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Crowdfunding

People often ask what they can do to approach others for investment. There is a very clear investment process for major companies listed on the stock markets, but what about smaller companies? What steps can you take to secure equity investment in your limited company and how can you ensure you stay the right side of reams of financial services legislation?

Private companies can issue shares to investors, this happens all the time. But there are criminal penalties for failing to comply with the relevant processes and procedures. Compliance requires an understanding of the relevant law, which is very complicated. This note looks at the main areas of concern for a company seeking to issue shares to investors, but each case will turn on its own facts and accordingly you will need to approach how you offer your shares to investors very carefully.

Why can't I just go out and raise the capital I need?

The law starts from the premise that the ordinary person in the street deserves to be protected from people offering investments, and in particular shares, for sale to them. The logic is, that these sorts of investments often require relatively significant sums of money and further that is it not easy for an investor to know at first glance what constitutes a 'good' investment. The law therefore is very prescriptive about what you can do to raise investment.

What does the law say then?

There are actually several overlapping layers of legislation and you will need to comply with them all to avoid committing an offence. European law, companies legislation and financial services rules all apply. The position can usefully be simplified by looking first at how you can lawfully attract the interest of potential investors and then by considering how the investment itself is made.

Attracting potential investors lawfully

Let's assume that you have prepared a general executive summary of your business and now want to approach an investor. The executive summary and any other materials you have prepared are designed to tell investors about the potential investment. As a result (in the eyes of the law) you have prepared an 'invitation or inducement' to subscribe for or buy shares or debt securities (and potentially some other categories of investment). This is termed 'financial promotion'. Financial promotions can be written or oral. Financial promotions must either be communicated or approved by someone who is authorised under the financial services legislation (e.g. an investment bank or an IFA), though this may be expensive and impractical), or financial promotions must be entirely covered by the statutory exceptions. These exceptions cover both what you say and to whom you say it. As mentioned this is a particularly complicated area and there are numerous exceptions. There is not time or space to discuss these in detail, but set out below are the most commonly used exceptions - and these have been simplified, because the exceptions themselves are very complex.

One-off communications- these are highly personalised, non-standardised communications to the person being contacted - this may be more helpful, for example, when you have already lawfully contacted an investor and you are now answering questions about the potential investment.

Communications to some overseas persons- communications can be made to individuals resident outside the UK, but need to be accompanied with a required set of bespoke and tightly drafted conditions and risk warnings. Do note though that this is an exception for the UK laws, you will also need to check the laws of the country in which the communication is being received.

Investment professionals- communications can be made to FSMA regulated persons including investment funds, Venture Capital firms as well as some others. If you are relying on this exception then you should require sufficient evidence that the recipient is an investment professional in the eyes of the law before making the communication and you should place an appropriate warning in the terms required by the legislation on the communication.

High net worth individuals- some communications can be made to wealthy individuals with a sufficiently high income and personal wealth - within the levels set out in detail the legislation. If you are relying on this exception then you will need a certificate (dated not more than 12 months before the communication) following the strict terms required by the legislation that the recipient is a high net worth person before making the communication and again you will need to give strict warnings, usually on the communication. This exception only applies to written communications or oral communications which the potential investor has requested.

Sophisticated Investors- this is similar to the exception relating to high net worth individuals. Communications can be made either to individuals who have certified themselves as sophisticated not more than 12 months before the communication or those who have been certified by an FSMA authorised person as sophisticated not more than three years before the communication. The onus is on you to check the certificate has been issued and yet again, you will need to give further (different) warnings, as part of the communication. If an investor certifies himself as sophisticated, then this only covers investment in unlisted companies, whereas certification by an FSMA authorised persons covers a wider range of investments.

Associations of high net worth or sophisticated individuals- groups of people falling into the preceding two categories.

Untrue statements and giving inaccurate profit forecasts

Lastly in relation to the materials you provide to potential investors, you must avoid making untrue statements and giving inaccurate profit forecasts, and this may lead to you having to compensate investors in certain circumstances. There are also specific criminal offences under FSMA relating to making statements, promises or forecasts which are misleading or untrue. Remember also that if you do not comply with the rules on financial promotions described above, an investor may be entitled to sue you for their money back.

Once I have an interested investor, how can I lawfully offer securities?

Making a financial promotion is just the first step; it is to gauge interest. The next step is the actual and definite offer of the securities themselves. This offer is subject to another layer of legislation.

First there are the Companies Act requirements preventing anyone but public companies from offering securities to the public. Accordingly, your offer must be made only to a limited group of pre-selected recipients or to one recipient.

Second, there are the requirements from Brussels (in the shape of the Prospectus Directive). The general rule is that any offer of "transferable securities" to the public must be made in a prospectus. This is a heavily regulated, long and prohibitively expensive document requiring regulatory approval. The Prospectus Directive will not apply in various circumstances including if:

So what about crowdfunding?

The law was designed before the idea of crowdfunding came into being. There is nothing illegal about crowdfunding per se, but to be used lawfully it must comply with all the layers of legislation touched on in this note (this article does simplify the law, there is a lot of detail it does not mention that may well be relevant to your circumstances). If the crowdfunding structure complies with the rules about communications/financial promotions and the rules about offering debt and equity securities (and subject to one point about collective investment schemes below) then it may be fine. But a word a warning: the rules have been designed to regulate and restrict any type of investment or potential investment being communicated to and sold to the public. Therefore, crowdfunding, which relies on many small investments being made by a large number of people, may be in conflict with these rules. This makes it very hard to achieve. Some companies have successfully carried out a type of crowdfunding, but their minimum investment was £10,000 and they have used the exceptions to financial promotions and offers of securities described above. Some others have used the approved prospectus route, looking for small subscriptions of shares or debt securities to a PLC. A third group of companies has stayed away from offering securities and has offered club membership or the like instead but sometimes these face another possible pitfall described below. Each method has its risks and needs to be carefully considered.

Finally, there is one last pitfall to avoid. There is another kind of structure known as a collective investment scheme ('CIS') based on (among other things) pooled investment. Even some companies can fall foul of this if they are regarded as 'open-ended' (a complicated and technical term relating to how shares/investments can be redeemed). The risk is that you inadvertently create a CIS, while looking for funding and in particular crowdfunding. A CIS may only be operated in the UK by an FSMA authorised firm. Breach of the CIS rules is a criminal offence and careful adherence to the rules is advised; if in doubt you will need legal advice.

In summary

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This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.

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