Crowd-funding is an increasingly popular way of raising capital over the internet in a climate where raising funds for commercial projects and business ideas through business angels or traditional lending from banks remains challenging or in some cases, simply unachievable.

Crowd-funding is an increasingly popular way of raising capital over the internet in a climate where raising funds for commercial projects and business ideas through business angels or traditional lending from banks remains challenging or in some cases, simply unachievable. The principle is simple; raise required levels of finance through a high volume of small scale investments from people who like your ideas and are prepared to back them. For example, a small business with a new product might “pitch” on a specialist crowd-funding website and seek to raise a set sum of money over a fixed period of time to help take their product to market. If visitors to the site like the idea or product, they can commit to invest and where they do so, they stand to receive a reward of some kind (such as a discount off the product once it hits the market or perhaps a limited edition version of the product). However, investors don’t typically stand to receive an equity stake in the business seeking to raise the finance, and there is a good reason for this, as explained below. More often, the investor will simply view it as an altruistic contribution to encourage development of a new idea they like, or even as a different way of shopping. Investors will usually not be bound to pay over any money until the target level of investment is reached and the level of investment is usually small enough not to be material if things don’t work out as planned. It’s a simple idea which is rapidly gaining traction and one which is testing the boundaries of regulation and traditional methods of raising capital.

Recent high profile examples include the “pebble” watch designed by a Canadian entrepreneur to work alongside smartphones. The expectations were originally fairly modest but which raised nearly $10 million on net funding site Kickstarter, all because the public loved the product and word spread through social media. In that case, most of those who have pledged cash stand to receive discounts on the watch when it launches.

Tapping into this mass market in this way has led to investors looking at similar models based on users of crowd-funding websites, either lending money to start-up businesses (often called the lending model) or taking equity and becoming shareholders in that business (often referred to as the investment model). The challenge here is much greater. Issues of investor protection, security and debt recovery all become relevant, as does the question of who polices investments to ensure that they are not open to abuse. A recent commentator in the US, where President Obama has championed the development and evolution of crowd-funding through the recently published JOBS Act, has described aspects of the crowd-funding proposals in the US as “a petri-dish for fraud”. In the UK, pressure from the EU is relentless in ensuring member states champion investor protection measures and a series of regulations and directives are proving a headache to the Government, as it tries to adapt it’s own investor-protection framework to embrace new technology and the general push to stimulate business activity and investment in a stagnant economy.

A lending or investment model can provide for a greater rate of return to investors than other models and can be a less expensive and risky proposition for businesses compared to borrowing from banks or institutional investors. However, existing forms of regulation are acting as a complex barrier to the development of investment and lending models in the UK and businesses, wishing to act as intermediaries between potential unsophisticated investors and potential recipients of funding, such as crowd-funding websites. They are currently faced with a myriad of rules regulating their involvement, such as those laid down in the Financial Services and Markets Act governing the control of investment activity and collective investment schemes. Website operators who promote lending and investment models can easily become subjected to requirements for them to assess the suitability of investment opportunities and management of funds committed by potential investees. The question therefore arises as to whether it is economically viable for crowd-funding website operators to secure authorised status, work alongside authorised advisors or adapt their business model in a way which means they can avoid authorisation. Setting up a cost-effective process to coordinate and manage investments, adequately assess the suitability of individuals making small scale investments and the business into which they are being invited to invest, as well as setting up the legal structures to regulate the relationship between a potentially large number of equity investors or lenders, is a challenging and costly prospect to say the least.

While it may clash with the objectives of European regulators, there is now more than ever a push to encourage the Government to establish a purpose built regime in which crowd-funding can flourish more easily and provide a viable alternative means of securing funding. Sitting alongside possible tax incentives for investors, this may involve setting maximum levels of investment per investor, thus minimising the risks of large scale losses befalling individual investors. The feeling is any initiatives will centre around the principle that individual investors should take a greater degree of personal responsibility for their own decisions and online spending and ultimate responsibility should not necessarily rest with an intermediary, such as a crowd-funding website. This is assuming of course the intermediaries have acted fairly in the process of introducing parties to an investment and given suitable warnings about potential investment risk.