The legal view on crowdfunding: from niche financing to mainstream activity

It’s plain to see why crowdfunding, which offers a more flexible alternative to traditional investments, has risen in popularity. At a time when securing financing is difficult and support from banks seems to be dwindling, it represents a viable alternative source of capital.

A recent report shows that crowdfunding platforms raised $2.7bn globally in 2012, an 81 per cent increase on the previous year. The very same report predicts the level in 2013 will rise to $5.1bn.

From what was once a niche type of financing – the first successful recorded instance funded a reunion of an obscure rock group – crowdfunding has become a mainstream activity.

It’s becoming inevitable that more businesses will want to get involved, which means that many have to go through an education process for an activity that was hitherto unknown.

First and foremost: there are four main types of crowdfunding. Rewards-based is the most common. It grants the investor a tangible item or service in return for their investment – this could be a prototype of the product. This is particularly popular with new technology innovations.

Equity-based crowdfunding gives an investor a stake in the company, while lending-based provides a steady return (depending on the success of the business). Charities can also receive this type of funding on a pure donation-only basis with no return.

In the UK, the legal framework around crowdfunding is complex, primarily because it is not specifically catered for by financial regulation.

The different forms of crowdfunding involve a number of legal instruments, which all vary in the extent to which they are regulated. For example, equity-based crowdfunding will be regulated as an investment activity as it provides a stake in the company, while lending-based may not be viewed in the same way. Instead, it will be subject to consumer credit requirements.

Another important regulatory issue is that of financial promotion. As it stands, the promotion of business financing (via a fund) to the general public is not permitted. Those looking to advertise their business should be wary.

Interestingly, some of the legislation governing forms of crowdfunding actually plays into the hands of the business. Though lawmakers have begun considering recommendations to regulation, investors do not have the benefit of a compensation scheme. The likelihood of recovering lost money through litigation is therefore unlikely.

The Financial Conduct Authority’s (FCA) standard credit agreement, found within a consultation paper issued in March 2013, is a right for the borrower, or business, to withdraw from the agreement within 14 days of it being made without giving any reason.

While pro-business legislation may seem helpful on the surface, in reality crowdfunding relies on investors. The more risky it seems to them, the less likely they are to invest. To them, crowdfunding is a gamble. They are essentially taking on the risks of a stranger’s business.

It is for this reason that the business should prepare itself in every way to reassure potential investors. As well as ensuring you are complying with the law when crowdfunding, you must also make investors aware of whether you have an exit route, whether you have completed a thorough due diligence process, whether you have an investment strategy, and whether you have the correct patents or copyright in place.

It also helps to join established, well-known funding platforms. In the United States, one of the best-known is Kickstarter.

Other big, established platforms, like Funding Circle, have self-imposed vetting systems to check people using the platform. Many platforms are regulated by the trade body P2P Finance Association, which has a set of rules and operating principles – adding another layer of credibility and security to the platform.

Helpfully, the government is consulting on plans for the FCA to specifically regulate peer-to-peer lending from 1st April 2014.

As platforms grow in size and prudent regulation comes into force, investor confidence in the system will grow. Already, the UK is showing Europe the way, with research from Crowdsourcing LLC last year showing that the UK had 44 crowdfunding platforms.

In what is such a complex industry, it’s integral that businesses get it right – otherwise they risk falling foul of the regulators, or indeed the investors. With a growing understanding, it could well be that we’ll see more and more starting to follow the crowd.

SOURCE: Real Business