20150105 Crowdfunding Understanding the Basics Note (3)

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JANUARY 2015 Denise Valentine

[email protected]

Crowdfunding: Understanding the Basics
mailto:[email protected]:[email protected]:[email protected]


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Crowdfunding: Understanding the Basics January 2015

2015 Aite Group LLC. All rights reserved. Reproduction of this report by any means is strictly prohibited. .

101 Arch Street, Suite 501, Boston, MA 02110 Tel: +1.617.338.6050 Fax: +1.617.338.6078 [email protected] www.aitegroup.com

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TABLE OF CONTENTSINTRODUCTION .............................................................................................................................................. 4

METHODOLOGY ........................................................................................................................................ 4

CROWDFUNDING: WHAT IT IS, WHAT IT DOES .............................................................................................. 5

MARKET OVERVIEW........................................................................................................................................ 7FINANCIAL INTEREST IN CROWDFUNDING ............................................................................................... 9

THE WHYTHE POST-RECESSION BLUES.................................................................................................. 9

THE WHOINVESTORS ........................................................................................................................... 11

THE WHATA GALAXY OF PLATFORMS ................................................................................................. 19

THE NOWPLATFORM METRICS ........................................................................................................... 21

THE BENEFITS AND RISKS OF CROWDFUNDING ........................................................................................... 27

THE BENEFITS .......................................................................................................................................... 27

THE RISKS ................................................................................................................................................ 29

THE REGULATION ......................................................................................................................................... 31

U.S. CROWDFUNDING REGULATION....................................................................................................... 31

U.K. FCA'S CROWDFUNDING REGULATION ............................................................................................ 35

CONCLUSION ................................................................................................................................................ 38

RELATED AITE GROUP RESEARCH ................................................................................................................. 40

ABOUT AITE GROUP...................................................................................................................................... 41

CONTACT ................................................................................................................................................. 41

LIST OF FIGURESFIGURE 1: CROWDFUNDING MARKET SIZE BY LOCATION .............................................................................. 7

FIGURE 2: NUMBER OF CROWDFUNDING PLATFORMS BY LOCATION .......................................................... 8

FIGURE 3: U.S. CONSUMER DEBT ................................................................................................................. 10

FIGURE 4: THE WORLD'S WEALTHIEST INVESTORS ...................................................................................... 12

FIGURE 5: THE SECURITIZATION OF P2P PLATFORM LOANS ........................................................................ 15

FIGURE 6: U.S. ENTREPRENEUR ATTITUDES ................................................................................................. 17

FIGURE 7: U.K. PARTICIPATION IN ENTREPRENEURIAL ACTIVITY ................................................................. 18

FIGURE 8: U.S. VENTURE-BACKED IPOS ........................................................................................................ 19

FIGURE 9: TOTAL NUMBER OF BORROWERS BY CUMULATIVE VOLUME ..................................................... 22

FIGURE 10: U.S. SNAPSHOT ON PRIVATE ISSUERS PUBLICLY RAISING ......................................................... 24

FIGURE 11: DISTRIBUTION OF CAPITAL U.S. PRIVATE ISSUERS PUBLICLY RAISING ...................................... 24FIGURE 12: U.K. CROWDFUNDING ASSETS ................................................................................................... 26


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LIST OF TABLESTABLE A: TOP 10 COUNTRIES BY NUMBER OF CROWDFUNDING PLATFORMS .............................................. 8

TABLE B: PROSPER P2P PUBLISHED LOSS RATES BY PROPRIETARY RATING ................................................. 22

TABLE C: ZOPA P2P PUBLISHED DEFAULT RATES BY TIME PERIOD, SEPTEMBER 2009 TO AUGUST 2014 ... 23

TABLE D: TOP 10 INDUSTRIES IN PRIVATE ISSUANCE PUBLICLY RAISING ..................................................... 25TABLE E: SUMMARY OF BENEFITS AND RISKS .............................................................................................. 27

TABLE F: HIGHLIGHTS OF IMPORTANT CHANGES ACHIEVED BY JOBS ACT .................................................. 32


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4

INTRODUCTION

Take heed: Crowdfunding is big, hairy, and audacious, and it's becoming more popular. The

crowdfunding tsunami is now visible, and the World Bank predicts that global crowdfunding (all

types) will reach US$93 billion by 2025. Financial crowdfunding platforms bring new forms of

investment opportunities to investors while helping the underserved borrower andentrepreneurial markets, from individuals to smaller companies. For example, the peer-to-peer

(P2P) market gives unsophisticated investors access to higher interest rates than they would at

many banks. Crowdfunding offers accredited investors1new opportunities: It gives the high-net-

worth individual access to equity deals either not broadly disseminated or previously out of

reach; institutions, too, can access equity deals and high-earning loan interest.

Crowdfunding has evolved over time, and it has reached "next-generation" status, with

platforms segmented by investor, structure, and investment type. As platforms seek economies

of scale, the nascent industry is seeing many new launches each month, and institutions are

appearing as investors and backers across the board. To those naysayers who say financial

crowdfunding will implode, Aite Group says "not likely." Platforms may stumble and retrench,but the many hands on this bucket suggest that it will right itself again and again.

This Impact Note focuses on financial crowdfunding in the United States and United Kingdom. It

offers a context for crowdfunding, including why it is happening, who the investors are, how the

platforms work, and what constitutes the growing community of participants as well as the

regulatory changes behind this growing industry.

METHODOLOGY

In September and October 2014, Aite Group interviewed platform founders, product managers,

and employees at a dozen financial crowdfunding platforms, as well as various types of serviceproviders supporting the industry, to explore key business trends and challenges, regulation, and

the anticipated evolution of this business.

1.

In the United States, an "accredited investor" is a natural person (as opposed to a legal person) who

earned income that exceeded US$200,000 (or US$300,000 together with a spouse) in each of the priortwo years and reasonably expects the same for the current year, or has a net worth over US$1 million,

either alone or together with a spouse (excluding the value of the person's primary residence). In the

U.K., an accredited investor has an annual income of GBP100,000 or more, and more than GBP250,000

in net assets (excluding primary residence and any loan secured against that residence, any rights

under a qualifying contract of insurance, and any benefits payable on the termination of service or

upon death or upon retirement). Further, in the U.K., an individual may qualify as a "sophisticated"

investor, regardless of income and/or net worth, based upon an "appropriateness" test, an exam

administered by an FCA-registered entity.


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CROWDFUNDING: WHAT IT IS, WHAT IT DOES

A financial crowdfunding platform is essentially buyers and sellers interacting in an online

marketplace. This form of alternative finance is now considered a growing asset class with a

wide range of participating firms. Many industry participants consider financial crowdfunding a

business channel that co-exists with traditional banking and securities methods. A majority oftraditional lending and equity business channels are perhaps skeptical of the new players,

however, even as their volume and visibility grow.

According to the European Securities and Markets Authority, crowdfunding comprises three key

elements:2

The small amount of money each participant provides

Online calls for participation

A platform that facilitates contact between money providers and users

Within the category, there are two types of crowdfunding venues: nonfinancial and financial (a

50/50 split, according to the European Securities and Markets Authority).

Within financial crowdfunding,P2P platformsare booming. Representing 90% of

the market, P2P platforms are structured to enable participation from non-

accredited investors. P2P platforms primarily focus on borrowers seeking to

consolidate debt or to make a major purchase; however, the usage list is broadening.

Investors, both non-accredited and accredited, make small loans to many borrowers.

Other types of platforms include equity, lending, venture capital (VC), and real estate

platforms:

Equity platformsoffer equity ownership in a business. Some offer the ability to

invest with "leads" or experienced investors. Estimates from 2011 show 21% of

funds raised for equity projects were for US$250,000 or more; 26% were

between US$50,000 and US$100,000.

Lending platformloans tend to be larger individual or commercial loans.

Investors may lend to borrowers via whole loans (as opposed to lending

portions of a loan).

VC platformscreate a network with experienced investors, either angel

investors or venture capital firms for equity investment in businesses. Investors

co-invest with an angel investor or VC fund, which establishes a syndicate. On

some platforms, investors may become "backers" committing to future deals (a

priority status) by a lead syndicator. Generally, the angels and VC firms provide

business acumen to the startup firms. Investors receive carried interest, a

percentage of the profit of a fund, if any. (VC platforms may offer their

2. European Securities and Markets Authority, crowdfunding position paper ESMA/2014/SMSG/010,

April 10, 2014.


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investments via a special purpose vehicle that is a limited liability company

created for each specific investment.)

Real estate platformsinvest in residential or commercial buildings, or both.

Some platforms provide for a focus on local community initiatives, aligning

investors with their neighborhoods or preferences.

Nonfinancial platforms involve donation or reward-based systems in which investors

donate, sponsor, or receive a product or gift in exchange for a monetary

contribution. Kickstarter and Indiegogo are two winner platforms in this realm. Five-

year-old Kickstarter has raised more than US$1 billion in pledges from 7.1 million

people, funding 70,000 creative projects. And the machine keeps pumping away.

Many view financial crowdfunding as an industry disruptor, which occurs when a business takes

an existing human behavior, moves it online, and makes it more efficient. Common examples of

industry disruption include shopping on Amazon, socializing on Facebook, downloading music on

iTunes, and dating on Match.com. Crowdfunding qualifies as a disruptor. If it can offer previously

unavailable opportunities to its buyers and sellers, it may even become a levelerproviding

broader access to investment and funding beyond the very wealthy and institutions. The wider

the beneficiary pool, the more likely crowdfunding will be called a pivotal financial services

moment. Hinging on its success is participation from members that fully understand its benefits

and risks.

Investors find direct access to an online marketplace financially liberating, and the energy in the

crowdfunding community, from the individual to the institution, is contagious. In this

environment, a broader range of borrowers and entrepreneurs has far quicker, easier access to

loans or capital respectively; some previously may not have had access at all. On the flip side,

investors have access to potentially better returns with fewer middlemen; however, investors

accept the risk of stepping in as creditors. To assuage these fears, new crowdfunding platforms

report unique credit-scoring models, due diligence in deal evaluation, and better service thantraditional venues. As the industry unfolds, a better understanding of practices in these areas

will become clear. Crowdfunding competition is healthy, and some traditional financial

institutions are taking notice.

Currently, crowdfunding terminology is in flux in the financial realm. The word "crowd" in

crowdfunding implies individuals and applies more to fundraising as a donation than to

platforms that offer a financial return to the investor. Further, usage of the terms "crowd" and

"P2P" in the financial context is less accurate as more institutional investors now access loans

either through investments or through securitization. Equity and lending platforms now prefer

the term "online marketplace" to crowdfunding. For simplicity in this report, Aite Group uses the

term "crowdfunding" and references the terms "P2P," "lending platform," or "equity platform"where the context is appropriate.


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MARKET OVERVIEW

As of December 2012, 536 crowdfunding platforms worldwide had raised US$2.7 billion,

primarily in the United States (Figure 1). In the year 2013, market participants estimate more

than US$5 billion was raised. In nine months in 2014, one U.S. platform alone, Lending Club,

raised nearly US$3 billion. Figures for mid-2014 across all types of platforms worldwide showmore than 1,000 platforms.

3From 2009 to 2012, the industry grew at a compound annual

growth rate (CAGR) of 63%. A World Bank study predicts global crowdfunding potential of up to

between US$90 billion and US$96 billion by 2025, and this strictly from individual investors.4The

number does not include the institutional investors also participating in the industry's growth.

Though these volume figures pale in comparison to the many trillions of dollars in the global

banking and securities sectors, crowdfunding's growth is phenomenal.

Figure 1: Crowdfunding Market Size by Location

Source: World Bank 2013, U.K. Financial Conduct Authority, Aite Group; data includes all types of crowdfunding platforms

Globally, new platforms launch each month, but the vast majority of crowdfunding platforms are

in the United States and the U.K. (Figure 2). In Europe, a good number of platforms are in France,

the Netherlands, Spain, Germany, and Italy, while platforms in the Americas exist in Canada,

Brazil, Argentina, and Chile. In the Asia-Pacific/Oceania region, platforms are in Australia, New

3. Crowd Data Center statistics place this figure at more than 1,000, many of which are very small or

niche sites. See "Mapping The State of The Crowdfunding Nation Documenting The Global Rise of

eFinance & the eFunding Escalator," Q2 2014.

4.

WorldBank, "Crowdfunding's Potential for the Developing World," 2013. Note: The World Bank further

states that the greatest potential lies in China, which accounts for US$46 billion to US$50 billion of the

forecast figure.

U.S.61%U.K.

19%

Europe16%

Other4%

Worldwide Crowdfunding Total Market Size by Location, 2012(N=US$2.6 billion)


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Zealand, India, China, and Japan, and in the Middle East and Africa, platforms are in the United

Arab Emirates, South Africa, and Zambia.

Figure 2: Number of Crowdfunding Platforms by Location

Source: World Bank, 2013

Table A lists the top 10 countries, ranked by the World Bank by number of crowdfunding

platforms of any type.

Table A: Top 10 Countries by Number of Crowdfunding Platforms

Country Number of platforms

United States 344

United Kingdom 87

France 53

Netherlands 34

Canada 34

Spain 27

Germany 26

Brazil 17

Italy 15

Australia 12

Source: World Bank, 2013

U.S.51%

U.K.13%

Europe26%

Other10%

Number of Crowdfunding Platforms Worldwide, 2012(N=672)


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FINANCIAL INTEREST IN CROWDFUNDING

In July 2014, Facebook acquired Oculus VR Inc. for US$2.3 billion 18 months after the latter listed

on Kickstarter. The magnitude of the acquisition price was startling. For the 9,522 backers of the

startup's online fundraising campaign, who received t-shirts and trial products but no

investment return, the financial exchange may have been a little disappointing (equity

shareholding has its merits). Especially in economically difficult times, more asset owners arelikely to begin seeking returns on their crowdfunding investments, particularly for larger sums of

money. Donation sites will continue among audiences looking to support meaningful ideas, but

financial return funding is increasing fast.

Traditionally, entrepreneurs in need of money often hit their savings and retirement plans, their

credit cards, and then friends and family. The next stop for a business with good prospects is

usually an "angel" investor (i.e., wealthy entrepreneurs that help fund growth). Bank loans and

VC firm funding is another or next option. From there, a successful, high-growth firm would

launch its initial public offering (IPO) with the help of an investment bank. Today, crowdfunding

is seen as expanding the "friends and family" network, and it offers options at other

development stages. Realistically, crowdfunding also offers a financial resource for mom-and-pop shops, solid businesses that are never destined for the IPO market or to attract the attention

of VCs oriented to glossy high-tech firms.

Among the financial-return platforms, the "crowd" in "crowdsourcing" is in P2P lending. In

equity, lending, and real estate platforms, the crowd is smaller, limited to the wealthy accredited

investor, institutions, and some citizensthe U.S. Jumpstart Our Business StartUps Act (JOBS

Act) aims to include all citizens in new investment opportunities. In the United States, only state-

specific equity crowdfunding platforms are or will be open to the public. In the U.K. (and other

parts of Europe), financial crowdfunding is already open to the public with a stipulation that

"unsophisticated" individuals may not invest more than 10% of their investable assets per year.

THE WHYTHE POST-RECESSION BLUES

T H E C O N S U M E R S C E N E

On the heels of the successful donation/reward platforms, crowdfunding platforms have caught

the attention of capital, loan-seekers and investors alike. These platforms facilitate access to

money, providing qualified recipients with rapid cash and lenders with returns above traditional

cash savings accounts and certificates of deposit, or for investors interested in long-term equity

investments, for core portfolio diversification.

The financial crisis of 2008 and its aftermath wrought havoc on many households and smallbusinesses. In particular, there has been a shortage of available credit to consumers and

businesses. Investors are in a quandary regarding investments given continued market volatility

and low fixed income rates. The details are widely written about manyindividuals are working

to improve their financial situations, whether through loan consolidation and debt payoff for

borrowers or through better returns than gained from savings accounts (at 0.7% or less) or from

other unsatisfactory investments in terms of investment returns, fees, or options.


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The U.S. consumer debt market represents an enormous opportunity for lending platforms.

Some portion of this consumer market can and will view the online marketplaces as a funding

source. How much of this market financial platforms can capture is a function of their credit and

operational effectiveness, building brand awareness and trust, and any impact regulators may

have upon the business. The U.S. consumer debt stands at US$12.2 trillion, andFigure 3 provides

the debt distribution across key categories. Home mortgages and home equity lines of creditrepresent 77% of debt, or US$9.4 trillion. Consumer loans, auto, and credit make up 14% or

US$1.8 trillion, while student loansa rapidly growing area for lending platformsis 3% or

US$0.4 trillion. Overall, retail loan balances excluding home-related loans is US$2.8 trillion.

Figure 3: U.S. Consumer Debt

Source: Aite Group analysis of data from the Federal Reserve and the Small Business Administration; "home mortgages" includes

farms, and "credit cards" includes demand deposit account overdraft

Crowdfunding platforms are gaining traction with people's growing reliance on and ease with

the Internet. Individuals are finding self-reliance through Internet searches and online activity is

a larger part of their investment education path. In fact, the U.S. Federal Reserve notes that use

of the Internet for decisions about borrowing increased from 38.4% in 2007 to 47% in 2013.5Use

of the Internet for decisions about investing rose from 28.3% in 2007 to 35.3% in 2013. Decision

sources such as friends and family were essentially the same for borrowing and declined slightly

for investing. Decision sources such as advertisements, media, and calling around declined,

however, while subject-matter experts such as financial services firms and financial networkadvisors overall increased somewhat.

5. U.S. Federal Reserve, "Changes in U.S. Family Finances from 2010 to 2013: Evidence from the Survey

of Consumer Finances," September 2014.

Home mortgages71%

Auto loans7%

Credit cards7%

Home equity lines6%

Small business

5%

Student loans3%

Other1%

U.S. Consumer Loan Balances by Loan Type as of December 2013(N=US$12.2 trillion)


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Figure 4: The World's Wealthiest Investors

Source: www.statista.com/chart/2852/where-the-worlds-millionaires-reside/ accessed on 10/24/14

A C C R E D I T E D V E R S U S N O N - A C C R E D I T E D I N V E S T O R S

In the United States, the most densely populated crowdfunding-platform venue, investors for all

non-P2P platforms must by law be accredited investorspeople with substantial net worth.

Title III of the JOBS Act is pending and will open crowdfunding to non-accredited investors. In

the words of U.S. President Barack Obama, the intention of the JOBS Act is to provide low-cost

funds to startups, small businesses, and others: "For the first time, ordinary Americans will be

able to go online and invest in entrepreneurs that they believe in."7But two years in, the U.S.

Securities and Exchange Commission (SEC) is yet to provide implementation rules. In the U.K.,

however, anyone may invest, provided his or her investment is not more than 10% of the

individual's net assets per year. Once again kudos go to the U.K., where taxpayers investing in

early stage equity-based deals receive significant tax relief for their effort.

Crowdfunding is a viable investment opportunity, and as with any investment, requires a person

to analyze the risks and rewards. Non-accredited investors (who do not make sufficient

minimum net-worth requirements to be considered accredited) argue that an individual can lose

7.

Barack Obama, U.S. President, remarks at JOBS Act Bill signing on April 5, 2012,

www.whitehouse.gov/the-press-office/2012/04/05/remarks-president-jobs-act-bill-signing, website

accessed 10/30/2014.
http://www.statista.com/chart/2852/where-the-worlds-millionaires-reside/http://www.statista.com/chart/2852/where-the-worlds-millionaires-reside/


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his or her entire life savings in the stock marketwhy should crowdfunding be treated

differently? As long as there is full disclosure of the facts, they say that individuals should be

allowed to make their own choices and the opportunity should be available to all.

In the United States, participation by less than the general population runs aground of the

intention of the JOBS Act, and the industry is restless with the wait for implementation. Broad

participation could support diversified investment in businesses and potentially improve

incomes and spending in the U.S. economy. This argument acknowledges the widening income

gap in the United States and frequently references the country's 1% wealth concentration. That

said, some crowdfunding platforms will remain in the accredited investor and institutional

markets, where fewer numbers of investors have larger investment amounts. If, for some reason,

Title III never implements, the JOBS Act still expanded the investment market for accredited

investors.

Critics raise concerns about the ease of fraud in an online marketplace and that unsophisticated

investors are particularly vulnerable. As evidence, the critic cites the nonfinancial crowdfunding

platforms which have encountered individuals who have absconded with donations. As with

most financial endeavors, the risk is genuine. Prevention is key, and the platform plays a rolewith its policies, procedures, operations, and quality of staff. Not all platforms are equal, and this

will become more apparent as the industry matures. The crowdfunding business must build in

the appropriate processes such as identity verification, anti-money laundering procedures, and

deal due diligence screening to avoid fraud.

R E T I R E M E N T A S S E T S W E L C O M E

Retirement assets are a significant opportunity for the crowdfunding business. In the United

States, accredited investors may invest on crowdfunding platforms with self-directed retirement

accounts. The P2P lending platforms with products structured as notes allow non-accredited

investors to use individual retirement accounts (IRAs).

Effective July 1, 2014, the U.K. government announced that (any) individual may use assets from

his or her tax-free individual savings accounts (ISAs) to invest in P2P loans. Individuals may invest

up to GBP15,000 each year in qualifying ISAs. This is a significant boon to the crowdfunding

industry. The ability to use tax-free savings also provides many an additional means to reach

retirement financial goals and allows even broader participation in this new asset class.

G O V E R N M E N T S U P P O R T

Crowdfunding and all its varied market participants are rapidly creating a new source of funding

and security instruments, and most governments are supporting the effort. Support takes the

form of legislation or rules to guide the industry as well as financial contributions. The U.S.awaits the SEC completion of certain sections of the JOBS Act.

The UK Government is eager to spur economic activity as well as support alternative finance. In

addition to developing peer-to-peer lending regulation that allows both retail and institutional

investors to lend on platforms, and creating equity investor tax advantages, they have set up the

British Business Bank which lends to small businesses directly through peer-to-peer lending

platforms. The Government-backed British Business Bank has pledged GBP60M to lend directly


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to small businesses through Funding Circles marketplace, and GBP10M via Ratesetters

platform.

I N S T I T U T I O N A L M A R K E T E N G A G E M E N T

In the aftermath of the financial crisis, regulation, in the form of Basel III, Dodd-Frank, etc., has

reshaped the global banking sector. Banks must maintain tighter capital and liquidity

requirements, and compliance to regulation adds to operational and technology costs. The

financial drain is changing how, and with whom, banks conduct business, making it more difficult

for those seeking funding. Crowdfunding participants are clearly not the only beneficiaries of the

funding void left by banks. Other players are emerging to fill the credit void. For example,

professional asset management firms are assuming market risk in activities such as securities

lending, direct lending, and trying to more actively identify internalization opportunities, and

individual investors are providing equity and debt money through crowdfunding platforms.

Alternative asset managers are engaging in lending. For example, in September 2014, New York-

based credit manager Marathon Asset Management was looking to raise US$500 million to

establish the Structured Product Strategies Fund. Primarily a U.S. fund, it will have a five-year

lifespan, originating loans in residential and commercial mortgages, commercial equipment

leasing including aircraft, and other related investments.

Some hedge funds are buying securitized loan bundles from crowdfunding platforms for

investment. The market is viewing financial crowdfunding as an asset class, as mentioned, and

frequently labeling it "alternative finance." Though investment and commercial banks are a

permanent structure in the financial landscape, they are undergoing a transition, and within

transitions sit competitive opportunities. Some banks are in wait-and-see mode, cautious with

regard to their response and unclear whether this new channel is a disruption or business they

would want, while others are ignoring it.

Figure 5 summarizes the securitization process for P2P loan platforms. At the start, the U.S.lending platform's balance sheet holds the loan (in this example a P2P lender holds consumer

loans in the form of an S-1 security). In conjunction with the institutional investor who selects

loans or via a random selection process, the platform assigns loans to a special-purpose vehicle

(SPV)a "bankruptcy-remote entity" whose operations are limited to the acquisition and

financing of specific assets. The SPV is usually a subsidiary company with an asset/liability

structure and legal status that secures its obligations, even if the parent company goes

bankrupt.8Institutions engaging platforms, particularly the P2P platforms, see securitization of

the loans as an opportunity for their client portfolios or even their own investment.

The SPV issues debt that is typically broken into tranches by credit grade or other criteria, and

tranches are then sold to institutional investors such as insurance companies, hedge funds, asset

managers, banks, broker-dealers, or other firms. A third-party services provider acts as handling

agent. The platform may also pay for a rating agency to provide a quality rating on the SPV. The

institutional firm may hold the asset on its company books, add it to client portfolios, or resell in

the general market.

8. For more information on the securitization market, please see Aite Groups reportThe Global

Securitization Market,December 2014.
http://aitegroup.com/report/global-securitization-markethttp://aitegroup.com/report/global-securitization-markethttp://aitegroup.com/report/global-securitization-markethttp://aitegroup.com/report/global-securitization-markethttp://aitegroup.com/report/global-securitization-markethttp://aitegroup.com/report/global-securitization-market


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Figure 5: The Securitization of P2P Platform Loans

Source: Aite Group

For the most part, traditional banks have hung back to observe the crowdfunding market,

anticipating regulatory obstruction or a potential reputational blow based upon platform failures

or poor credit underwriting. Other banks have jumped in at the start, however. Notably, overseas

banks, for example banks in Japan (Union Bankparent Tokyo-Mitsubishi Bank), Australia

(Westpac), and Spain (Santander), have formed various partnerships:

Union Bank formed a strategic alliance whereby it will purchase personal loans from

Lending Club. Both firms create new credit products to market to their respective

customer bases.

Westpac Banking Corp'snew VC fund has an equity stake in Australia-based P2P

lender, SocietyOne. The investment provides Westpac insight into SocietyOne's

proprietary technology platform, known as ClearMatch, which assesses

creditworthiness by using algorithms.

Santandar and Funding Circle now have a referral arrangement in place where

Santander proactively refers small business customers looking for a loan to the

marketplace when they are not able to help. This is the first partnership between aUK bank and an online finance provider and is helping to provide creditworthy small

businesses with access to finance when they cannot get it directly from the bank.

Banks may find opportunities to invest in loan inventory, buy and securitize loans, take an equity

position in the online marketplace, or leverage the platform's technology and expertise to

broaden their own product offerings or customer experiences. This is an area likely to come alive

over the coming years as the crowdfunding community and banks learn to co-exist. And banks

are not the only institutions engaging in this market's potential. Family offices, insurance

P2P platform

1. Platform intermediates

consumer loans creating an S-1

security on their balance sheet

Cash inflow for new loans

or company investment

Special-purpose

vehicle (SPV)

3. Securitization

structure enables a

legally separate entity

from the P2P platform.

2. Platform assigns

loans to SPV; removes

from balance sheet5) Platform engages third-

party services:

-Asset handler

-Rating agency review, may

rate individual tranches

4. SPV issues debt, typically

in risk tranches or quality

grades for investors to buy

Tranche B

Tranche C

Tranche D

6) Broker-dealers, alternative

funds, asset managers, insurance

companies buy to sell, add toclient portfolios or to hold on

their balance sheets

Tranche A


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companies, and asset managers see benefits in holding loans (but not underwriting and servicing

the loans).

I S C R O W D F U N D I N G I N S T I T U T I O N A L I Z I N G ?

Critics that speak of the "institutionalization" of financial crowdfunding object to the loss of the

industry's original ideals, such as helping like-minded people and leveling the playing field for

the average investor. Certainly, the mighty presence of institutions popping up in multiple

capacitiessuch as platform backer, investor, and funding resource through securitizationas

well as the significant dollar amounts involved are eye-catching. At the same time, the dollars

flowing through for consumer loans and to entrepreneurs for new and existing businesses is

significant and quantifiable. In the end, the average person with a necessary financial goal or a

business dream can still realize it, even with institutions in the game.

Will someone suffer? It is possible that non-accredited investors who lack investment analytic

expertise or access to financial advice will receive lower returns on their loan portfolio, and it is

possible that securitizations are removing higher-interest or better credit opportunities from the

"crowd." Accusations of sophisticated institutional investors' cherry-picking loan portfolios arefrequent. In response, platforms speak of randomized assignments.

It is possible that many intermediaries piling into the crowdfunding business will, over time,

lower the net returns for investors. Even so, it is difficult to ignore that the average person is still

earning a good deal more through P2P lending than the 0.7% he or she was receiving from his or

her bank's savings account, and that the P2P platform has a shorter duration and a less volatile

return than a mutual fundlower fees as well, depending upon the chosen mutual fund

investment.

Today, the industry is promoting transparency for risk, fees, and returns. Platform participants

speak about establishing trust with investors and borrowers/entrepreneurs. This outreach

reflects the core values of the original crowdfunding founders. As the industry grows

dramatically with the participation from the institutional markets, the challenge is to maintain

these principles while retaining fair access to mainstream investors. For quite some time now,

information and participation barriers have meant that the majority of investment opportunities

have gone to larger investors. The new online marketplace provides broader access, and the trick

is to make sure that access beyond institutional investors is fair and equitable.

Becoming an enabler, cost-reducer, and opportunity-maker sits within the hearts of many a

platform founder. Many have no intention of letting go of original ideals, yet these smart people

recognize the industry must adjust as it matures. Founders are seeking new approaches to

attract buyers and sellers to their online marketplaces, requiring creativity and openness to new

business ideas.

T H E L O T O F T H E E N T R E P R E N E U R

The United States consistently exhibits one of the highest entrepreneurship rates in the

developed world.9According to a 2013 survey, an estimated 25 million Americans were starting

9. Global Entrepreneurship Monitor, "2013 United States Report," 2014.


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17

or running new businesses that year, and 7.7 million projected they would employ six or more

people in the next five years. In addition to these entrepreneurs, an estimated 14 million

Americans were running established businesses, of which 3.2 million projected employing six or

more employees in the next five years. Nonetheless, of late the figures are not as good as they

once were. In the late 1970s, about 15% of all businesses were new, while today that percentage

hovers around 8%.

10

Crowdfunding platforms could dampen this decline.

Figure 6 suggests an increasingly optimistic entrepreneurial mindset, as most individuals feel

there are opportunities. In 2013, 47% of those surveyed felt they had stronger capabilities to

achieve their goals, more so than in the last five years. Advancements in e-commerce may well

support this increasingly enthusiasm.

Figure 6: U.S. Entrepreneur Attitudes

Source: Global Entrepreneurship Monitor, "2013 United States Report," 2014

In the U.K., entrepreneurial activity is holding steady or is slightly down (Figure 7), likely

reflecting economic difficulties in Europe. Access to capital could support greater

entrepreneurial activity.

10.Kauffman Foundation, www.kauffman.org, accessed October 10, 2014.

56% 56%60%

56% 56% 56%

37%

28%

35% 36%

43%47%

25%27% 27%

31% 32% 31%

2008 2009 2010 2011 2012 2013

Trends in U.S. Entrepreneurial Attitudes, 2008 to 2013(Percentage of adult population aged 18 to 64)

Perceivedopportunities

Perceivedcapabilities

Fear of failure


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Figure 7: U.K. Participation in Entrepreneurial Activity

Source: Global Entrepreneurship Monitor, "2013 United Kingdom Report", 2014

Entrepreneurs, as self-issuers or borrowers, access crowdfunding capital to start up or grow their

business, hire talent, expand or improve their product, or open new offices. Startup business

costs vary widely depending upon the type of product, but they run easily into five- and six-

figure sums needed to kick off. Advances in mobile technology and the Internet as a resource for

designing and building a business and connecting to resources has lowered such costs, while

access to cloud technology and shared operational environments provide for quicker

implementations. Perhaps there's been no better time to run with a new idea, as there are more

resources than ever to support the entrepreneur.

T H E S H R I N K I N G V C I N D U S T R Y

U.S. VC assets under management declined to US$192.9 billion in 2013, from a prerecession high

of US$288.9 billion in 2006. The number of deals in 2013 was 4,041, up only 4% from 2012,

which was relatively flat from 2011. The National Venture Capital Association reported that

1,050 VC firms each invested US$5 million or more per year in 2000; however, by 2013, only 548

of firms did so. The industry, by number of firms and number of principals, has declined from

2007 levels, and the association reports that only 43 firms managed more than US$1 billion,

while 277 firms managed less than US$25 million.11

Generally, the statistics show the VC

business concentrating among large, boutique, or specialist firms.

From 1991 through 2000, the median number of IPOs per year was 163, and the average annual

offer amount was US$10 billion. From 2001 through 2013, the median number of IPOs per year

was 51, with an average annual offer amount of US$7.4 billion. As of September 30, 2014, the

figure stood at 88 IPOs with an offer amount of US$10.8 billion, which made 2014 a better year.

Figure 8 shows the history of venture-backed IPOs since 2000.

11.National Venture Capital Association, "2014 National Venture Capital Association Yearbook."

84.3 84.7 84.1 84.7 83 79.2 75.7 80

7.8 7.4 6.8 6.1 7.2 9.8 11.3 5.6

3.2 3 2.8 2.73.2 4.2 5.7 3.8

2.8 2.7 2.9 3.2 3.4 3.4 4.3

3.6

6 5.8 6.2 6.5 6.5

2006 2007 2008 2009 2010 2011 2012 2013

U.K. Participation in Entrepreneurship by Established Stage of Activity,2006 to 2013 (Percentage of adult population aged 18 to 64)

Established businessowner/manager

New businessowner/managre

Nascententrepreneur

Intend to s tart (within3 years)

No activity orintention


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Figure 8: U.S. Venture-Backed IPOs

Source: National Venture Capital Association

Despite success in 2014, venture-backed IPOs have not gained momentum in the new

millennium, and the past handful of woeful economic years worsened the experience.

Crowdfunding advocates argue that businesses that hold the ear of a diverse group of willing

investors provide potential for new ideas to come to fruition or for business opportunities to

thrive outside of the preselected, ultra-high-growth, VC-favored industry areas such as

technology. Indeed, crowdfunding platforms are providing options for early-stage equity seekers.

Entrepreneurs may initially work with an equity crowdfunding platform for proof of concept,

perhaps returning multiple times and, if appropriate, graduate to a VC-syndicate crowdfundingplatform or an independent firm.

THE WHATA GALAXY OF PLATFORMS

Raising cash is appealing to many. The types of platform are burgeoning with something for

everyone, and the sample list inTable B: Sample Types of Crowdfunding Platforms is hardly

exhaustive. Like any hot new industry, the flow of newcomers is an open spigot. Table B: Sample

Types of Crowdfunding Platforms

Humanities Business Personal interests

Arts/film/creative Entrepreneurs (existing or startup) Consumer debt

Social/civic/religious Young entrepreneurs (teens or younger) Personal pleas

Student/alumnus Business Charities

Science Venture capital Microfinance

Innovation Women-owned

238

3724 26

82

5967

91

7 13

70

51 49

81 88

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 YTD9/14

Venture-Backed IPOsNumber of Deals


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22

Figure 9: Total Number of Borrowers by Cumulative Volume

Source: Crowdnetic, Lendvious product; total number of borrowers includes active borrowers as well as those who paid off their loans

and those whose loans were charged off.

A topic of ongoing discussion and refinement for a lending service is underwriting quality and

the resulting default and loss experience (a default rate reflects borrowers' failure to remain

current on their loans, and a loss rate is the percentage of principal declared nonreceivable and

written off). The platforms have algorithms that determine the estimated percentage of principal

loss for a basket of loans of a particular quality grade. Some firms may report their loss figure net

of any recoveries and feesthe website generally confirms how it is reported.

Lending platforms are typically transparent, publishing significant amounts of data regardingloan experience. Two examples include platforms Prosper (Table B)and Zopa (Table C), which

take different approaches to presenting their dataProsper offers quality grades, while Zopa

provides vintage loan years. That said, P2P platforms often provide detailed spreadsheets of

aggregated data that readers can dissect. Further, P2P platforms have varying credit models and

return and loss calculations. Some data collection companies look to standardize the data; until

then, it pays to read the fine print. The following tables provide an overall idea of investor

experience on the P2P platform.

Table B: Prosper P2P Published Loss Rates by Proprietary Rating

Prosper proprietary rating Estimated average annual loss rate*AA 0% to 1.99%

A 2% to 3.99%

B 4% to 5.99%

C 6% to 8.99%

D 9% to 11.99%

897 3,47012,018 21,264

49,922

87,571

4,451 8,704

36,453

112,241

154,656

316,505

2010 2011 2012 2013 YTD 2014(Sept. 30)

Total

Total Number of Borrowers on P2P Platforms, 2010 to YTD 2014

Prosper Lending Club


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Prosper proprietary rating Estimated average annual loss rate*

E 12% to 14.99%

High risk (HR) >=15%

Source: Prosper.com, accessed on 10/29/14; figures are subject to updates by the platform.

*The estimated loss rate for each listing is based on the historical performance of Prosper loans with similar characteristics. The base

loss rate is determined by two scores: (1) a custom Prosper Score and (2) the FICO score. Adjustments can be made to the base loss

rate based on additional characteristics, such as the presence of a previous Prosper loan. Any adjustments are added to the base rate

to get the final loss rate, which then determines the Prosper Rating. The loss rates are not a guarantee and actual performance may

differ from expected performance.

Table C: Zopa P2P Published Default Rates by Time Period, September 2009 to August 2014

Time period Average default rate

9/09 to 8/10 2.07%

9/10 to 8/11

0.92%

9/11 to 8/12 0.49%

9/12 to 8/13 0.25%

9/13 to 8/14 0.70%

Overall history

0.55%

Source: Zopa.com, accessed on October 10, 2014

Crowdnetic's Lendvious platform reports return on investment (ROI) for 36- and 60-month

loans.13

The average ROI for 36-month loans originated during the full fiscal year ending

September 30, 2014 is 14.0% for Prosper and 12.6% for Lending Club. ROI and loss rate

differences between platform providers are likely attributable to many different factors,including differences in the underlying borrower pools.

E Q U I T Y A N D R E A L E S T A T E O F F E R I N G S

In equity and real estate, Crowdnetic is popularizing the term "private issuers publicly raising," or

PIPR, to refer to this line of business. Its CrowdWatch product tracks 13 equity and real estate

platforms, including Alchemy Global, AngelList, Crowdfunder, EarlyShares, EquityNet,

MicroVentures, OurCrowd, Patch of Land, RealCrowd, Realty Mogul, Return on Change,

SeedInvest, and WeFunder.Figure 10 andFigure 11 highlight the number of deals and

distribution of capital, respectively, for the tracked platforms. Title II of the JOBS Act, which lifted

the ban on general solicitation, became effective on September 23, 2013. In the year between its

effect and September 30, 2014, CrowdWatch aggregated and normalized data for 4,712 total

deals or PIPRs, which collectively have raised US$385.8 million. As of September 30, 2014, 3,787

active deals had raised US$283.2 million.

13.Crowdnetic calculates ROI by dividing net gain by the quotient of interest paid and interest rate plus

estimated loss on remaining principal.


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Figure 10: U.S. Snapshot on Private Issuers Publicly Raising

Source: Crowdnetic; includes only those platforms tracked by the CrowdWatch product: Alchemy Global, AngelList, Crowdfunder,

EarlyShares, EquityNet, MicroVentures, OurCrowd, Patch of Land, RealCrowd, Realty Mogul, Return on Change, SeedInvest, and

WeFunder. For the purposes of presenting an overview of total PIPR activity, data includes both active PIPRs as well as those no

longer active.

Figure 11: Distribution of Capital U.S. Private Issuers Publicly Raising

Source: Crowdnetic, CrowdWatch product: The crowdfunding venues included are:Alchemy Global, AngelList, Crowdfunder,

EarlyShares, EquityNet, MicroVentures, OurCrowd, Patch of Land, RealCrowd, Realty Mogul, Return on Change, SeedInvest, and

WeFunder.

2,790

3,593

4,3944,712

1/23/2014 3/31/2014 6/30/2014 9/30/2014

Total U.S. Private Issuer Equity Deals Since Regulation Inception,9/23/13 to 9/30/14

642

234

70

6

More than $0 to$250,000

More than $250,000 to$1 million

More than $1 million to$5 million

More than $5 million

Number of U.S. PIPR Deals by Amount Raised, 9/23/13 to 9/30/14(Amounts in US$)


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Real estate development and investments lead industry sectors in terms of capital commitments.

Social media and e-commerce stand out for number of deals.Table D provides the top 10

industries for PIPR offerings by capital and number of deals. Industries included in both lists are

e-commerce, music, and entertainment. CrowdWatch points out, "Fourteen of the remaining

twenty industries appear on only one compilation, showing that the industries that attract

entrepreneurs are not necessarily the same ones that attract investors."

14

Table D: Top 10 Industries in Private Issuance Publicly Raising

Industry Recorded capital

commitments

(US$ millions)

Industry Number of

deals

Real estate development $38.1 Social media 289

Oil and gas $32.0 E-Commerce 235

Real estate investments $21.5 App software 161

E-Commerce $12.5 Education K-12 111

Entertainment, other $10.5 Digital media/New media 100

Music services $9.7 Online and mobile gaming 80

Alternative energy, other $9.5 Business software and services 66

Investments, other $9.2 Entertainment, other 66

Organic food and beverage,

other

$9.1 Specialty retail, other 65

Fitness services $7.4 Music services 64

Source: Crowdnetic Corporation, one year ending September 30, 2014

U . K . F I N A N C I A L C R O W D F U N D I N G G R O W T H

U.K. think-tank Nesta predicts that 2014 will deliver a total of GBP1.6 billion in equity and P2P

lending platforms ("alternative finance") in the United Kingdom and provide GBP840 million

worth of business finance for startups and small to midsize enterprises (SMEs). The overall

industry grew by 91% in 2013 over 2012 to GBP939 million.Figure 12 shows the breakdown of

the various crowdfunding categories and amounts raised for 2013.15

14.Crowdnetic, "Quarterly PIPR Data Analysis. Title II Turns One," September 30, 2014.

15.Nesta, "The Rise of Future Finance," December 2013.


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Figure 12: U.K. Crowdfunding Assets

Source: Nesta

287.0

193.0

97.0

28.02.7 1.5

330.5

0.8

U.K. CrowdFunding Assets in 2013 by Platform Type(GBP Millions)


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often touted as a major benefit; in general, this released source of funds is helping improve local

economies.

Equity investors direct their money to ideas that have significance for them. Aside from

potentially making or losing money, the exuberant vibe for crowdfunding is the ability to align

one's belief system to one's actions. Crowdfunding makes such investment opportunities

available to select from and provides centralized access and logistical ease with tracking and

reporting. Through access to crowdfunding, entrepreneurs are motivated and empowered to

follow dreams and start businesses that create change or solve problems. (Normally,

entrepreneurs have had to navigate a labyrinth to identify funding sources.) The breadth of

innovation and ideas on crowdfunding platforms open an entire world of potential to investors

with their own criteria (versus a screen by intermediaries).

Let's take an example of the power of crowdfunding ideas to change daily lives: Featured on

WeFunder.com is the successfully funded MotionSavvy, which utilizes recent improvements in

gesture-recognition technologies to create an easy-to-use translation tool for the deaf and hard

of hearing.16

A motion detector attached to a tablet uses an app to translate sign language to

voice. In turn, the software converts voice to a visual on the tablet, allowing for instantcommunication. Think about what this could mean to 360 million deaf and hard-of-hearing

people worldwidenot to mention that it's a US$10 billion market.

Even the crowdfunding platforms are highlighted as societal game-changers. The industry

frequently buzzes about the greater number of women engaged in this business. High-profile

financial platforms led by women include Realty Mogul, Plum Alley, Golden Seeds, Cutting Edge

Capital, Peerbackers, and EarlyShares. CrowdCheck, a due-diligence service commonly used by

crowdfunding platforms for background checks and other protection services, is also headed by

a woman. Women also run a number of nonfinancial platforms, such as Indigogo and Razoo.

It's no secret that statistics consistently show half or more of all new businesses failing, but

startup-oriented investors seek to diversify their portfolios to potentially capture the "big win."

In other words, most sophisticated investors understand that early stage investing is something

of a numbers game. High-growth (often tech) firms are the apples of the VC community's eye;

such portfolios include dozens of investments in the hope that a small few will contribute

significant returns. Crowdfunding investors, too, can make small commitments to multiple deals.

And shouldn't the many other businesses that don't hit huge numbers or vast markets but have

a significant return (and potentially a solid one) receive funding?

Entrepreneurs who meet with equity fundraising success early on can better attract the interest

of larger funding from angel investors or VCs. The networking contacts they meet along the way

are no doubt beneficial to funding and other aspects of their business, from advice to

partnerships. In fact, donation/reward platforms have come to represent an opportunity todemonstrate proof of business or market concepts and thus better position a firm for larger

amounts of successful funding from equity platforms or beyond.

16.WeFunder.com, www.wefunder.com/motionsavvy, accessed on 10/13/14.


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THE R ISKS

Of course, regulators, traditional providers, and investors worry about the flip side: There are

always risks in making an investment, and investment ideas require vetting. This is why

internationally regulators are actively addressing the crowdfunding industry. The due diligence

on the startup company and the prospects for a new business idea require expertise in assessing

the financials, the business operations, and the subject area. General investors, even accreditedones, do not often have this type of expertise.

In some cases, lossesespecially of retirement assetscould place investors in a difficult

financial situation. Platforms are not insured by any regulatory agencies. In the United States,

non-accredited investors may easily glide by this fact in pursuit of attractive returns. Investors

signing up in the United States typically see loss rates of a conservative portfolio in the 3%-to-5%

range, far higher for a more aggressive portfolio. (In some instances, the five-year rolling track

record is still forming, as these loans are just now coming due.) In the U.K., P2P platforms such

as Ratesetter and Zopa have provisional funds to protect investors from loss; however, the

reserve funds are neither guaranteed nor insured, and they may not be able to compensate a

large volume of investors. Generally though, losses in the U.K. are low. Since its inception, P2PZopa has seen an overall loss rate of 0.55%. Borrowers pay a small fee to fund the reserve funds,

and the provision fund size is ultimately determined by incoming loan growth.

Crowdfunding platforms must engage in investor education, and as the industry matures,

expectations in this area are likely to rise. Investors currently read a 200-page prospectus written

in legalese to understand details such as fees for collection agencies, tax implications, and the

legal structure of their investment, and no one is entirely sure investors are reading the

documents. As a result, platforms, regulators, and other participants are concerned that

investors will claim, after a loss, that they did not understand the investment. None of this is a

surprisethe mutual fund industry has struggled for decades to enhance investor education and

simplify or summarize registered-fund legal documents.

Another concern is liquidity risk. Investors require a willing buyer to exit an investment;

otherwise, their investment is locked up for the duration of the contract. And while P2P

platforms may support identifying a peer member willing to buy the investment, it is not

guaranteed and not under their control. Fraud is another concern. Will an issuer or borrower

walk away with investors' funds? All too frequently, newspaper headlines remind us of the levels

of human scheming.

If crowdfunding platforms experience a class-action suit or other significant event that

jeopardizes their firm as an ongoing entity, platform risk exists. Will the platform be able to

continue to service its member community? Most regulatory actions include the requirement

that platforms have full business continuity arrangements with third-party service firms tocontinue the fund collection and distribution process. Losses, either through credit quality or

fraud, are a major concern for crowdfunding platforms that understand reputation risk will have

a blanket effect on this young industry. The ability for crowdfunding platforms to gain trust

among all their participants is a significant endeavor to attract, retain, and repeat business.

For equity investors, there is the risk of equity dilution. Investors invest in a company that may

raise funds well beyond its target goal. This is extremely beneficial to the entrepreneur, but not


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entirely beneficial to the investor, who will see a fractional share reduced by other investors

piling into the deal.

Regulation is still an open question. As the industry matures, regulators are watching, and future

regulations that modify existing laws or create new requirements could be disadvantageous to

business models or investor access, or perhaps affect those currently invested. As platforms seek

to add clients across borders, adhering to varying regulation and anticipation of regulation

change could be highly detrimental to revenue models.


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THE REGULATION

It's a simple human quality that exuberance can, at times, lead to regret. As such, although avid

investors and needful entrepreneurs and borrowers are rightfully excited about crowdfunding

opportunities, the industry requires oversight. Crowdfunding investments are investments at

risk, from the initial due diligence to instances where investors funds might require several yearscommitment. In the end, these investments may not meet investors' expectationsretirement

funds could be at risk, and lawsuits, perhaps class-action lawsuits, could occur, damaging a

platform or the industry. Regulators must walk the proverbial tightrope, building a framework for

educated participation, good platform governance, and fair and reasonable charges to as wide a

population as possible.

Legal counsel is kept busy in the crowdfunding business. Crowdfunding legal matters are

complicated, requiring legal counsel to work with the nuance and practical aspects of marketing

and operating a platform.

U.S. CROWDFUNDING REGULATION

The JOBS Act, signed into law in 2012, modifies multiple existing securities laws, creating

exemptions to alleviate the registration, audit, and reporting requirements of a traditional

registered security offering. The JOBS Act also created a new Section 4(a)(6) of the Securities Act,

permitting the crowdfunding industry to operate in the United States. Parts of the JOBS Act have

not been fully implemented. For example, the SEC must determine rules for Title III of the JOBS

Act, which will permit non-accredited investors to participate on platforms that accept them.

Currently, as earlier noted, financial platforms in the United States, except for P2P lending

platforms, may only accept accredited and institutional investors, and they rely on the existing

private placement safe-harbor rule under Regulation D of the U.S. Securities Act of 1933.

W H A T Y O U N E E D T O K N O W A B O U T T H E J O B S A C T

The JOBS Act is primarily intended to reduce barriers to capital formation, particularly for

smaller companies. Prior to the JOBs Act, entrepreneurs relying on traditional methods such as

bank loans, angel investors, or VCs to raise capital had to leap many hurdles to obtain financing.

The crowdfunding platform as a bridge to equity or debt financing simplifies much for small and

midsize businesses, and it opens doors to a greater number and variety of wallets. The JOBS Act

made several changes to existing regulationTable F highlights important selected changes at a

high level.


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Table F: Highlights of Important Changes Achieved by JOBS Act

Regulation Changes to regulation

General JOBS

Act Highlights

Accredited investors have no maximum on their individual investments.

Investors must sign off that they understand the risks involved with the

investment.

U.S. entrepreneurs and small businesses (firms with less than US$5 million in

revenue in each of the last three years) may now raise up to US$1 million per

12-month period from an unlimited number of investors.

Investor disclosure must be filed with the SEC at least annually. Shares

purchased on an equity crowdfunding site are "restricted" and must be held

for one year.

Those not allowed to self-issue on a crowdfunding platform include companies

already publicly listed, foreign issuers, and investment companies (and certain

private funds) as defined by the Investment Company Act of 1940.

Crowdfunding platforms must provide for continuance of loan servicingoperations should the platform become inoperable.

JOBS Act Title

II; General

Solicitation

On July 10, 2013, the SEC adopted paragraph (c) of Rule 506 effective September 23,

2013. Section 201(a) of the JOBS Act requires the SEC to eliminate the prohibition on

using general solicitation. General solicitation is permitted where all purchasers of the

securities are accredited investors and the issuer takes reasonable steps to verify that

the purchasers are accredited investors. Section 201(a)(1) further states that the issuer

take reasonable steps to verify that purchasers of the securities are accredited

investors.

The JOBS Act also removed the general solicitation constraint from private offerings

relying on Rule 144A under the Securities Act of 1933.

JOBS Act Title

III; Mass

Market,

Proposed Rules

Pending

Title III of the JOBS Act created an exemption under the securities laws so that the

crowdfunding method can be easily used to offer and sell securities.

New Section 4(a)(6) of the Securities Act of 1933 permits any investor, including an

unaccredited investor, to provide funds for loans or equity investment. Investors must

receive basic education before committing to the first deal. Annual maximum

investment caps apply:

For investors with less than US$100,000 in net worth or annual income, the

greater of US$2,000 or 5% of their net worth or annual income

For investors with more than US$100,000 in net worth or annual income, up to

10% of their net worth or annual income not exceeding US$100,000

For issuers: Title III requires robust disclosureincluding descriptions of key personnel,

the business, financial condition, ownership and capital structure, and financial

statements (in some cases, audited)as well as periodic disclosure requirements to the

SEC and investors. Issuers will be subject to liability for material mis-statements or

omissions similar to an SEC-registered offering. Crowdfunding investors are not counted

against the shareholder cap, which requires public reporting requirements with the SEC.

Intermediaries (either broker-dealers or funding platforms) may not have a financial


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Regulation Changes to regulation

interest in an issuer using the platforms services.

JOBS Act Title

III: new Section

3(h) to the

Exchange Act

Crowdfunding

platforms

register as a

funding

portalto

access the

general public.

Pending

To access the general public, crowdfunding intermediaries must register with the SEC

either as a broker or as a funding portal. The JOBS Act requires the SEC to exempt,

conditionally or unconditionally, an intermediary operating a funding platform* from

the requirement to register as a broker permitting them to register as a funding portalsubject to the SEC's examination, enforcement, and rule-making authority. A funding

portal may only engage in 4(a)(6) [Securities Act of 1933] offerings. (Some market

participants are referring to this registration as broker-lite.)The funding portal also

must become a FINRA member.

Funding portal activities are more limited than broker-dealer activities. For example, a

funding platform may not:

Solicit transactions for securities displayed on its website or platform

Compensate anyone for soliciting investors or pay compensation based on the

sale of securities on its website or platform

Hold customer funds or securities

Offer investment advice or recommendations

Rule 147:

Intrastate

Exemption

(Section 3(a)11

of the

Securities Act

of 1933)

In the regulatory void left by the SEC not yet finalizing rules for Title III, individual states

may take action to legalize crowdfunding under the intrastate exemptions. U.S. states

such as Georgia, Alabama, Kansas, North Carolina, and Wisconsin have proposed or

enacted new laws for local businesses to secure financing from local residents.

Regulation A

(Securities Act

of 1933)

Pending

For public offerings of securities of US$5 million or less that are sold over a 12-month

period, Regulation A currently offers an exemption from certain registration

requirements. Under the JOBS Act, Regulation A will be amended to increase the cap on

offering size to US$50 million in a 12-month period. (Increasing this low threshold

increases company-funding opportunities.)

Source: U.S. Securities and Exchange Commission, U.S. FINRA

*The SEC defines a platform as a crowdfunding intermediary that does not (1) offer investment advice or recommendations; (2) solicit

purchases, sales, or offers to buy securities offered or displayed on its website or platform; (3) compensate employees, agents, or

others persons for such solicitation or based on the sale of securities displayed or referenced on its website or platform; (4) hold,

manage, possess, or otherwise handle investor funds or securities; or (5) engage in such other activities as the SEC, by rule,

determines appropriate. Please refer to the SEC website (www.sec.gov/spotlight/jobs-act.shtm) and FINRA website

(www.finra.org/Industry/Issues/Crowdfunding) for additional information.

In the United States, the majority of platforms focus on accredited and institutional investors.

Generally, this type of crowdfunding platform forms a broker-dealer subsidiary. Broker-dealers'

regulatory requirements are strict concerning investor and due diligence vetting as well as net

capital requirements and employee licensing requirementsadvantages in the sales and

marketing approach. Examples include SOFI and CircleUP. The platforms may receive a

transaction-based fee. Platforms may also partner with third-party broker-dealers.

Another option for crowdfunding platforms is the fund model used by AngelLIst and

FundersClub. Investor funds are pooled into a separate investment fund for each startup.


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Investors are limited partners of the fund (under Rule 506(b)). The platform operates as an

investment advisor, and it receives a share of the profits distributed at termination.

The P2P platforms accepting investments from non-accredited investors offer fractional shares

of promissory notes, which are created daily and held on the P2P platform's balance sheet. This

is a workaround, since Title III of the JOBS Act is not fully implemented to permit investors from

the general public. For some, Title III implementation is a much-anticipated event; for others, an

appeal to the mass market (any investor with the cash and inclination) is a contentious topic.

Concerns are the sophistication level of the individual (whether he or she can understand the

risks), the added costs associated with attracting retail investors, and the cost/benefit trade-off,

given expected added regulatory requirements and some attributes of the regulation itself. For

example, Title III crowdfunding offerings must be fully funded to complete the transaction. If the

set target amount is not achieved, no securities are sold. That would infer sunk costs to the self-

issuer with no benefit. In any case, the SEC has much to think about.

Most U.S. financial platforms use Rule 506 of Regulations D (SEC Securities Act of 1933), which is

targeted at wealthy individuals and institutions for a private placement offering. Rule 506 is

considered a "safe harbor" for the private offering exemption of Section 4(2) of the SecuritiesAct, and companies using the Rule 506 exemption can raise an unlimited amount of money. A

company can be assured it is within the Section 4(2) exemption by satisfying the following

standards:

The company may sell its securities to an unlimited number of "accredited investors"

and up to 35 other purchasers. Unlike Rule 505, all non-accredited investors, either

alone or with a purchaser representative, must have sufficient knowledge and

experience in financial and business matters to evaluate the merits and risks of the

prospective investment.

Companies must decide what information to give to accredited investors, so long as

it does not violate the antifraud prohibitions of the federal securities laws. But

companies must give non-accredited investors disclosure documents that are

generally the same as those used in registered offerings. If a company provides

information to accredited investors, it must make this information available to non-

accredited investors as well.

The company must be available to answer questions by prospective purchasers.

Financial statement requirements are the same as for Rule 505.

Purchasers receive "restricted" securities, meaning that the securities cannot be sold

for at least a year without being registered. In addition, companies using the Rule

506 exemption do not have to register their securities but must file a Form D, which

is a brief notice that includes the names and addresses of the company's owners and

stock promoters, but contains little other information about the company.17

17.U.S. SEC, www.sec.gov, accessed 9/22/2014.


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U . S . S T A T E R E G I S T R A T I O N

In the United States, platforms must register in each U.S. state. States may have additional

regulation beyond national regulation. For example, P2P lending platforms use legal exemptions

to market to non-accredited investors; specifically, the platforms create payment-dependent

notes which are SEC-registered securities sold in fractions to investors; however, not all states

permit their offering. The fine print on websites informs participants the states having regulatoryapproval.

As noted in the table above, a few states have worked around the lack of Title III passage using

Rule 147's intrastate exemption.

U.K. FCA'S CROWDFUNDING REGULATION

In the U.K., crowdfunding platfo

20150105 Crowdfunding Understanding the Basics Note (3)

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