Crowd funding is fast emerging as a viable alternative capital raising strategy for start-up businesses in a difficult economic environment. Associate, Rohan Pardasani and Law Clerk, Philip Chow discuss the growth of this phenomenon and provide some practical suggestions for entrepreneurs considering this relatively new model of fundraising.

Conducted online through websites such as the US based, kickstarter.com, or its Australian competitor, pozible.com.au, crowd funding provides entrepreneurs with an online platform to pitch their new business projects to a large pool of casual online investors. This type of fundraising is expected to raise approximately US$3bn in 2013.

A crowd funding platform invites investors to contribute small sums to support and develop projects pitched on the website by way of donations or, more commonly, upfront payments from investors in exchange for the goods or services which the entrepreneur is seeking to commercialise at the end of the project (rewards). For example, a project pitched on kickstarter to develop a smart phone controlled light bulb was backed by thousands and raised US $1.3m. In that case, investors received a light bulb as the reward for a minimum investment of US$69. Recently, an Australian company, Gordagen Pharmaceuticals, launched a campaign on the RocketHub crowd funding platform to raise funds for clinical trials of an over-the-counter pharmaceutical product.

Notwithstanding the immense potential to raise significant capital with minimal upfront cost, Australian entrepreneurs should be aware of the legal implications of crowd funding.

Individual crowd funding platforms have their own legal terms and conditions. Entrepreneurs need to ensure that they fully understand the legal implications of those terms and conditions. For example, the website terms and conditions for kickstarter and pozible require "project creators" to ensure all rewards which may be promised to investors are eventually provided. That is, the provision of a reward to an investor is not intended to be a speculative proposition. If a project creator is unable to provide a reward to a particular investor or a group of investors, the project creator may be required under the terms and conditions to offer a refund to such investors of their initial contribution. This may mean that some crowd funding platforms may not be suitable for projects where there is a risk that goods or services may not be able to be developed.

Additionally, rewards provided through crowd funding platforms will still be subject to consumer protection laws such as the Australian Consumer Law. For example, entrepreneurs may be required to guarantee that their rewards are ‘of acceptable quality’ and comply with product safety and labelling requirements. Entrepreneurs should also make certain that their investor pitch on the crowd funding platform and any subsequent interactions with investors are not likely to mislead or deceive. In this regard, successful project creators often provide updates to their investors and are honest and upfront about the difficulties faced (or which may be faced) at various stages of a reward’s commercialisation.

Some overseas crowd funding platforms permit more traditional fundraising methods such as allowing entrepreneurs to recognise investor contributions as a loan or, alternatively, as a form of equity in the entrepreneur’s project or business. However, Australia is yet to establish a regulatory regime to deal appropriately with debt and equity crowd funding models. Recently, ASIC has warned that projects funded by a crowd funding website could be a managed investment scheme if funds contributed are pooled or used in a common enterprise to produce financial benefits or benefits consisting of interests in property for the contributors. Similarly, equity crowd funding models and may require the preparation of a disclosure document in order to satisfy the requirements under the Corporations Act for fundraising. This uncertainty has prompted the government to request a review of equity-based crowd funding by the Corporations and Markets Advisory Committee. Although CAMAC’s review will not be completed until April 2014, it may choose to recommend that Australia follows the US example which exempts equity-based crowd-fundraisers from the US securities compliance regime if less than $1m is raised in a 12 month period.

Beyond the above legal implications, entrepreneurs should also take into account other practical considerations. Raising capital is usually not a one-off event. Businesses adopting the crowd funding model may have difficulty obtaining additional funds from traditional sources as investors may be less inclined to fund a project that is restrained by commitments to provide rewards.

Despite the attractiveness of crowd funding, individuals and companies must carefully consider the legal ramifications and commercial risks involved in crowd funding. This is further complicated by the legal uncertainty of crowd funding schemes in Australia. While kickstarting your business is very much possible, businesses must tread with utmost care.