Crowd Funding: Implications for the South African Entrepreneur

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.

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[1] Jumpstart Our Business Startups.

[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.

[4] Exchange for value.

[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.