Thursday 13 October 2016 5:32 am

Smoke and mirrors: Who's responsible for greater transparency in equity crowdfunding?

What's in store for crowdfunding now? The FCA has reached the final stages of its latest review of the rules governing the sector, and this comes at a critical time in the cycle, when many deals are starting to conclude (and failures are becoming painfully apparent).

Moreover, investment volumes have fallen for the first time ever – down 17 per cent in the first half of this year according to a recent report by Beauhurst, a research firm. In such an environment, the FCA needs to be careful not to stifle the innovation that crowdfunding offers – but it shouldn’t tread too carefully.

Value for money

Ensuring that platforms provide sufficient protection and value to investors is crucial. Current rules are heavily reliant on retail investors self-certifying their eligibility to participate, while the onus on platforms to make sure investors are provided with clear and robust investment information is relatively light.

What’s required, in my view, is a much greater emphasis on transparency and disclosure. Platforms need to take more responsibility for the information given by investee businesses, and they need to disclose more clearly what due diligence has been done. In addition, there needs to be an end to any “smoke and mirrors”, whereby investments appear more attractive to (and in demand from) the crowdfunding community than they really are – for instance, by presenting a deal as almost fully funded when most of the capital has come from other, non-crowdfunded sources.

Unfortunately, the competitive landscape makes it hard for crowdfunding platforms to raise standards. Dominated by just a handful of major players, existing business models leave little room to increase the focus on transparency and more detailed due diligence without significantly raising costs.

However, unless standards improve, there’s a risk that the Treasury may simply decide that EIS and SEIS (the government’s tax-efficient schemes designed to encourage SME investment) are being abused and call a halt to these kinds of incentives. This would have a major knock-on effect on venture capital of all kinds – and it would be an existential crisis for equity crowdfunding platforms. According to recent research by Radius Equity, 96 per cent of deals listed on platforms qualify for EIS or SEIS.

Vote with their feet

Could investors themselves provide the answer? I’m a firm believer in caveat emptor, and think that, ultimately, investors will vote with their feet. Either they will pull out of the market, or they will recognise the need to start paying more for a better quality service.

The reality is that SME investing requires a huge amount of expertise and hard work on the part of the intermediaries who do the deal. That means conducting thorough due diligence pre-investment to ensure that business models are sound, that the management team has got what it takes to drive growth and that realistic exit plans are in place. It also means ongoing oversight and management of the investment post-deal if the promised returns are to be delivered. This is the kind of approach that an institutional private equity investor would expect – private investors deserve similar treatment.

It’s a delicate balancing act for the FCA: not to overburden an industry which has an important role to play in providing funding for small, growth businesses, while also looking after the interests of the individuals who want to back them.

But the crowdfunding industry needs to change, or it could ultimately implode – and that would be a great shame for businesses, investors and the economy as a whole. What actions the FCA might take to tighten its regulatory stance remain to be seen, but investors could also have a significant role to play as key drivers of change.