Funds from the crowd can assist start-ups

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Crowd-funding – the collection of finance from backers to fund an initiative usually on internet platforms – could be be seen as an attractive alternative to people looking for microloans.

With banks like African Bank and Capitec experiencing difficulties in the unsecured lending market, and tightening up their lending criteria, crowd-funding could provide an effective platform for companies to access much-needed start-up capital.

However, it is important to note that crowd-funding is primarily available to enterprises undertaking specific ventures.

It is not, therefore, a direct alternative to individuals looking for small loans for general purposes. And such funding is not without its own challenges – both to investors and the borrowing companies.

Crowd-funding is usually made available to companies and investors through trusted third-party websites.

The lack of effective access to the internet, especially in many rural or non-urban areas, means that crowd-funding will not always target or find its way to a significant segment of the economy that could potentially use it the most.

While there are many ways to structure a crowd-funding initiative, one of the more popular is a borrowing company offering shares in the enterprise to potential investors in exchange for funds.

Companies Act

One of the main challenges facing the parties here is that such an offer could constitute what is known as an “offer to the public” under our Companies Act.

If it does, then the borrowing company is required to follow a costly and lengthy process, including preparing a detailed advertisement or prospectus, before it can make the offer.

This process defeats the object of what should be an inexpensive and quick crowd-funding exercise.

It is possible, however, to structure the offering such that it does not constitute an offer to the public or to make use of certain exemptions built into the Companies Act.

Any company should therefore take legal advice before using crowd-funding in this way, given that the failure to follow the procedure set out in the Companies Act could amount to a criminal offence.

From an investor’s perspective, this form of crowd-funding probably means that he or she will acquire a small minority interest of shares in a company with multiple other minority shareholders.

Furthermore, the borrowing company is unlikely to have a shareholders’ agreement or memorandum of incorporation in place that is appropriate for a shareholding arrangement of this nature.

This creates a dynamic that is often difficult to manage, especially where the company begins to do well.

While shares are attractive in the sense that they give the investor an ownership interest in the borrowing company that has the capacity to grow with the business and prospects of the company, the investor is not able to recoup his or her investment until the company becomes profitable, and then only in the form of dividends.

In addition, if the company fails and goes into liquidation, the investor stands at the back of the queue when it comes to repayment of the investment out of the company’s residual assets.

The commercial benefits of crowd-funding, however, mean that it is probably here to stay.

The popularity of this form of funding has led to a number of governments around the world, including in the US, paying close attention to its developments.

It is not yet clear whether governments will feel the need to develop specific legislation targeting crowd-funding.

But until such decisions are made, investors and borrowing companies can expect scrutiny of how they structure and implement their transactions.

This requires all parties to carefully consider the legalities of what they are doing at the earliest possible opportunity.

* Jared Nickig is a director at Werksmans Attorneys.


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