1
The Promise and Perils of Crowdfunding:
Between Corporate Finance and Consumer Contracts
John Armour
*
Luca Enriques
**
Abstract
‘Crowdfunding’—raising capital through large numbers of small contributions—is a burgeoning
phenomenon, spurred by the internet’s capacity to reduce communication costs. Its still-evolving status
is reflected in diversity of contracting practices: for example, ‘equity’ crowdfunders invest in shares,
whereas ‘reward’ crowdfunders get advance units of product. These practices occupy a hinterland
between existing regimes of securities law and consumer contract law, in which their treatment is not
consistent. For example, consumer protection law in the UK (but not the US) imposes mandatory terms
that impede risk-sharing in reward crowdfunding, whereas US (but not UK) securities law mandates
expensive disclosures that hinder equity crowdfunding. This article offers a normative roadmap for the
regulation of crowdfunding. We suggest that while crowdfunding poses real risks for funders, neither
the classical regulatory techniques of securities or consumer law provide an effective response. At the
same time, a review of rapidly-developing mechanisms in crowdfunding markets suggests they offer
the potential to provide meaningful protection for funders. In light of this, an initially permissive
regulatory approach, open to learning from market developments yet with a credible threat of
intervention should markets fail to protect consumers, is justified.
Keywords: consumer contracts, consumer finance, crowdfunding, distance selling, securities law, start-
up finance
*
Hogan Lovells Professor of Law and Finance, University of Oxford; Fellow, ECGI.
**
Allen & Overy Professor of Corporate Law, University of Oxford; Fellow, ECGI.
We are grateful for feedback received at presentations at an Oxford Business Law Workshop; the University of
Auckland Law Faculty; Universidad Carlos III de Madrid Department of Business; the ETH-NYU Law &
Banking/Finance Conference 2015 in Zurich; Munich University’s Center for Advanced Studies; the NUS-ETH
Law and Banking Colloquium 2016 in Singapore; the University of Hong Kong; the AEDE 7
th
Conference at
Catolica Global Law School, Lisbon; Durham Law School and the European Commission (DG-FISMA). We
thank in particular Doug Cumming, Horst Eidenmüller, Lars Hornuf, Lin Lin, Geoff Miller, and Tjio Hans and
two anonymous referees for helpful comments. Martin Bengtzen provided excellent research assistance. The usual
disclaimers apply. All URLs were last accessed 29 May 2017.
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A Introduction
Start-up firms—with untried products, and often untested founders—frequently find it difficult
to obtain finance.
1
This difficulty has arguably been exacerbated by constriction in bank
lending since the financial crisis.
2
Because start-up firms are disproportionately associated with
innovation and job creation,
3
the possibility of a ‘funding gap’ for start-up firms is a significant
concern for policymakers.
4
In the last few years, a new source of finance for start-ups, known as ‘crowdfunding’
(‘CF’), has become widely available. As the name implies, this involves raising capital from a
large number of individuals, each of whom typically contributes a small sum. The internet has
lowered the costs of raising funds in this way, by facilitating the dissemination of information
about small projects. Use of CF has grown exponentially. Industry statistics estimate a total of
1
See BIS, ‘SME Access to External Finance’, BIS Economics Paper No 16, January 2012; A. Freeman,
Challenging Myths About the Funding of Small Businesses: Finance for Growth (London: Demos, 2013); National
Audit Office, BIS and HM Treasury, Report by the Comptroller and Auditor General: Improving Access to
Finance for Small and Medium-Sized Enterprises, HC 734, November 2013, 13-15; British Business Bank,
‘Analysis of the UK Smaller Business Growth Loans Market’, Research Report, March 2015; cf R. Brown and S.
Lee, Funding Issues Confronting High Growth SMEs in the UK (Edinburgh: ICAS, 2014).
2
See eg I. McCafferty, ‘UK Business Finance Since the Crisis—Moving to a New Normal?’, speech given at
Bloomberg, London, 20 October 2015.
3
See eg B.H. Hall, ‘Innovation and Productivity’, NBER Working Paper No 17178 (2011); L. Kogan et al,
‘Technological Innovation, Resource Allocation, and Growth’, NBER Working Paper No 17769 (2012); National
Audit Office, BIS and HM Treasury, Report by the Comptroller and Auditor General: Improving Access to
Finance for Small and Medium-Sized Enterprises, HC 734, November 2013, 13; BIS, ‘SMEs: The Key Enablers
of Business Success and the Economic Rationale for Government Intervention’, BIS Analysis Paper No 2,
December 2013; J. Edler and J. Fagerberg, ‘Innovation policy: what, why, and how’ (2017) 33 Ox Rep Econ Pol
2, 9-10.
4
For details of recent policy initiatives, see BIS and HM Treasury, ‘2010 to 2015 Government Policy: Business
Enterprise’, Policy Paper, May 2015, available at
https://www.gov.uk/government/publications/2010-to-2015-
government-policy-business-enterprise.
3
$34 billion was raised worldwide using crowdfunding in 2015, having grown thirteen-fold over
just three years.
5
This is just over a sixth of the amount raised worldwide through initial public
offerings (‘IPOs’) on equity markets in the same year.
6
While the availability of CF is clearly good news for entrepreneurs, its merits for those
providing the funding are less certain. Because funders typically invest only small sums in
projects, CF may appeal to consumers, that is, unsophisticated individuals. However,
consumers have limited capacity to assess the prospects of a business, and are prone to making
investment decisions subject to biases and herd behaviour. In addition to losses to funders, this
can cause finance to be misallocated to inferior business projects. These risks raise important
questions for regulators.
In this article, we sketch out a normative roadmap for the regulation of CF in relation
to business start-ups. This is a highly salient enquiry. In the UK, the Financial Conduct
Authority (‘FCA’) has recently conducted its third review of CF regulation in as many years.
7
In the US, the Securities and Exchange Commission (‘SEC’) regulations for retail CF came
into force in May 2016 pursuant to the JOBS Act of 2012;
8
their operation is being carefully
5
Massolution, Crowdfunding Industry 2015 Report (2016).
6
EY, EY Global IPO Trends 2015 4Q, 4 (2016).
7
FCA, Interim Feedback to the Call for Input to the Post-Implementation Review of the FCA’s Crowdfunding
Rules, FS16/13 (2016). See also FCA, The FCA’s Regulatory Approach to Crowdfunding over the Internet, and
the Promotion of Non-Readily Realisable Securities by Other Media, PS14/4 (2014).
8
SEC, ‘Crowdfunding: Final Rule’ (2015) 80 Federal Register 71388 (17 CFR Parts 200, 226, 232, 239, 240,
249, 269 and 274).
4
studied. Meanwhile, the European Commission is actively seeking to promote CF as part of
the Capital Markets Union action plan.
9
We begin by considering the use of CF and the characteristics of typical CF contracts.
One type of CF contract—the ‘reward’ model, in which funders are rewarded with units of
product—offers both firms and funders the promise of reducing uncertainty by generating new
information about consumer demand. By using reward CF, founders capture synergies between
their product and capital markets. Rather than raise capital and aggregate information about
likely success as a by-product (through the price mechanism), they tap the product market, thus
directly testing demand, and raise capital as a by-product.
In contrast, with ‘equity’ CF, where funders buy shares, their valuations are based on
estimates of others’ future consumption of the product and the venture’s profitability, about
which they have no special expertise. There is consequently a real peril that consumers (whom
hereinafter we refer to as ‘retail investors’ when they invest in equity CF) will simply ‘herd’
into backing projects that early adopters have previously found attractive, which can lead to
misallocation of capital.
We then review the regulation of CF in the UK (which largely reflects the
implementation of EU law) and the US. Because CF is a novel practice, regulatory policy has
tended, to some degree, to take the form of the application of existing frameworks designed
with other contexts in mind. This has led to inconsistent, and in places misconceived, regulatory
treatment.
9
See European Commission, Action Plan on Building a Capital Markets Union, COM(2015) 468 final, 30
September 2015, 7; European Commission, Crowdfunding in the EU Capital Markets Union, SWD(2016) 154
final, 3 May 2016.
5
Reward CF binds together a start-up firm’s financial and product markets. The
involvement of the product market means that the practice appears to be subject, in the UK, to
the regime established by EU consumer protection rules, mandating amongst other things that
consumers have an option to cancel the transaction and reclaim their money. This, we argue,
fails to take account of funders’ dual function as product consumers and financiers, in the latter
aspect of which they bear risk associated with the product’s completion. In contrast, few
mandatory terms are imposed on consumer contracts in the US. This gives parties greater
freedom to design reward CF arrangements. While reward CF is virtually non-existent in the
UK, it has flourished in the US.
Equity CF involves issuing securities to investors, and for that reason is formally
within the domain of ‘securities law’. A central plank of securities law is mandatory disclosure,
the compliance costs of which are often prohibitive for small firms. Despite the reduction of
these costs in the US through a special regime for equity CF, with effect from May 2016, they
still seem too high to foster the development of equity CF in that country. In contrast, equity
CF has flourished in the UK, where there is an exemption from disclosure obligations under
the Prospectus Directive for small offerings. In our analysis, the way equity CF markets operate
is sufficiently different from traditional securities market contexts that the justifications for
mandating disclosure in those other market contexts do not carry across.
The structure of the problems of CF are common to many consumer finance
transactions. However, evidence-based regulatory solutions in consumer finance tend to be
context-specific, and poorly-crafted intervention can easily make things worse rather than
better. At this early stage of the market’s development, we consequently advocate a permissive
regulatory regime. This allows the promise of reward CF to be fulfilled, and offers the
opportunity for the development of market solutions in respect of equity CF. In the penultimate
section, we review the range of market mechanisms that have been deployed in the UK and
