Crowdfunding and the $40 000 potato salad

As this form of collective investment rises in popularity, South African regulatory bodies will need to specifically address this form of funding.
Amy Eliason, candidate attorney with Webber Wentzel

Zach “Danger” Brown was hoping to raise a mere $10 when he started his crowdfunding campaign in July, asking the Internet to help fulfil his dream of “making potato salad”. To date, more than 6 000 backers have pledged over $40 000 to his cause.

How much money would you give to a total stranger to fund a single serving of potato salad?   

Kickstarter, the United States-based website that facilitated the “potato salad” initiative, is one of many crowdfunding platforms that have been developed in recent years. Crowdfunding is the practice of funding a project or venture by raising small amounts of money from a large number of people, typically via the Internet. It is essentially an alternative means of collecting finance to sustain an initiative.

 This is not a new concept. Crowdfunding was used as far back as the 1700s when Mozart used it to raise funds for some of his Viennese concerts. However, with the advent of the Internet, crowdfunding has become a prolific capital-raising vehicle for many start-ups around the world. In 2013 alone, crowdfunding websites raised over $5 billion. 

There are typically three main forms of crowdfunding. The first is equity-based funding, whereby the entrepreneur offers a percentage of equity in exchange for funds. Debt-based funding (also known as peer-to-peer lending) occurs when funders are promised financial returns or interest in return for loans. Finally, donation-based funding, arguably the most popular form of crowdfunding, occurs where funds are donated to campaigns and projects, sometimes in exchange for small gifts or rewards. 

Kickstarter is a form of donation-based funding. Project creators set a funding goal and timeline and if people like the project on offer, they can pledge money to make it happen. Backers on Kickstarter do not invest to profit financially. Rather, they invest for numerous other reasons, such as philanthropy or an appreciation for the arts. In the case of the potato salad campaign, the gifts on offer in exchange for funds from backers range from a public ‘thank you’ to receiving a bite of the actual potato salad. 

Yet, these gifts do not appear to be the basis for investing in the potato salad initiative. In the same vein as proponents of the aesthetic movement support the doctrine of art for “art’s sake”, it seems as though Zach Brown’s backers are supporting potato salad merely for “potato salad’s” sake, separate from any didactic, moral or utilitarian function. The potato salad’s Kickstarter success has been celebrated by many and touted as a harmless social media trend. Others find it mindlessly profligate and, frankly, just plain silly. 

The debate surrounding potato salad aside, crowdfunding appears to be growing in popularity world-wide. Proponents of the crowdfunding approach argue that it allows ideas which do not fit the pattern required by conventional financiers to break through and attract untraditional sources of capital, whilst creating a network previously unavailable to early stage companies. Unlike investment banking, crowdfunding gives independent investors complete transparency and visibility into the investments of their peers.

Crowdfunding is also unique in its ability to create a forum whereby entrepreneurs can engage with investors. This provides valuable market research and essentially builds an audience for the idea.

Nevertheless, this sort of investment vehicle has a number of potential risks, including the risk of fraud. Numerous stories abound regarding “new and exciting” crowdfunding projects which have turned out to be empty shells. Funding platforms claim to take comprehensive fraud-prevention measures, but exclude liability in their terms of use for any losses relating to the authenticity of any data or information that users provide about themselves or their campaigns.

Inevitably, backers have no guarantee of authenticity of projects and must merely trust the system and its entrepreneurs. This brings to mind the latin phrase caveat emptor, quia ignorare non debuit quod jus alienum emit – ‘let the buyer beware, for he ought not to be ignorant of the nature of the property which he is buying from another party’. 

The major problem with crowdfunding is the lack of regulation, particularly in South Africa. Unlike the United States’ Jumpstart Our Business Startups Act (JOBS Act), there is no explicit mention of crowdfunding in any of our legislation, nor has draft legislation been proposed in Parliament.

One of the questions surrounding donation-based crowdfunding in South Africa is whether such crowdfunding platforms could constitute “banks” which receive deposits as defined in the Bank Act No.1994 of 1990 (Banks Act).

In Registrar of Banks v Net Income Solutions and Others (2013) it was held that Government Notice 498 of 27 March 1997 should be read with the definition of the “business of the bank” in the Banks Act and, if the entity constitutes a bank in terms of either of these definitions, then the Banks Act applies and the entity must be registered as a bank. The case goes on to highlight the main elements of a bank as being:

“the acceptance or obtaining of money, directly or indirectly, from members of the public, as a regular feature of a business practice with the prospect of such members receiving payments or other money related benefits, directly or indirectly, on or after the introduction of other members of the public to the business practice, and from funds accepted or obtained from participating members or new participating members in terms of the business practice.” 

Therefore, whether a crowdfunding vehicle constitutes a bank for the purposes of the Act depends on its structure. As long as the investor receives goods or services in exchange for the payment, and does not receive funds that were accepted or obtained merely from other participating investors, then the crowdfunding platform would not be acting as a “bank”. Thundafund (https://www.thundafund.com/), a donation-based crowdfunding website specifically states that it is not a bank, but rather a connector for project creators and backers.

When it comes to debt-based (peer-to-peer) crowdfunding, such platforms could possibly fall under the provisions of the National Credit Act No. 34 of 2005 (NCA). In terms of the NCA, a credit provider is, inter alia, a party who extends credit under a credit facility. A credit facility is an agreement whereby the credit provider undertakes to pay the consumer an amount of money and defer repayment and charge a fee for such arrangement. A credit provider in a credit agreement which exceeds R5 000 000 must be registered in terms of the NCA. Lendico South Africa is a debt-based crowdfunding platform and a registered credit provider. Lendico connects borrowers with investors directly and allows investors to invest in private loan projects while Lendico undertakes the task of controlling the credit quality of the loan.

Equity-based crowdfunding projects would likely be facilitated through offers of securities to the public by private companies. In terms of s100 of the Companies Act No.71 of 2008, when unlisted securities are to be offered to the public, such an offer must be accompanied by a detailed prospectus. The content and registration of prospectuses must be in compliance with Chapter 4 of the Companies Act.

Crowdinvest, a South African equity-based crowdfunding platform makes investment opportunities available online to the public. Crowdinvest creates a special purpose vehicle (SPV) with a share capital, which acquires the total investment proposal once the project achieves its target amount. Investors receive preference or normal shares in the SPV proportionate to their investment.

It will also be interesting to see if s12J of the Income Tax Act No.58 of 1962 will play a role in the equity-based crowdfunding sphere in South Africa. Section 12J allows for deductions from the income of certain qualifying investors in respect of expenditure actually incurred for shares in a venture capital company. If crowdfunding platforms can be registered as venture capital companies in terms of s12J, then any funds invested in the crowdfunding platform may be allowed as a deduction for tax purposes.

In order to qualify as a venture capital company, crowdfunding platforms would have to meet certain preliminary requirements, as set out in s12J(5). The platform must, inter alia, have as its main objective the management of investments in developing companies, and it must be licensed in terms of s7 of the Financial Advisory and Intermediary Services Act No.37 of 2002. The platform also cannot be deemed to be performing an “impermissible trade” (as defined in s12J). Per the definition, any trade carried on in respect of financial services, as well as any trade carried on by a bank as defined in the Banks Act constitute “impermissible trades”.

Ultimately, crowdfunding in South Africa is still in its infancy stage. As this form of collective investment rises in popularity, South African regulatory bodies will need to specifically address this form of funding. It is likely that this will be an arduous task for our regulatory bodies. Certainly, in other countries such as the United States, legislators are struggling to strike the right balance between the protection of investors and the promotion of capital formation, particularly in the context of equity crowdfunding.

Nevertheless, crowdfunding is a novel and exciting vehicle for entrepreneurship around the globe. It has become an international movement and it will be interesting to see the evolution of the industry in South Africa over the coming years. Perhaps one day I will be writing an article titled “crowdfunding and the R500 000 malva pudding”.

Eliason is a candidate attorney with Webber Wentzel.

This article first appeared in the Q3 2014 DealMakers magazine.

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