Crowdfunding

What is crowdfunding?

Crowdfunding (in German Schwarmfinanzierung) refers to the financing of a company or project by a large number of individuals, each of whom provides a comparatively small amount via an internet platform. Depending on the form, the funders receive nothing, a good or service, a share in economic success or an interest-bearing repayment claim.

The parties involved are the company seeking capital (project owner), the platform as intermediary and the investors or supporters. For growth companies, crowdinvesting (also equity crowdfunding) is particularly relevant, which stands alongside or ahead of a round with business angels or venture capital. The basis is the platform's terms, the contract on the respective investment instrument and the prescribed investor information.

Four forms of crowdfunding

• Donation-based: Supporters give money without consideration, mostly for non-profit, cultural or social projects. For a commercial company, such payments are generally operating income.
• Reward-based: Supporters receive consideration, often the later product. Economically this is a pre-sale: the payments are advance payments received until delivery, and value added tax (VAT) already arises for the period in which they are received.
• Crowdinvesting: Investors share in economic success, mostly through profit-participating subordinated loans (partiarische Nachrangdarlehen). These are loans with performance-linked remuneration that rank behind the other creditors. Less common are silent partnerships (contribution against a share of profits), profit participation rights (contractual profit rights without voting rights), securities or direct company shares.
• Crowdlending: Investors grant an interest-bearing loan that is repaid according to plan. There is no participation in the value of the company.

Legal framework for crowdfunding in Germany and the EU

Since 10 November 2021, Regulation (EU) 2020/1503 on European crowdfunding service providers for business has applied. Platforms that mediate crowdinvesting and crowdlending then need authorisation, in Germany from the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin), and can operate with it throughout the EU. Offers up to an upper limit set in the regulation per project owner and twelve-month period are covered. The project owner is responsible for a key investment information sheet, a short standardised document on the offer and its risks. The regulation protects inexperienced investors through a knowledge test, a simulation of possible losses and a reflection period before they become bound.

Outside this framework, national law applies. Subordinated loans, profit-participating loans, silent partnerships and profit participation rights are in principle financial investments (Vermögensanlagen) under the German Financial Investments Act (Vermögensanlagengesetz) in Germany; prospectus and information obligations apply to their public offering, with statutory exemptions. For securities, the rules on the securities prospectus and the securities information sheet apply. Which obligations apply depends on the instrument, volume, distribution channel and the version of the laws in force at the time.

Banking supervision law draws a further line. If a company accepts repayable funds from the public, this can be a deposit-taking business requiring authorisation under the German Banking Act (Kreditwesengesetz). Crowdinvesting loans therefore contain a qualified subordination (subordination): the investors are served only after all other creditors and only to the extent that the payment does not trigger insolvency. According to case law, this clause must be worded clearly and comprehensibly. If it is invalid, the investors stand in the position of ordinary creditors, and there may be an unauthorised deposit-taking business. The drafting of the contract therefore belongs in the hands of a law firm experienced in capital markets law.

Crowdinvesting, shareholder base and later rounds

With the profit-participating subordinated loan, the most widespread instrument, the investors do not become shareholders. The list of shareholders and the shareholder structure remain unchanged, and no voting rights arise. Economically, however, the investors often receive a share of the company value on a sale, which behaves like a shareholding and is legally a liability. Such instruments count as mezzanine capital. On the balance sheet they appear as a liability and lower the equity ratio; banks partly count them as economic equity because of the subordination.

If, by contrast, small investors become shareholders of a GmbH (German limited liability company) directly, every acquisition requires notarial form, every shareholder appears in the list of shareholders and takes part in resolutions. Capital increases and a sale then require the cooperation of many parties. Bundling through an investment company or a trustee is therefore common, so that only one shareholder appears in the list; trust agreements over shares, too, often require notarial form. So that a sale does not fail because of the bundling company, it is bound into a drag-along obligation (drag-along).

Investors in a later round examine the crowd contracts closely. They ask whether the investors' share is diluted along with the shareholders in capital increases, what termination and repayment rights exist, whether a change of control triggers early payment and how the proceeds share is calculated. These claims belong in the fully diluted cap table, that is, the overview of holdings including all future claims, and in the distribution of proceeds (waterfall). A publicly communicated valuation above the level of institutional investors makes the next round harder still.

Worked example: crowdinvesting with a profit-participating subordinated loan

A consumer goods company with its own customer base raises EUR 1 million via a platform as a profit-participating subordinated loan. For the proceeds participation, the contract uses a valuation of EUR 9 million before the financing and provides for a fixed interest rate of 4% per year. On a sale, the investors receive a share of the purchase price for the company instead of repayment. In this example the platform receives 7% of the amount raised.

• Net inflow: EUR 1 million minus EUR 70,000 = EUR 930,000
• Proceeds participation of the investors: EUR 1 million / (EUR 9 million + EUR 1 million) = 10% of the later purchase price
• Interest: EUR 1 million × 4% = EUR 40,000 per year, EUR 240,000 after six years
• Series A after three years: EUR 4 million at a valuation of EUR 16 million before the round; the shareholders are diluted by 4 / 20 = 20%
• Variant A with dilution along with the shareholders, so the investors' share falls like that of the shareholders: 10% × (1 minus 20%) = 8%
• Variant B, no adjustment: investors' share unchanged at 10%
• Sale after six years for EUR 40 million: In variant A the investors receive 8% × EUR 40 million = EUR 3.2 million, in variant B 10% × EUR 40 million = EUR 4 million

The difference of EUR 0.8 million is borne in variant B by the shareholders alone, including the new Series A investor. Because the proceeds share is a liability of the company, it is served before distribution to the shareholders. A net inflow of EUR 930,000 thus becomes payments of up to EUR 4.24 million (EUR 4 million proceeds share and EUR 240,000 interest). Economically this is comparable to a 10% shareholding.

Distinction: crowdfunding, business angels, venture capital and STO

• Business angels: individual private persons with larger amounts, who usually become shareholders directly and accompany the founders personally.
• Venture capital: institutional investors with large amounts, preferential rights and rights of co-determination. Crowdinvesting rarely replaces such a round but can complement it.
• Security token offering: issue of digital securities on the basis of a blockchain. Here too many investors invest small amounts, but securities law applies.

Common mistakes

• Campaign without commitments in advance. Campaigns that have not secured a significant part of the target amount within their own circle at launch reach their goal less often. If the campaign fails publicly, the brand suffers too.
• Contract terms without a view to the next round. Missing rules on dilution, termination rights or change of control lead to renegotiation in the review for the follow-on round.
• Small investors directly in the GmbH. Many individual shareholders make resolutions, capital increases and a sale harder, because every one of them has to cooperate.
• Public valuation above market level. A high valuation eases the campaign but sets a benchmark that institutional investors later fall below.
• Ongoing obligations underestimated. Reports to the investors, interest payments and repayments at the end of the term tie up liquidity and working time for years.
• Rewards without full-cost calculation. Production, shipping and VAT on the promised products can consume a considerable part of the funds raised.

Frequently asked questions

How does crowdfunding work?

Via a platform. The company presents its project there with a target amount and term, and interested parties subscribe amounts. If the campaign reaches its minimum amount (funding threshold), the platform pays out the money after deducting its commission. If it falls short, the funders generally get their payments back.

Do crowdinvestors become shareholders of the GmbH?

Mostly not. With the widespread profit-participating subordinated loan and with silent partnerships, they receive contractual claims but no shares and no voting rights. They become shareholders only through a direct participation or indirectly through a bundling company.

Does a company need BaFin authorisation for a crowdinvesting campaign?

As a rule not the company but the platform does. The project owner must, however, prepare the prescribed investor information and is responsible for its content. Outside authorised platforms, prospectus obligations may apply.

How much capital can be raised through crowdinvesting?

Mostly amounts in the six-figure to low seven-figure range. At the upper end, the European regulation limits the volume per project owner and twelve-month period. When it began to apply in November 2021, the limit was EUR 5 million; the version in force at the time is decisive. Larger amounts require other forms of offer with their own prospectus obligations.

Does crowdinvesting rule out a later venture capital round?

No, if the contracts are prepared for it. Investors expect clear rules on dilution, on treatment in a sale and on bundled voting. If they are missing, they are renegotiated before the round, which costs time and requires the investors to be involved.

Is crowdfunding suitable for B2B software companies?

Rarely. Crowdfunding thrives on a product that many people know and use. Companies whose customers are themselves businesses usually reach neither their target group nor significant amounts through a public campaign.

The Roemer Capital view

The clients of Roemer Capital are technology companies with a product on the market and ongoing revenue that close rounds from EUR 1 million with institutional investors. There, crowdfunding mostly appears as existing business: earlier subordinated loans with a proceeds share or a campaign among the customers of a consumer goods company.

In preparing a round, Roemer Capital records all crowd contracts and maps their payment claims in the fully diluted overview of holdings and in the sale scenarios. This shows which clauses new investors are likely to want to renegotiate. Whether the contracts are effective and viable under supervisory law is assessed by the company's law firm.