Abstract:
Crowd funding is a new concept. There are specific implications to be considered by entrepreneur and investor alike. It is too early to tell how crowd funding will shape South Africa’s entrepreneurial landscape. Time will eventually tell the story. Until then, entrepreneurs should carefully consider this funding option. And, when they do decide to use crowd sourcing, they should proceed with caution, courage and wisdom.
INTRODUCTION
Crowd funding seems to be the
latest silver bullet for start-ups and small entrepreneurs that are looking for
funding.
A quick search on Google reveals
that there are there are 7.1 million pages on the Web that refer to crowd
funding. Narrowing the search to pages
from South Africa, yielded 15 thousand pages at the time of writing this paper
(23 August 2012). Many of these pages
represent popular views about crowd funding.
Some are from news agencies (magazines, newspapers, etc.) that offer
basic information about crowd funding.
Other pages are blogs where one can find many personal and anecdotal
views about the subject. A few pages
contain academic articles about the subject, and a commensurate few refer to
legal issues that could arise from crowd funding.
From a South African perspective,
crowd funding has been on the scene for about four years. Being a relatively new concept, little
objective information exists about crowd funding in South Africa.
This paper is an attempt to present
exploratory research about crowd funding.
Readers must take care that it is not an exhaustive elaboration about
the subject. Nor is it able to address
all current and potential issues associated with crowd funding.
ORIGINS OF CROWD FUNDING
Wikipedia lists a number of groups
or organizations that kicked off the concept of crowd funding:
·
In 1997 a British rock group, Marillion, raised
$ 60 000 from fans through the use of an internet campaign
·
ArtistShare launched a crowd funding website in
the USA around 2000/2001. This was
quickly followed by similar websites – each claiming huge successes
·
The Japanese rock band, Electric Eel Shock,
raised 10 000 Pounds Sterling from fans in 2004
·
A certain Franny Armstrong funded a movie and is
associated with the funding of a rock band named Morton Valence in 2007.
DEFINITION OF CROWD SOURCING
At present, there is no standard definition for the term
crowd funding. A number of definitions
are listed hereunder:
·
The Online Oxford Dictionary defines crowd
funding as a “practice of funding a project or venture by raising small amounts
of money from a large number of people, typically via the Internet”
·
The website DailyCrowdSource.com states that
crowd funding is “asking a crowd of people to donate a defined amount of money
for a specific cause, project in exchange for rewards”. The website also explains three categories of
crowd funding:
o
Equity based funding, where the entrepreneur
offers a percentage of equity in exchange of funds
o
Donation based funding where tangible tokens
such as T-shirts, CD’s. etc. can be offered in exchange of funding
o
Debt-based funding where lenders or donators are
promised financial returns or interest at some point in the future
·
The Financial Times Lexicon defines crowd
funding as “A new and emerging way of funding new ideas or projects by
borrowing funding from the crowds”
·
The MacMillan Online Dictionary defines crowd
funding as “the activity of getting a large group of people to finance a
particular project, especially by using a website where people can make
contributions”
·
The website USLegal.com states: “Crowd funding
refers to the collective cooperation, attention and trust by people who network
and pool their money and other resources together, to support efforts initiated
by other people or organizations. The purpose of crowd funding varies, from
disaster relief to citizen journalism to artists seeking support from fans, to
political campaigns. Crowd funding is also used for startup (sic) companies. It
is sometimes called crowd financing or crowd sourced capital. An entrepreneur
seeking to use crowd funding typically makes use of online communities to
solicit pledges of small amounts of money from individuals who are typically
not professional financiers”
·
Lastly, the South African website startme.co.za
repeats the Online Oxford Dictionary’s definition of this term.
Other websites state the dominant role that social media
plays in the solicitation of crowd funding.
Considering the definition of USLegal.com, a few essential
characteristics of crowd funding can be listed:
·
There has to be some form of trust between
entrepreneur and investor
·
Funding is obtained mainly in the form of
pledges
·
There can be different forms of
counter-performance from the entrepreneur in exchange for funding
·
Investors can demand equity, interest or some
form of dividend in exchange for funding.
Another form of crowd funding is known as “Social
Franchising”. The purpose of social
franchising is to provide funding for community upliftment. Examples include but are not limited to:
·
Building of schools;
·
Donate food to communities;
·
Teaching language courses;
·
Teaching financial literacy (such as the micro
bank, MyBnk, that was founded in the UK);
LEGAL OR REGULATORY FRAMEWORKS
In 2012 the United States President, Barack Obama signed the
JOBS[1]
Act in an attempt to boost small business development. At the same time the
Crowdfund Act of 2012 was announced and the US Securities Exchange Commission
was tasked with the creation of rules to control crowd funding in the US.
The JOBS Act allows accredited investors to provide equity
funding to entrepreneurs who want to make use of crowd funding.
The Crowdfund Act, on the other hand, puts limitations on
the maximum amounts that could be sourced through the use of crowd
funding. In addition, it puts a duty
upon brokers, issuers and funding portals to safeguard investors against
fraud. The Act also allows for the
creation of self-regulatory institutions that can safeguard entrepreneurs and
investors alike. There is also a duty of
full disclosure that must be made to investors.
In the South African context, crowd funding is still in an
infant stage. At the time of writing
this paper, no draft legislation has yet been proposed about crowd funding in
Parliament. In 2011, D. J. Hislop argued
that crowd funding is view with a great degree of scepticism. The resemblance to a pyramid scheme has been
mentioned, which is understandable.
Since the famous Kubus[2]
debacle of the late 1970’s, South Africans cannot be blamed for being sceptical
about crowd funding. Though there is not
yet any direct evidence to associate crowd funding with a pyramid scheme, investors
and entrepreneurs may want to err on the side of caution – especially in cases
where funds are offered from off-shore sources.
A quick visit to crowd funding websites in South Africa and
elsewhere shows that some investors are found outside one’s own national
borders. Dealing with contracts or legal
actions in one’s own jurisdiction is already difficult, time consuming and
expensive. To transact with investors, lenders or donators in other jurisdictions
(such as India, Germany, Lebanon, Russia, Bulgaria, etc.) can make this type of
funding very expensive – especially if entrepreneurs prefer to have written
agreements in place. The cost to make
use of off shore funds through crowd funding can thus outweigh any potential
benefit that was contemplated through such funding.
Even when dealing with crowd funding sources within South
Africa’s national borders, great circumspection would be advisable. In many cases, investor/lender and
entrepreneur are introduced to one another through some sort of mediator. Typically, parties are introduced to one
another through a website or social medial site. This implies that there are three parties in
any crowd funding transaction, namely:
·
Investor;
·
Entrepreneur;
·
Intermediary;
It is thus not uncommon (like in other situations where
investors and entrepreneurs are introduced to one another) that a commission is
payable to the intermediary by either the investor or the entrepreneur. Great care must also be taken to guard all parties
against misrepresentation by anyone in this tri-partition.
Next, there is no guarantee that intellectual property
rights are protected in this type of finance.
Many institutions that offer crowd funding, advise that entrepreneurs
should protect their intellectual property before making use of this type of
funding. The intermediaries in crowd
funding transactions sometimes take a position that investor and entrepreneur
must reach agreement on the protection of intellectual property. Until some definitive case law[3]
is published in South Africa about the protection of intellectual property
rights in a crowd funding situation, entrepreneurs must be aware of a vast
minefield that awaits them.
In 2011 a patent dispute arose between Kickstarter and
ArtistShare. Both organizations claimed
that they have legal right to operate as crowd funding service providers. In addition, ArtistShare insisted that it is
not infringing on the patent rights of Kickstarter to offer crowd funding
services. This type of dispute can create complications for investor and
entrepreneur if it is found that ArtistShare indeed infringed on the other
party’s patent rights. Thus the one party,
who loses such court case, could be in a position where the relationship
between entrepreneur and investor is being threatened.
It is not yet clear what view South African legislation will
take in terms of interpreting crowd funding as a form of dealing in
securities. In Canada and the United
States, security and exchange rules are being reviewed. In the United States, the so-called Howey
Test is used to discover whether a transaction is an investment contract or
not. Investment contracts in the United
States are directly associated with securities.
In terms of the Howey Test, a transaction would be an investment
contract (security) if:
·
There was an exchange of money
·
There was an expectation of profit arising from
the exchange of money
·
The exchange of money was about a common
enterprise
·
There is a sole dependence on the efforts of a
promoter or third party to obtain finance.
Nor is it clear what position the SA Reserve Bank will take
when overseas crowd funding sources are being used. International banking transactions and
exchange control rules could be very difficult to understand. Entrepreneurs would therefore have to make
use of respectable international bankers to assist with such transactions.
PRACTICAL CONSIDERATIONS
This paper referred in a previous section to an opinion that
crowd funding could be a type of a pyramid scheme. If one considers some of the definitions of
crowd funding, it is understandable why crowd funding could be seen as a
pyramid scheme. Firstly, there are
multiple people who are approached to invest.
Secondly, unless the money received is a donation (which has to be
recorded in anyway on one’s accounting system), meticulous records need to be
considered regarding each investment.
The entrepreneur must be able to know:
·
Who donated/invested
·
What was the quantum of donation/investment
·
What is the return (interest, equity or
dividend) expected by the investor
·
What are the main conditions and performance
clauses that control the investment
·
What are the maturity date(s) by which
investments must be paid back, interest must be paid, or dividends must be
paid.
The consequences of ill-kept records could be disastrous and
could lead to great losses for the entrepreneur and investor alike.
In practice, Skopus Business Consultants have encountered
many entrepreneurs who believe that angel investors (a synonym for crowd
funding in some circles) are great humanitarians that do not expect anything
back in return for funding that is given to the entrepreneur. Though there are such humanitarians around,
the majority of organizations or individuals that offer crowd funding expect
definitive quid pro quo[4]. There is thus no free lunch in the world of
crowd funding. Angel investors, however,
differ from crowd funders in the sense that the angel investor is a single
person taking a risk, whereas the risk is spread out when crowd funding is
used.
Any form of funding – even a donation – should be viewed in
a very serious light. It would be
expected that the entrepreneur managers his/her business frugally and that
there will be sufficient cash flow at the end of a given time to:
·
Pay back the investor; or
·
Pay the dividend expected by the investor; or
·
Pay back the interest demanded by the investor;
FEASIBILITY
Crowd funding is associated with innovation. Thus, a new idea is in need of funding so
that it can be developed or commercialised.
Given this association with innovation, it stands to reason that ideas
have to be well thought out. The
slightest scepticism from an investor/donator about an idea could mean that the
entrepreneur cannot meet his/her funding targets.
Some products may evoke more scepticism than others. As an example, a device that claims to work
with resonance frequency and that can relieve or cure all sorts of illnesses
(including cancer or HIV/AIDS) would have to have thorough research and test
results – including clinical tests – to back up claims. Without such rigorous evidence, the
investor/donator could just as well consider to fund a cough mixture made out
of “Indonesian snake sweat”[5].
There may be requirements that certain certifications (such
as the CE-certification or an SABS mark) must already be assigned to the
product before an investment/donation could take place. Other standards such as ISO standards may
also be required to convince funders. Working
prototypes may be required to secure funding.
There are many funders that will not consider any pitch or application
unless a working prototype can be demonstrated.
For the entrepreneur, this can be a Catch-22 situation because all
available funding may be exhausted, thus not leaving any room for
certifications or working prototypes. The
entrepreneur would have to spend significant time to convince funders about the
validity of the idea[6],
whilst the funder would have to take a giant leap of faith.
Fortunately, this Catch-22 is slowly but surely changing in
South Africa. As more innovation hubs
are created, and as more universities start to focus their third stream
activities on innovation, innovators will have a sporting chance in the future
to go to funders with working prototypes that are well designed and that have
all certifications either in progress or in place.
GOING FORWARD
This paper is by no means comprehensive. More research is required to understand how
crowd funding will shape the South African innovation or entrepreneurial
landscape. Important lessons will be
learned on this journey. Entrepreneur
and investor alike are going to make mistakes and pay an expensive price in the
process. But, like the pioneers before
them, someone has to break the way open so that future generations can benefit.
No one can say how crowd funding is going to benefit or harm
the South African entrepreneur. That
will be determined by the jury of time and the facts uncovered by future
research.
[2]
The Namakwaland farmer, Adriaan Nieuwoudt started a scheme with milk cultures
that was called “Kubus” cultures. It was
one of the most widely published pyramid schemes in South Africa at the time.
[3]
Neither Skopus Business Consultants nor the author of this paper is law
practitioners. The view expressed in
this sentence should not be construed as legal advice. It merely represents reasonable business
circumspection.
[5]
In the 1800’s, many salesmen travelled around with cures that apparently
contained snake oils and that were purported to have had magical curative
powers.
[6]
The old-fashioned Harm vs. Utility argument thus needs to be dusted off,
dressed in a new coat, and used with vigour.
