09 Oct 2014   |   Viewpoint

Unlocking the potential of crowdfunding

Europe’s SMEs are starved of cash. Crowdfunding represents a potential way to overcome some of the fragmentation of Europe’s capital markets and improve access to financing for start-ups, says Karen Wilson of the policy thinktank Bruegel

The financing gap for innovative, high-growth SMEs is a serious concern. These companies should be the drivers of the job creation and economic growth that is much needed to break through economic malaise across Europe. But the bank lending drought caused by the financial crisis, coupled with the lack of alternative funding sources, is a huge constraint on the development SMEs.

At a time when banking intermediation is under pressure, it is important for European Union policymakers to further explore alternative forms of financial integration. Commission President Jean-Claude Juncker recently spoke about the need to improve financing in Europe by, “further developing and integrating capital markets” and reducing the dependence on bank lending.

Juncker and his new team need to address the regulatory fragmentation in financial markets head-on, to promote efficient funding and growth of innovation in Europe.

For innovative young firms, equity capital can be particularly important to fuel growth across borders. However, European capital markets are highly fragmented, with different rules and regulations applying to various types of financial instruments and financial intermediaries from one country to another.  

This complexity not only makes it hard for SMEs to access finance outside their home markets, it also makes it difficult for potential investors to identify and evaluate the potential of start-up and high-growth companies.

Barriers to cross-border venture capital

Venture capital and angel investors are playing an increasingly important role in Europe, but the level of activity is overshadowed by the US, where the capital markets are more developed. While Europe has made some progress in reducing barriers to cross-border venture capital transactions, most angel investment remains at a local level.

A paper published recently by Bruegel suggests that crowdfunding has potential to provide cross-border finance for new ventures. This new and fast-evolving form of funding has a number of manifestations. Currently, the bulk of crowdfunding is in the form of donations for philanthropic projects. It has also been used - in the form of either pre-funding orders or old-fashioned lending - to get creative ventures such as music and films off the ground.

Equity crowdfunding, also referred to as crowdvesting, is a more recent development and currently comprises the smallest part of the crowdfunding market.

While equity crowdfunding represents a new channel for start-ups to access finance, policy makers should carefully assess the risks of this new financial intermediation tool. Questions remain about the appropriateness of crowdfunding for providing seed and early stage equity finance to new ventures and how this market could be developed and regulated.

Indeed, the challenges of equity crowdfunding are more complex, and distinct, from those posed by other forms of crowdfunding. The risks are also different from other types of seed and early-stage equity finance, such as angel investment and venture capital.

For a start, unlike other forms of equity financing, crowdfunding is mediated by online platforms. These platforms differ in terms of the services they offer for screening and evaluating companies. Also, their role during the investment and post-investment stages varies considerably.

Legal protections

Limited regulatory oversight has put Europe at the forefront of equity crowdfunding globally. However, the lack of regulations leaves funders with few legal protections.  In response, some member states have introduced ad hoc legislation for crowdfunding, while others are due to introduce new laws.  

Being internet-based, equity crowdfunding has the potential to contribute to a pan-European seed and early-stage financial market to support European start-ups. To deliver on this potential, member state policies need to be harmonised, with the aim of maximising the benefits of equity crowdfunding, while reducing the risks.

A harmonised approach would also help to address some of the fragmentation in Europe’s financing markets and encourage new forms of financial intermediation.

The Commission should cooperate with member states to address the current patchwork of national legal frameworks that currently constitute such an obstacle to the appropriate development of this nascent model of funding across Europe.

This in turn, would be an important contribution to the work towards a Capital Market Union.

Never miss an update from Science|Business:   Newsletter sign-up