Access to Funds from the Crowd a Step Closer for Innovators

Public consultation recently closed – yes, I know, my timing isn’t great, but I was off-line for three months with a gang of nasty viruses, so sue me – on a potential regulatory framework for crowd-sourced equity funding (CSEF) in Australia. CSEF is an emerging form of funding that enables someone to raise funds online from a large number of small investors in return for an equally small equity stake in the project or company for which funds are being raised. Worldwide, crowd-sourced funding (without the equity) has been used to fund everything from scientific experiments to feature films and medical treatment, but it is its potential to fundamentally transform the ability of small and start-up businesses that has innovation junkies like me all a-quiver. 

To understand why, we need some context. According to the Organisation for Economic Co-operation and Development (OECD), whose 34 members represent all of the developed and the leading emerging economies, world-wide most businesses are micro-enterprises ie firms that employ fewer than 10 persons. Micro-enterprises (MEs) account for 70% to 95% of all firms across member countries, and small to medium enterprises (SMEs) which are firms with fewer than 250 employees, for 99% (Science, Technology and Industry Outlook 2014).  That means that most of the firms in an economy – the parts of the economy that make up the engine room of productivity, and which we want to take up innovation to increase everyone’s standards of living – are not very big.

The problem with that is that, particularly compared with firms that are very big, SMEs and MEs have a notoriously hard time accessing finance. Bank advertisements may claim to want to “partner with” more businesses, but the truth is not unlike the residential mortgage market – they still want ideally to lend to people who really don’t need it. Which makes sense, when you consider it from the bank’s perspective – they may make money from interest repayments, but that pre-supposes that the borrower has both the money to make those payments and to repay the amount borrowed. If not, the banks lose money, and banks hate that.

Risk is a big deal to banks, and SMEs and MEs often have neither the consistent track record or assets that will comfort a bank in the same way a large corporation does. Plus banks expect loan repayments to start immediately which if, as is usual, the improvements and enhancements – the value – that will flow from using that money in the business will be realised over time.

And if the problem is bad for SMEs and MEs, it’s worse for start-ups.  According to the Discussion Paper released in December 2014 as part of the CSEF consultation process, some banks have noted that they decline approximately twice as many loan applications for start-ups as for established small businesses – around 20% compared with 8% for small businesses as a whole – at least in part because of the costs involved in assessing the risk involved in lending to a smaller business.

Which leaves the equity market.  Where it’s not necessarily much better, given the impact of the global financial crisis. According to the OECD, during the period 2007-10 equity finance was severely affected world-wide and in 2011, the level of equity investment in many countries was still well below pre-2007 levels. To quote the Science, Technology and Industry Outlook 2014:

A significant degree of uncertainty continued to characterise the financial environment at the time of drafting. In view of these resource constraints, new sources of finance, such as peer-to-peer lending, crowdfunding and IP-backed equity funds are promising but remain marginal.

Interesting term, ‘marginal’; one has to remember that the OECD is using it in the context of global financial markets.  The same report puts the total funds leveraged by crowdfunding globally in 2011 at roughly USD 1.5 billion and notes anecdotal evidence of “explosive” growth in both the numbers of crowdfunding platforms and the amount of funds committed for a relatively short time in the period 2008-13.

There are initiatives related to the regulation and institutionalisation of crowdfunding underway around the world.  In recent years, the United States’ Jobs Act legalised crowdfunding for start-ups raising up to USD 1 million a year through small investments online and social media. The New Zealand model, which forms one of the pillars of the consultation paper, is light on restrictions for investors or investees beyond that of being incorporated in their country, and the Discussion Paper notes initiatives in Canada and the United Kingdom.

There are, as the Discussion Paper observes, a small number of operators of online platforms already offering investment in Australian start-ups. However, under current legislation none of the are able to make its services available to all investors.

It’s not just our existing legislation that is a hurdle for some.  According to the OECD, crowdfunding raises issues of security in cyberspace and in monetary transactions as well as the question of the true motivation of platform managers.  It also ” suffers from a lack of mentoring and coaching of non-professional investors who may be unfamiliar with sophisticated risk and return analysis and decision-making tools,” a criticism with which I have issues given one doesn’t need mentoring to trade on-line shares or, for that matter, invest in the dead-certainty of poker machines.

While these risks are no doubt why Australian Government is yet to fully commit to implementing a CSEF framework, this paper is a huge step forward.  The reality is that countless reports, Chief Scientists, respected industry figures and even academics have been pointing fingers at the lack of available capital for early stage investment and uptake as a key limitation on the Australian Innovation system’s ability to perform closer to its potential. At present, the size of stake necessary for an individual investor to step up to meeting that challenge is so high that it is beyond all but the very few, and a great many of them seem to prefer giving money to medical research, social causes and the arts**.

The Discussion Paper is explicit in its belief that facilitating CSEF would provide additional investment opportunities to retail investors who, they say, are “generally unable to be directly involved in early-stage financing activities, such as angel investing, due to the size of investment required.” If CSEF were more widely available, particularly if that width included the type of ventures in which one could invest as well as the size of the investment one could make, retail investors could “broaden their range of investments and to become involved in funding products and services that interest them”.

Which brings me (finally) to the a-quiver bit.

It’s the potential of these “interests” which is most exciting.  According to the OECD’s Science, Technology and Industry Outlook 2014, untapped private wealth is an abundant and growing source of funding for innovation globally.  Private wealth, in contrast to commercial providers of finance, has a far greater spectrum of interests to serve as motivation to become involved in innovation, whether that involvement takes the form of an investment in a single innovative start-up or in a SME or ME’s efforts to innovate to improve its performance.  That interest may be a willingness to embrace greater risk for the potential of greater reward which, given Australian private equity and venture capital outperformed the listed market by over 20% in the 12 months to 30 September 2014*, could be very worthwhile. Or it may reflect their interest in a particular issue or technology, such as clean energy or advanced manufacturing.

And that’s an entirely new funding pool, one of significant proportions and one which doesn’t require sacrificing hospital beds or safe highways for the sake of innovation. One that will define “competitive” in entirely new ways, ways that if we can master, have the potential to improve not just the quantity but the quality of our innovation output as well as its chances of making it out into the wider economy.

Perhaps the OECD were on to something, and not just on something, after all:

This alternative funding mechanism has far-reaching potential, for instance to accelerate technology transfer from universities

* Report of the Australian Private Equity & Venture Capital Association Limited (AVCAL) and Cambridge Associates, released 19 February 2015. The full media release and report are available on-line.

** based on desktop analysis using Fundraising Research & Consulting’s  Australian Philanthropy Top 250 list

Information on the consultation process, including a downloadable form of the December 2014 Discussion Paper, is available at www.treasury.gov.au

Publications of the Organisation for Economic Co-operation and Development (OECD) are available on-line through their iLibrary

One thought on “Access to Funds from the Crowd a Step Closer for Innovators

  1. Pingback: Expanding the Funding Pool for Innovation – CSEF is Not Just for Start-ups | Fiona McNee

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