Andrew Sheng, Distinguished Fellow of Asia Global Institute, discusses the positive impact of crowdfunding on young, aspiring entrepreneurs.
The year has started with such doom and gloom in financial markets that everyone thinks start-ups may be the future of jobs and growth. But small and medium-sized enterprises, which are the major providers of jobs in any economy, are also typically long on passion and short of cash and funding.
Conventional stock markets raise funds for large corporations and it takes a long track record in earnings and reputation before SMEs can find the sponsors and funding to list. Crowdfunding is now the buzzword for start-ups but, until recently, it was illegal to raise equity (in the form of tradable securities) from the public unless approved by regulators. That process is not only costly but complicated for SMEs.
Crowdfunding became popular in the US when website platforms started to raise money for charities (and political donations) in small amounts from the public. The US Securities and Exchange Commission (SEC) has issued new rules, effective from May 16, that allow companies to use crowdfunding to sell securities to the investing public. This revolutionizes SMEs' access to funding and also gives investors access to equity in start-ups.
Traditionally, start-ups get their equity from family and friends. Since the arrival of the internet, some enterprising firms have tried to access capital from strangers, through "start-up exchanges" and other platforms. The risks of investing in such unregulated platforms are twofold - the possibility of investing in fraudulent companies and also being cheated by the platform.Unregulated peer-to-peer (P2P) platforms in China are now shutting down and losing investor trust because quite a few are scams.
To protect the public, the SEC generally bans companies and private funds from offering securities unless the transaction has been registered with the commission or there is an exemption from registration. Exemptions are only made for certain securities, such as hedge and venture funds with higher risks, if the investor is "accredited." This means that if the investor is rich and experienced enough, he or she would be allowed to buy these exempted funds or securities because the principle of "buyer beware" fully applies.
The definition of rich enough is someone with an annual income of US$200,000 (US$300,000 including a spouse's income) and whose net worth (excluding primary residence) including their spouse's is more than US$1 million. In Hong Kong, the broad definition of a professional investor is one with net assets of over HK$8 million.
With crowdfunding, however, the door is now wide open to anyone to invest in these start-ups. So how can the SEC protect investors? The protection is again twofold. The first is by telling investors how to judge how much they can risk investing in these assets. The second is to ensure that the crowdfunding platforms are actually run by broker-dealers or funding portals regulated by the SEC or the Financial Industry Regulatory Authority.
Each crowdfunding investor should learn how much they can afford to invest. The investor is subject to both an income and wealth test. If the income or net worth is less than US$100,000 (excluding primary residence), then they can invest within one year up to US$2,000 in crowdfunding security, or 5 per cent of annual income or net worth, whichever is less. If the annual income or net worth is more than US$100,000, then the investor can invest up to 10 per cent of annual income or net worth, whichever is less, but not exceeding US$100,000.
Since the crowdfunding portal or broker-dealers are regulated, the chances of fraud are reduced, though not zero. Companies or start-ups cannot access crowdfunding directly from the public but must use the regulated portals or broker-dealers.
Furthermore, to safeguard themselves, crowdfunding investors are advised to do their homework thoroughly. They need to understand fully their speculative risks, illiquidity, cancellation restrictions, difficulties of valuation, limited disclosure and information, fraud, lack of professional advice, and most of all, that they are betting not on assets, but on individuals or teams. Young start-ups often make many mistakes. Thus, the risks could be very high and the chances of success are not great. But some do make it big.
The good news is that once the SEC takes the lead in clarifying the rules for crowdfunding, other regulatory agencies in Asia will be able to adapt these rules to help create a local ecosystem for crowdfunding. Last year, the Malaysian Securities Commission published guidelines to facilitate equity crowdfunding. The Hong Kong Securities and Futures Commission consulted on the subject in 2014, but has yet to introduce specific laws or regulations.
The real issue about start-ups is finding the right expertise to coach them on how to make their ideas and ventures more commercial, professional and fundable. This is highly intensive work, which is currently not taught in universities, but mostly learnt on the job.
Policymakers throughout Asia pay a lot of lip service to the need to help nurture SMEs, but the record is so far uneven. Throwing money at the problem is not the right answer. The reason is that there is a terrible shortage of skills, not just in the marketplace but even more so at the official and bureaucratic levels, to understand the real difficulties that start-ups face. Cutting back the barriers to SME success needs a concerted effort from different agencies and departments to clear the regulatory hurdles. Skills from academia, business associations and civil societies must also be harnessed.
If we don't channel the energies of our youth into start-ups, should we be surprised that they are channelling their energies onto the street or fighting for different causes?
Crowdfunding is not the be-all and end-all of helping SMEs, but the SEC guidelines are a good start.
This article first appeared in the South China Morning Post on February 19 as How rules easing access to crowdfunding can kick-start the economy by boosting SMEs
The views expressed in this article are the author's own and do not necessarily reflect Asia Global Institute's editorial policy.
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