Marketlend submission to the government on Facilitating crowd sourced equity funding and reducing compliance costs for small businesses – CSEF

Introduction

Marketlend itself is not a facilitator of crowd-sourced equity funding. However, Marketlend is a facilitator of crowd-sourced debt funding. The two models work very similarly, and as a result of the similarity in models, Marketlend believes that it can input some valuable information regarding CSEF and the reduction of compliance costs.

The differentiation of equity or debt crowdfunding, or separately treating crowdfunding based on equity or debt by the regulation is not considered a good idea by Marketlend. The concept of crowdfunding, and its operation, is similar whether it is debt or equity crowd funding. If small business is to obtain a significant benefit from crowdfunding, it is debt and equity that the Government should consider at the same time.

The role of small business in the economy

We acknowledge that small businesses are a significant driver of the economy. They create jobs, facilitate innovation, competition and are able to cater directly to niches, where larger businesses with subsequently larger over-heads, cannot. In addition to this, we believe that small businesses should not be subject to higher levels of risk due to the lack of their ability to access finance. The origination of small business should be encouraged and compliance costs should be reduced to a minimum. We believe that certain issues discourage the development of small business and thereby disincentive competition and innovation; these two things being large factors in the development of an economy.

Small Businesses and Compliance cost

To begin with, a look into the high compliance costs for newly established businesses is important especially in regards to crowd funding. Later on in the submission, we will discuss the two factors that affect origination of business, but for now we will discuss the compliance costs of funding. At present, it is difficult for a newly originated business to attain funding; if they are without private investors, they typically look to a range of banking services or middle-men that search for investors, for a fee. A lot of time they are unsuccessful.

Access to Finance, with respect to small businesses

Our work in facilitating crowd-sourced debt funding (CSDF), means that we work closely with small businesses. We believe that a major issue in the origination of small businesses is access to funding regardless of debt or equity. The issue boils down to two factors: the ability to access funding and the length of time required for adequate funding.

The ability to access funding is an issue that is systematic in many small businesses in the early stages of development. Small businesses are given a choice; access funding through debt, or through equity.

Contrary to traditional use, most businesses are reluctant to offer equity in the early stages of a business, due to the difficulty in determining evaluation of the business and the perception of the valuation, based on growth expectations versus other valuation methods.
If crowdfunding is to be considered a benefit to small business, it is that small business should be given the benefit of being able to offer various forms of equity and debt. These forms would include securities as a generalised definition, including but not limited to; shares, preferential shares, warrants, convertible debt and bonds.

Financing through debt

Through debt, the majority of small business owners take a large risk. The majority of business loans require security; which for many small business owners is residential property. When security is not given through residential property, interest rates are typically much higher and the ability for the loan to be approved is much lower. However, many business owners, especially those that are young and new to the labour market, do not own residential property. This makes it increasingly hard to gain access to debt, and thereby may prematurely extinguish what could have been a perfectly viable and profitable small business.

Innovative ideas that establish a new business are not so easily accepted by traditional lending institutions so it is unlikely such businesses are able to obtain sufficient funds to operate or proceed to a stage when they are more suitable to a banking funding solution. That is a start-up is unlikely to be financed through present funding sources provided by traditional means and needs crowdfunding in either debt or equity to assist its establishment and growth.

Access to funding through equity

For a lot of small businesses, there is a tendency towards financing through equity funding; typically through friends, family or colleagues. This introduces an extra level of risk, social risk, where many small-business owners have an added level of stress or risk of letting people close to them down. Marketlend believes that this is a large deterrent to the creation of small businesses. Through crowd-sourced funding, this issue is mitigated. In crowd-sourced funding, a level of anonymity is developed; this plays a large role in mitigating the issue of social risk.

Marketlend believes that there should be more feasible ways of raising capital. CSEF is a great option to look into for many businesses. However, of course, CSEF is currently limited by the current laws that surround investment into proprietary companies.

Micro-investment & Transparency

Many believe that micro-investment hinders transparency and accountability; we believe this is incorrect. The current platform for crowd-sourced debt raising (CSDR) is based on a marketplace model. Companies that are not transparent and do not allow investors to gain adequate information before investment, simply do not have their loans funded. These companies must go through the conventional platforms for accessing finance. However, the companies that are transparent and do reveal as much information as possible, are typically the companies that have their debts funded quickly and efficiently. They are rewarded with ease of access to finance and much faster processing times, relative to banks.

Relating this to CSEF is not too difficult. If anything, CSEF promotes transparency even more so than CSDR, as investors accept more risk and play a role in the company after purchasing equity. By using the marketplace model, once again, in the CSEF setting, it allows the companies that are transparent to access finance and those that aren’t, to be denied access to finance through CSEF.

Current legal framework surrounding micro-investment and equity

Current laws, specifically the Corporations Act Sect 113, that limit the number of non-employee share-holders in a proprietary company; are a contentious topic. On one hand, there is the ability for many investors to quickly invest small amounts into a business. Each investor does not bear as much risk and the equity is funded at much faster rates. However, the downside being that a large amount of investors slows the rate at which resolutions can be passed and incentivizes a hold-out dilemma if a company wishes to buy shares back.

Increasing the cap

This however, all relates to what the cap would actually be increased to. The determination of the size of the cap will be dependent on how it is manageable by the intermediate or the company itself and provided that it is sufficiently meeting the required regulatory compliance requirements.

Transparency as a proprietary company with >50 non-employee shareholders

As a solution to the questions regarding transparency, we believe that a proprietary company that surpasses the 50 non-employee shareholder cap should be held under increased reporting obligations. This also provides a solution to those public companies with non-employee shareholders under the newly formed cap that want to return to proprietary status.

The means of communication has significantly developed over recent times and at a significantly reduced cost. Accordin it is possible to enable small-business to communicate the risks and also the benefits to its investors through electronic means.

The present legislation doesn’t fully consider the concept of being able to provide disclosure through electronic means. Not only should it be the case that disclosure should be accepted if it is provided electronically, there should also be an allowance that the verification of investors and the participation of investors below the definition of a sophisticated investor needs to be amended.

Definition of Sophisticated Investor

If permitted to access CSEF, proprietary companies are still required to ensure that the only participants are sophisticated investors unless a prospectus approved by ASIC is provided to the investor, and the offering exemption applies to the proprietary company. As a result there will be no reduction in the compliance costs and few intermediaries willing to assist.

A possible solution would be that a retail investor, being an investor not defined as a sophisticated investor, could be issued a product disclosure document by the proprietary company that is only reviewed on a retrospective basis by ASIC if it seeks to do so. Such a solution would enable proprietary companies to be able to raise money quickly and reduce legal costs in completing such process. Furthermore it would protect investors, because if ASIC found the product disclosure document unsatisfactory it could require investors are made good any loss, if there was any, and also perform an amendment to the document in cases where no loss occurred.

Management accountable to shareholders

It is recognised that whilst it may be attractive for proprietary companies to take advantage of the CSEF, there remains a need for accountability by management to the shareholders.

The environment of crowdfunding is typically electronically advanced and with the recent solutions in the field of cloud based access, a proprietary company could offer shareholders the ability to have access to accounts, and other reporting measures through a cloud technology solution. A proprietary company does have the ability at present to restrict the type of access and provide sufficient information to the shareholders so that they can be completely aware of the progress of the company, but have the same time protect the proprietary company from misuse of such information.

Amend the law to increase the investor base

The law should be amended to increase the 20 investor limit and/or the $2 million limit. A proprietary company does need a lot more than 20 investors or $2 million to enable itself to grow at a sufficient pace within the prison that is the Australian environment. By increasing the limit either by the number of investors or the dollar amount, a proprietary company will gain an ability to open itself to greater participation within the investor market.
Investors do bear the risk that the company may misuse its ability to grow the investor base in an unmanageable manner, however sufficient disclosure as well as suitable compliance management being set in place at the time, as well as suitable intermediaries to assist the management should be able to mitigate such risk. At this time, the law restricts the number of investors and the dollar amount and also restricts the economics for intermediaries to participate in compliance or management of such an investor base.

Increases in shareholder limits should not be temporary

If the increase in shareholder limits was to occur temporarily, and later be cancelled for businesses that took advantage of it, the risk would be that when it is cancelled or removed, investors are at risk of being placed in a difficult position with the company needing to determine how they can either remove investors, or reduce their size to enable themselves to meet the requirements of the law.

If the thought is that temporarily means that it would be brought into play and stay that way for the companies that took advantage of it to see how it progresses, it would reveal the difficulty that crowdfunding is not a short-term concept and the businesses that provide crowdfunding services will have the difficulty of determining how to plan for the future to assist small business.

Ongoing transparency

The establishment of a small business and funding the ongoing costs to operate the small business through the first years, can be difficult. If Australia is to participate in the innovative environment within funding, it needs to embrace the changes that are occurring in the US, the UK and otherwise. The Government can require those who want to access crowdfunding to use electronic means to provide better disclosure and transparency.