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JANUARY 2015 Denise Valentine

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Crowdfunding: Understanding the Basics

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Crowdfunding: Understanding the Basics January 2015

TABLE OF CONTENTS
INTRODUCTION .............................................................................................................................................. 4
METHODOLOGY ........................................................................................................................................ 4
CROWDFUNDING: WHAT IT IS, WHAT IT DOES .............................................................................................. 5
MARKET OVERVIEW........................................................................................................................................ 7
FINANCIAL INTEREST IN CROWDFUNDING ............................................................................................... 9
THE WHY—THE POST-RECESSION BLUES.................................................................................................. 9
THE WHO―INVESTORS ........................................................................................................................... 11
THE WHAT—A GALAXY OF PLATFORMS ................................................................................................. 19
THE NOW—PLATFORM 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 FIGURES
FIGURE 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 ...................................... 24
FIGURE 12: U.K. CROWDFUNDING ASSETS ................................................................................................... 26

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Crowdfunding: Understanding the Basics January 2015

LIST OF TABLES
TABLE 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 ..................................................... 25
TABLE E: SUMMARY OF BENEFITS AND RISKS .............................................................................................. 27
TABLE F: HIGHLIGHTS OF IMPORTANT CHANGES ACHIEVED BY JOBS ACT .................................................. 32

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Crowdfunding: Understanding the Basics January 2015

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 and
entrepreneurial 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
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many banks. Crowdfunding offers accredited investors new 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.

M E T H O D O LO G Y
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 service
providers 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 prior
two 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: Understanding the Basics January 2015

CROWDFUNDING: WHAT I T 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 of
traditional 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
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elements:

 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 platforms are 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 platforms offer 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 platform loans 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 platforms create 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 platforms invest 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 leveler—providing
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 than
traditional 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 show
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more than 1,000 platforms. From 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
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between US$90 billion and US$96 billion by 2025, and this strictly from individual investors. The
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

Worldwide Crowdfunding Total Market Size by Location, 2012


(N=US$2.6 billion)

Other
4%
Europe
16%

U.S.
U.K. 61%
19%

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.

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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

Number of Crowdfunding Platforms Worldwide, 2012


(N=672)

Other
10%

Europe
26%
U.S.
51%

U.K.
13%

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

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F IN A N C IA L I N T E R E S T IN C R O W D F U N D IN G
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 are
likely 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 citizens―the 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.

T H E W H Y — T H E PO ST - R E C E S S IO N B LU E S

THE CONSUMER SCENE


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 small
businesses. 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―many individuals 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, and Figure 3 provides
the debt distribution across key categories. Home mortgages and home equity lines of credit
represent 77% of debt, or US$9.4 trillion. Consumer loans, auto, and credit make up 14% or
US$1.8 trillion, while student loans—a rapidly growing area for lending platforms—is 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

U.S. Consumer Loan Balances by Loan Type as of December 2013


(N=US$12.2 trillion)

Student loans Other


Small business 3% 1%
5%
Home equity lines
6%
Credit cards
7%

Auto loans
7%

Home mortgages
71%

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
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of the Internet for decisions about borrowing increased from 38.4% in 2007 to 47% in 2013. Use
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 network
advisors 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.

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THE SMALL-BUSINESS SCENE


Either through entrepreneurial desire or job necessity, the small-business environment
increasingly demands funding, and crowdfunding could help. Indeed, the U.S. Small Business
Administration (SBA) loan program reached another lending record in its fiscal year 2014. As of
Q3 2014, the SBA approved 52,044 loans for a total US$19.2 billion, an increase of 12% in
number of loans and 7.4% in dollar amount over the prior fiscal year. For loans of US$150,000 or
less, the SBA had set fees to zero at the start of the fiscal period (which will run another year).
These smaller loans saw an increase of 23% in number of loans (to 30,675) and 29% in approved
dollars (US$1.9 billion) over the prior year (24,923 and US$1.4 billion respectively). Expanding its
network, the SBA added 308 new partner lenders, which collectively made 684 loans for nearly
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US$317 million. Loan demand exists for U.S. small businesses.

T H E W H O ― I N VE S T O R S
For the average investor, private market investing is new terrain, and crowdfunding platforms,
entirely new venues. Until now, individuals obtained investment products from their bank,
broker, investment firm, or financial advisor. Financial crowdfunding offers a new access point.
Of course, investors, even the high net worth, may rely on a financial advisor for help in selecting
investments on a financial crowdfunding platform (a likely new growth area for the wealth
management business).

Around the globe, crowdfunding investments are presenting an opportunity for accredited
investors. The fact that U.S. platforms have grown so rapidly merely reflects a large U.S.
concentration of wealthy individuals, at 41% of the world's millionaires. As Figure 4 illustrates,
continental Europe, Australia, Japan, and China are opportunities—as is the Middle East—for
new and existing crowdfunding platforms to expand their investor reach, at least should these
countries' regulatory frameworks permit nondomestic investors. Likewise, expect more
homegrown crowdfunding platforms to emerge in these countries.

6. U.S. Small Business Administration, "SBA Hits Another Lending Record in FY 2014," November 6, 2014.

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Crowdfunding: Understanding the Basics January 2015

Figure 4: The World's Wealthiest Investors

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

ACCREDITED VERSUS NON-ACCREDITED INVESTORS

In the United States, the most densely populated crowdfunding-platform venue, investors for all
non-P2P platforms must by law be accredited investors―people 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
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able to go online and invest in entrepreneurs that they believe in." But 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.

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his or her entire life savings in the stock market―why 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 role
with 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.

RETIREMENT ASSETS WELCOME


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.

GOVERNMENT SUPPORT
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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Crowdfunding: Understanding the Basics January 2015

to small businesses through Funding Circle’s marketplace, and GBP10M via Ratesetter’s
platform.

INSTITUTIONAL MARKET ENGAGEMENT


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
8
bankrupt. Institutions 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 Group’s report The Global
Securitization Market, December 2014.

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Figure 5: The Securitization of P2P Platform Loans

P2P platform
Cash inflow for new loans
1. Platform intermediates
or company investment
consumer loans creating an S-1
security on their balance sheet
2. Platform assigns
loans to SPV; removes
from balance sheet
5) Platform engages third-
3. Securitization party services:
structure enables a Special-purpose -Asset handler
legally separate entity vehicle (SPV) -Rating agency review, may
from the P2P platform. rate individual tranches

Tranche A
4. SPV issues debt, typically Tranche B 6) Broker-dealers, alternative
in risk tranches or quality funds, asset managers, insurance
grades for investors to buy Tranche C companies buy to sell, add to
client portfolios or to hold on
Tranche D
their balance sheets

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 Bank—parent 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's new 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 a
UK 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

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

IS CROWDFUNDING INSTITUTIONALIZING?
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
capacities―such as platform backer, investor, and funding resource through securitization―as
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 are
frequent. 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 fund―lower 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.

THE LOT OF THE ENTREPRENEUR


The United States consistently exhibits one of the highest entrepreneurship rates in the
9
developed world. According to a 2013 survey, an estimated 25 million Americans were starting

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

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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
10
hovers around 8%. 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

Trends in U.S. Entrepreneurial Attitudes, 2008 to 2013


(Percentage of adult population aged 18 to 64)

60%
56% 56% 56% 56% 56%
Perceived
47% opportunities
43%
37% Perceived
35% 36% capabilities
28%
Fear of failure
31% 32% 31%
27% 27%
25%

2008 2009 2010 2011 2012 2013

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.

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Figure 7: U.K. Participation in Entrepreneurial Activity

U.K. Participation in Entrepreneurship by Established Stage of Activity,


2006 to 2013 (Percentage of adult population aged 18 to 64)
6 5.8 6.2 6.5 6.5
2.8 2.7
3.2 3 2.9 3.2 3.4 3.4 4.3
2.8 2.7 3.2 4.2 5.7 3.6
7.8 7.4 6.8 6.1 7.2 3.8
9.8 11.3 5.6 Established business
owner/manager
New business
owner/managre
Nascent
84.3 84.7 84.1 84.7 83 entrepreneur
79.2 75.7 80
Intend to start (within
3 years)
No activity or
intention

2006 2007 2008 2009 2010 2011 2012 2013

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.

THE SHRINKING VC INDUSTRY


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

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Figure 8: U.S. Venture-Backed IPOs

Venture-Backed IPOs
Number of Deals
238

91 88
82 81
67 70
59
51 49
37
24 26
7 13

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 YTD
9/14

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 crowdfunding
platform or an independent firm.

T H E W H A T — A GA LA XY O F P LA T F O R M S
Raising cash is appealing to many. The types of platform are burgeoning with something for
everyone, and the sample list in Table 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

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Humanities Business Personal interests


Real estate

Source: Aite Group

In the U.K., financial crowdfunding platforms are required to register with the U.K. Financial
Conduct Authority (FCA) as a crowdfunding platform. In the United States, registration as a
funding portal with the U.S. SEC and Financial Industry Regulatory Authority (FINRA) is pending
under the JOBS Act, Title III. Donations or rewards-based websites, on the other hand, do not
require registration, and projects often secure funding well beyond the US$1 million limitation
(over 12 months) set by the JOBS Act for financial crowdfunding.

Platforms work in different ways, but they often specialize. CircleUp, for example, is an equity
platform focusing on the consumer goods industry, and dozens of real estate platforms focus on
specific types of investments, services, or geographies. Some funding platforms, such as
12
AngelList, have a subsidiary registered as investment advisor to provide financial guidance to
the self-issuer or investors. Others such as the Funders Club, on the other hand, abide by an
exemption from registration as an investment advisor (given the Funders Club's status as a VC
advisor under the Dodd-Frank Act). Different structures and owners also sit behind the
crowdfunding platforms―BlackRock, for example, is a company investor to both Lending Club
and Prosper, the two largest lending platforms in the United States.

GEOGRAPHY OF PLATFOR MS
Platforms exist around the globe. The list in Table A is changing quickly as governments
recognize the potential benefits of crowdfunding and regulate accordingly to formalize
participation in the crowdfunding community.

12. In March 2013, the SEC's Division of Trading and Markets issued no-action letters permitting the
business models proposed by FundersClub Inc. and AngelList LLC. These platforms target high-growth
startup companies, often appealing to venture capitalists. The firms agreed to not accept any
transaction-based compensation, thereby avoiding the broker-dealer registration and its compliance
requirements.

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T H E N O W — P LA T F O R M M E T R IC S
Information is fuel for action. As the crowdfunding business matures, a growing number of
entities look to aggregate and report on the experience. Founded in 2011, Crowdnetic is one
such firm, providing a centralized hub for real-time market data aggregated from equity and
lending platforms. Crowdnetic's product CrowdWatch tracks equity platforms, and its Lendvious
product tracks marketplace-lending platforms.

Crowdnetic has provided data to illustrate the growth of the crowdfunding business based upon
its currently collected data. Table 9 provides the growth in volume of loans on the two largest
U.S. P2P platforms, Lending Club and Prosper. Already with Lending Club’s December 2014 IPO,
the firm has completed US$6 billion in loans since its inception and surpassed that amount as of
December 31, 2014.

Figure 9: Growth in U.S.-Dominant P2P Platforms

Loan Originations Growth for Largest U.S. P2P Platforms,


2010 to YTD 2014 (In US$ millions)
$6,393

$1,369

Prosper
$2,660
$2,333
$5,049 Lending Club
$361 $741
$891
$156 $1,972 $1,919
$161 $348
$735

2010 2011 2012 2013 YTD 2014 Total


(Sept. 30)

Source: Crowdnetic, Lendvious product. Figures are through September 30, 2014; as of December 31, 2014, Lending Club has
surpassed US$6 billion.

P2P platforms generally do not report total number of investors. Figure 9 summarizes the
borrower activity on the Lending Club and Prosper. Prosper reported returning borrowers of
more than 12,000, which is about 14% of the cumulative number of borrowers from October 1,
2009 (for which the data becomes available) through September 30, 2014. Across the pond, P2P
lender Zopa is reporting steady increases in loan volume over the years, reached GBP658 million
in loans with approximately 100,000 cumulative borrowers. Zopa repeat borrowers are in the
700-borrower range, or just under 1%, as of Q2 2014.

As the crowdfunding business matures and gains visibility and familiarity in the marketplace,
repeat business will likely become an important component of growth. The figures are not
always comparable across platforms, of course, which may target different types of borrowers
(for example consumers or small businesses). Nonetheless, in any given strategy, creditworthy
borrowers returning for the right reasons are ideal, as they are known entities.

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Figure 9: Total Number of Borrowers by Cumulative Volume

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

316,505

154,656

112,241
87,571
49,922
36,453
21,264
897 4,451 3,470 8,704 12,018

2010 2011 2012 2013 YTD 2014 Total


(Sept. 30)
Prosper Lending Club

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 fees—the website generally confirms how it is reported.

Lending platforms are typically transparent, publishing significant amounts of data regarding
loan experience. Two examples include platforms Prosper (Table B) and Zopa (Table C), which
take different approaches to presenting their data—Prosper 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%

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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
13
loans. 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.

EQUITY AND REAL ESTATE OFFERINGS


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 and Figure 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

Total U.S. Private Issuer Equity Deals Since Regulation Inception,


9/23/13 to 9/30/14

4,712
4,394

3,593

2,790

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

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

Number of U.S. PIPR Deals by Amount Raised, 9/23/13 to 9/30/14


(Amounts in US$)

642

234

70
6

More than $0 to More than $250,000 to More than $1 million to More than $5 million
$250,000 $1 million $5 million

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.

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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
14
entrepreneurs are not necessarily the same ones that attract investors."

Table D: Top 10 Industries in Private Issuance Publicly Raising


Industry Recorded capital Industry Number of
commitments deals
(US$ millions)
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, $9.1 Specialty retail, other 65


other

Fitness services $7.4 Music services 64

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

U.K. FINANCIAL CROWDFUNDING GROWTH

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
15
the various crowdfunding categories and amounts raised for 2013.

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

U.K. CrowdFunding Assets in 2013 by Platform Type


(GBP Millions)
330.5
287.0

193.0

97.0

28.0
2.7 1.5 0.8

Source: Nesta

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THE BENEFITS AND RISKS O F CROWDFUNDING


Many questions surround this new financing channel. The market seems somewhat divided
between those fully confident in it and those extremely apprehensive about it as well as perhaps
every mix in between. Table E summarizes a few of the more common benefits and risks
mentioned by industry players.

Table E: Summary of Benefits and Risks


Benefits Risks
P2P lending returns higher than that of cash Default risk: Accounts not insured, and underwriting
savings accounts models vary

Quick access to capital; relatively speaking, the Liquidity risk: Asset lock for 3 to several years
process is much faster than traditional means

Alignment of investments to cultural, social, and Equity dilution: Increasing investor contributions
local (even neighborhood!) goals and affinities dilute the investment

Financing supports the economic recovery Platform risk: Calls into question the stability and
long-term viability of the platform and its operations
and business model

Successful equity fundraising can garner Fraud risk: Platforms requiring less disclosure and
attention of VCs the Internet's somewhat faceless front pose greater
risks for fraud

Can offer proof of market concept Litigation risk: For example, a class-action lawsuit
(entrepreneurs tap donation/reward platforms against the platform from disgruntled investors
and "graduate" to financial platforms)

Business networking opportunity: introductions Transparency/disclosure risk: Questions about


to other entrepreneurs, angel investors, and investors' ability to adequately perform their own
other business enablers due diligence and whether a platform's due
diligence is up to snuff

Entrepreneurs stay independent longer, a Future regulatory action could alter the business
general preference to retain sole control longer model or investor access

Source: Aite Group

T H E B E N E F IT S
Crowdfunding empowers investors, entrepreneurs, and borrowers alike. Investors in P2P lending,
for example, may select their desired returns and commensurate level of risk (and, as
mentioned) earn quite a bit above the typical 0.7% savings account). Through crowdfunding,
businesses receive bridge loans and individuals borrow funds to consolidate creditors, lower
interest rates, better manage household debt, buy a car, or make other improvements in their
lives. At a high level, crowdfunding generates a "feel-good" atmosphere in which people improve
their life circumstances and investors and entrepreneurs align win with personal goal alignment.
Entrepreneurs and borrowers receive their cash in days or weeks. In fact, quick access to cash is

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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
16
of hearing. 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 instant
communication. Think about what this could mean to 360 million deaf and hard-of-hearing
people worldwide—not 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 to
demonstrate 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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T H E R IS K S
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 accredited
ones, do not often have this type of expertise.

In some cases, losses—especially of retirement assets—could 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, P2P
Zopa 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
surprise―the 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 to
continue 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 years
commitment. In the end, these investments may not meet investors' expectations―retirement
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 . C R O W D F U N D IN G R E G U LA T IO N
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.

WHAT YOU NEED TO KNOW ABOUT THE JOBS ACT


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 regulation―Table 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  Accredited investors have no maximum on their individual investments.
Act Highlights
 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 servicing


operations should the platform become inoperable.

JOBS Act Title On July 10, 2013, the SEC adopted paragraph (c) of Rule 506 effective September 23,
II; General 2013. Section 201(a) of the JOBS Act requires the SEC to eliminate the prohibition on
Solicitation 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 Title III of the JOBS Act created an exemption under the securities laws so that the
III; Mass crowdfunding method can be easily used to offer and sell securities.
Market,
Proposed Rules New Section 4(a)(6) of the Securities Act of 1933 permits any investor, including an
Pending 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 disclosure―including 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 To access the general public, crowdfunding intermediaries must register with the SEC
III: new Section either as a broker or as a funding portal. The JOBS Act requires the SEC to exempt,
3(h) to the conditionally or unconditionally, an intermediary operating a funding platform* from
Exchange Act the requirement to register as a broker permitting them to register as a funding portal
subject to the SEC's examination, enforcement, and rule-making authority. A funding
Crowdfunding portal may only engage in 4(a)(6) [Securities Act of 1933] offerings. (Some market
platforms participants are referring to this registration as “broker-lite.”) The funding portal also
register as a must become a FINRA member.
“funding
portal” to Funding portal activities are more limited than broker-dealer activities. For example, a
access the funding platform may not:
general public.
Pending  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: In the regulatory void left by the SEC not yet finalizing rules for Title III, individual states
Intrastate may take action to legalize crowdfunding under the intrastate exemptions. U.S. states
Exemption such as Georgia, Alabama, Kansas, North Carolina, and Wisconsin have proposed or
(Section 3(a)11 enacted new laws for local businesses to secure financing from local residents.
of the
Securities Act
of 1933)

Regulation A For public offerings of securities of US$5 million or less that are sold over a 12-month
(Securities Act period, Regulation A currently offers an exemption from certain registration
of 1933) requirements. Under the JOBS Act, Regulation A will be amended to increase the cap on
Pending 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 requirements—advantages 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 Securities
Act, 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
17
stock promoters, but contains little other information about the company.

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

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U.S. STATE REGISTRATION


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 regulatory
approval.

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 . F C A ' S C R O W D F UN D IN G R E G UL A T IO N
In the U.K., crowdfunding platforms must register with the FCA. Early in 2014, the FCA added
specifically that lending platforms must register with the agency; previously, investment-based
crowdfunding was covered under existing regulation. Some platforms, however, opt for other
types of registrations. For example, equity platform Seedrs chose to be regulated as a “fund
manager” rather than an arranger of a transaction, thereby acting as an investor nominee who
enforces shareholder protections. The same investors are eligible to invest through Seedrs as
those that are eligible to invest through the platforms that come under the U.K. crowdfunding
rules. Due to their type of registration, investors coming to Seedrs are not subject the 10% of net
assets cap on investing.

Effective as of April 1, 2014, the U.K. FCA's Policy Statement 14/04 on crowdfunding platforms
expanded investor eligibility criteria to include unsophisticated investors—the general public—
provided that the individual invest no more than 10% of his or her investable assets. In the U.K.,
investments are essentially open to everyone. In the U.K. P2P loan market, for example, there is
a direct agreement between the lender (investor) and borrower versus the creation of a P2P
promissory note in the U.S. market.

U.K. rules require the financial crowdfunding platform to (1) have a means for unsophisticated
investors, called "restricted investors," to self-declare that their financial investments meet the
investment restriction and (2) be able to ensure such investors understand the investment and
the associated risks. The rule also requires the crowdfunding site to provide clear and fair
information to its customers about the platform's role and activities. Finally, in terms of
advertising, a crowdfunding platform can promote the platform services, but not the investment
itself, to entrepreneurs and investors.

In the P2P lending category, crowdfunding platforms must ensure they have a business
continuance plan should the platform fail so investors may continue to collect their loan
payments. The FCA requires the platforms to be able to administer the loans in the event the
platform fails and to segregate client funds from those of the company. Lending platforms must
obtain a consumer credit license. The FCA also requires platforms to maintain a scaled capital
reserve beginning at 0.2% of outstanding loans for the first GBP50 million (minimums apply) to
mitigate the risk of their business failing. FCA disclosure requirements include financial position,
loans outstanding, client positions, and complaints.

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The rule establishes equity shares in nonlisted companies (such as those purchased on a
crowdfunding platform) as "non-readily realizable securities." Per PS 14/04, permitted investors
include the following:

 Professional clients

 Retail clients who confirm that, in relation to the investment promoted, they will
receive regulated investment advice or investment management services from an
authorized person

 Retail clients who are VC contacts or corporate finance contacts

 Retail clients who are certified or self-certify as sophisticated investors or who are
certified as high-net-worth investors

 Retail clients who certify that they will not invest more than 10% of their net
investible financial assets in unlisted equity and debt securities (i.e., they certify that
they will only invest money that does not affect their primary residence, pensions,
and life cover)

Additionally, the 2014 regulation set forth other requirements such as volume-based capital
requirements, reporting disclosure, appropriateness testing, and dispute resolution, among
others.

A WORD ON THE EUROPEAN UNION


In the European Union, where crowdfunding activity was between US$2 billion and US$2.4
billion in 2013, the main issues legislation addresses are anti-money laundering, advertising,
consumer protection, and (when applicable) intellectual property. Regulation implications exist
under multiple existing EU directives. For example, financial crowdfunding may fall under
banking legislation―encompassing the European Payment Services Directive, Consumer Credit
Directive, or the Mortgage Credit Directive―or under securities legislation―which would
involve the Prospectus Directive and MiFID. Still other considerations include the Anti-Money
Laundering Directive, the E-Commerce Directive, Directive on Advertising, and Unfair Contract
Terms Directive.

The EU commission reports that 44% of all financial platforms claim that the lack of information
18
about applicable rules prevents them from operating in more than one EU country. Clearly,
there is work to be done to create cross-border opportunities and allow crowdfunding platforms
to garner economies of scale across the market. For 2014, the EU Commission focused on
studying the market's position within the broader financial system and establishing the
European Crowdfunding Stakeholder Forum as an expert group on the topic.

At a national level, Germany, the Netherlands, and Belgium have issued guidelines on
crowdfunding. Regulatory action has been taken or is under consideration in Italy, France, and
Spain, and, as mentioned above, the U.K. Individual member countries are busily working to

18. European Commission, "Unleashing the Potential of Crowdfunding in the European Union," COM
(2014) 172 Final, March 3, 2014.

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Crowdfunding: Understanding the Basics January 2015

build the lending marketplace. The Central Bank of Ireland proposed that the EU establish a
dedicated regulatory regime for loan funds to operate under the EU's Alternative Investment
Fund Manager's Directive―the proposal suggests a new pooled product for qualified investors
that would provide an exception to current prohibitions on lending. The initiative recognizes the
difficulties for small and midsize companies to access the corporate bond market. In terms of
market potential, estimates for the European private debt origination market (including direct
19
lending by investment funds) are US$33 billion in assets under management.

19. HedgeWeek, "Irish Funds Industry Association Welcomes Loan Origination Fund Initiative," August 8,
2014.

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CONCLUSION
The ingenuity of the rising crowdfunding marketplace reflects the trying economic times and the
evergreen pursuit of return on investment. At a high level, crowdfunding represents the
following opportunities.

 New ideas, human connections: Given the economic and reputational damage the
financial services industry has endured over the last several years, the observing
public is eager for new ideas and delighted to cut out intermediary fees. The power
and connection that donation- and reward-based funding have inspired among the
masses reminds people what it is to be human and to care about another's
outcome. This is powerful stuff, if the outcome is equal opportunity and a voice for
all.

 Transparency: For investors, equity and lending platforms offer an opportunity to


participate in a new investment asset class. True, there are perils (anyone else lose
money in the stock market during the recent financial crisis?). Yet, buyers and sellers
may also experience rewards, greater control, and personal satisfaction. The key to
success is platform transparency, market education, and venues that earn the trust
of their participant members.

 Investor education: Breaking new ground requires the crowdfunding platform to


invest in educating industry participants, which requires both time and money.
Platform websites are full of "how the process works" schematics, frequently asked
questions, and financial loss warnings. Large platforms have call centers to chase
registrants and answer inbound queries. Platform challenges include establishing a
comfort zone for participants and answering questions such as the following: Will I
lose my money? How well are the investments vetted? Is the rate too good to be
true? Will the platform stay in business? Will new regulation alter my experience,
the platform/product, or my return?

 Final definitions and regulation: The United States awaits finalization of the SEC
proposed rules for Title III, which may add to product offerings. There is also talk of
modifying the definition of accredited investor per Dodd-Frank regulation, which
calls for an ongoing four-year review of the definition. The debate sways between
increasing net-worth values to accommodate inflation and widening the term of the
accredited investors to include other types of sophisticated investors who simply
have not yet reached a certain dollar figure, much as in the U.K. FCA. In effect, these
respective views would narrow or widen the crowdfunding market base.

 A need for advice: A market for professional investment advice across financial
crowdfunding—as well as the private placement market generally—is likely to grow
considerably as the JOBS Act's ban on general solicitation and the platform's desire
to provide ancillary services mesh. Of course, the wealth management advisory
business will find opportunities to work with the platforms or independently. Some
crowdfunding platforms are also setting up investment advisory subsidiaries; for
example, Lending Club with Lending Club Advisors.

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Crowdfunding: Understanding the Basics January 2015

 Financial institution opportunity: Traditional banking and securities venues are


finding opportunity in crowdfunding; it is undeniable that the online marketplace is
garnering interest from individuals and institutions alike (even if, for some banks, it is
a question of timing and determining capacity). Over time, crowdfunding will
mature, but the underlying concepts will remain—perhaps with different owners
and more partnerships. Serious interest from a greater number of banks, broker-
dealers, securities exchanges, and those with pools of capital, such as asset owners
and a wider group of investment firms, is just a matter of time.

 Additional offerings, niches: In the near-term, the crowdfunding industry will


expand product offerings and additional niche firms will pop up. For example, more
sites may focus on particular industry sectors or specific needs; for example, mining
projects, energy, or litigation finance. Business lending sites are now looking beyond
startup and general loans to specialty funding, such as inventory or receivables
funding.

The birth of new ideas is often messy and chaotic. The financial crowdfunding industry is no
exception as it evolves its business model and creates a venue for others to develop new
business ideas or enhance their life experience. As in any new industry, the business life cycle
repeats with the great boom, the split-offs, the unions, the withering, and the eventual
consolidation. The joy is in the making, and for some, the watching.

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Crowdfunding: Understanding the Basics January 2015

RELATED AITE GROUP R ESEARCH


Capital Markets Tech Vendors 2.0: Disrupting the Status Quo, March 2014.

Capital Markets in the Cloud: Not Such a Gray Area, July 2014.

Game-Changers: New Financial Products and Platforms for Uncharted Territories, April 2009.

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Crowdfunding: Understanding the Basics January 2015

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