invest no more than 10% of their net investment assets. In general, the UK regulation is primarily aimed at protecting investors which is facilitated by the rules on disclosure of detailed, accurate and truthful information about their financial condition and investment opportunities; disclosure of information to potential investors about credit risks associated with debt-based crowdfunding; the need for platforms to create effective credit management plans, etc.

The European Union (EU) also has a separate supranational act, Regulation (EU) 2020/1503, which sets out the rules for the operation of crowdfunding service providers.

Who are crowdfunding service providers and what license do they need?

Crowdfunding service providers (CSPs) are legal entities that provide crowdfunding services. In the aforementioned Regulation (EU) 2020/1503, crowdfunding services are defined as the matching of business funding interests of investors and project owners through the use of a crowdfunding platform and which consists of any of the following activities:

• the facilitation of granting of loans;
• the placing without a firm commitment basis of transferable securities and admitted instruments for crowdfunding purposes issued by project owners or a special purpose vehicle, and the reception and transmission of client orders in relation to those transferable securities and admitted instruments for crowdfunding purposes.

Such activities generally require a special license or authorization or registration with a regulatory authority. For example, EU law provides that a legal entity incorporated in the EU that intends to provide crowdfunding services must apply to the competent authority of the country in which it is incorporated for a special permit.

To do this, such persons need to:

1. Prepare and submit an application that must contain all the necessary information (including name, legal address, the articles of association, description of management and internal control mechanisms, etc.).
2. Attach evidence of the following to the application:absence of a criminal record in respect of infringements of national rules in the fields of commercial law, insolvency law, financial services law, anti-money laundering law, fraud law or professional liability obligations for all the natural persons involved in the management of the prospective crowdfunding service provider and for shareholders who hold 20 % or more of the share capital or voting rights; andproof that the natural persons involved in the management of the prospective crowdfunding service provider collectively possess sufficient knowledge, skills and experience to manage the prospective crowdfunding service provider and that those natural persons are required to commit sufficient time to the performance of their duties.

Within 25 days, the application is checked for all the necessary information, and within another 3 months, the competent authority decides whether to grant or refuse to grant authorisation to operate as a crowdfunding service provider.

European law imposes a number of requirements on such CSPs, including, in particular:

• Providing annual reports to the competent authority on projects funded through the CSP’s crowdfunding platform;
• Providing the competent authority with information about third countries (non-EU) in which the СSP plans to operate;
• Providing clients with the necessary information, including financial risks associated with investments and crowdfunding, project selection criteria, fees, etc.;
• Disclosure of information on the default rate of crowdfunding projects offered on the CSP’s platform;
• Assessing the suitability of projects before offering them to inexperienced investors, etc.

In addition, CSPs must comply with anti-money laundering and personal data protection requirements.

The authority to which a CSP should apply for the authorization to operate depends on the country in which the company was incorporated. For example, in Estonia, this authority is the Estonian Financial Supervision and Resolution Authority (Finantsinspektsioon), in Poland – the Polish Financial Supervision Authority (KNF), in Germany – the Federal Financial Supervisory Authority (BaFin), in France – the Autorité des marchés financiers (AMF) and so on. In the United States, this is the responsibility of the SEC, and in the United Kingdom – the FCA.

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The content of this article is intended to provide a general guide to the subject matter, not to be considered as a legal consultation.