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Crowd Funding

Posted on Jun 07, 2011 by Sandy Finlayson  | 0 Comments

A lot of people have been asking me about crowd funding recently.  What is it?  How does it work?  Is it legal?  The idea of crowd funding is very simple.  It involves using the extensive reach of the internet to target lots of small investors rather than the conventional approach of targeting a small number of large investors.  Examples are www.kickstarter.comand www.crowdcube.com.  Perhaps the best example which can be given is the recent £50 Million bond issue by John Lewis  with cash interest of 4% and additional interest of 2% represented by John Lewis vouchers.  This was a sophisticated and successful financial promotion at one end of the spectrum.  However, for most people crowd funding means the other end of the spectrum with people looking for small sums of money to launch a new business or develop a new product.

The UK has a rigorous Financial Services regime intended to prevent financial scams and fleecing the unwary.  The regulations are very detailed and highly complex.  The principal Act is the Financial Services and Markets Act 2000 which sits on top of the Regulated Activities Order 2001, the Financial Promotion Order 2005 and the Prospectus Regulations 2005.  

Any financial promotion intended for general distribution must be approved by an authorised person which means that it must be prepared to prospectus standards.  Financial promotions which are not prepared to this standard can only be distributed to a restricted audience of high net worth individuals, sophisticated investors, high net worth companies and high value trusts (all of which are defined in the regulations).

Every jurisdiction has its own financial promotion regime.  Even if a financial promotion complies with the Financial Services regulations in the UK that does not mean that it may be distributed outside the UK.  If it is also aimed at American investors for example it must also comply with all relevant American regulations.  This is something which must be taken extremely seriously as we already have examples of UK executives being apprehended in America for “wire fraud” in States where online betting is illegal.

The internet is racing ahead of the regulators who have a great deal of catching up to do in all jurisdictions.  There are no doubt crowd funding opportunities being promoted either in blissful ignorance or wilful defiance of the law.  However, as an illegal financial promotion is a criminal offence which may carry a custodial sentence, that is certainly not to be recommended!  

It would simply not be economic to produce a document to prospectus standards for a small crowd funding project.  One possible approach to this problem would be to post a Business Plan to a website with a “tick box” approach so that prospective investors are not given access to the Business Plan until they have certified that they are entitled to see it.  This may or may not overcome regulatory concerns but issues then arise over practical questions such as:-

•    Do the promoters have to raise the minimum amount they have asked for or can they just take whatever they get?

•    How will investors be sure that they will get a Share Certificate?

•    How will investors be certain that they will get EIS relief if is that is important to them?

•    What sort of rights will investors have once they have subscribed for shares in the company?

•    Will the investors get any of the investor protections which are usually sought by sophisticated investors?

•    Do the investors have any idea what they are getting involved in if they have no opportunity to carry out even the most basic due diligence?

Crowd funding techniques may develop so that trusted providers are able to address all of these concerns in a reliable, robust and legal way.  However, sophisticated investors are only too well aware of the risks associated with this type of investment.  They know that rigorous due diligence is critical as are robust investor protections and post-investment monitoring.  Even with these safety checks in place, the failure rate is high although the overall returns for investors who invest on a portfolio basis can be very satisfactory.  Prudent investors should look carefully at the strength of the underlying investment proposition, the legality of the process and the effectiveness of the investor protections before they commit their hard earned savings.

For those seeking to raise money for a new venture we still have a very long way to go before crowd funding may be considered as the fundraising method of first choice or even seriously considered by anyone seeking to raise significant sums for a serious business venture.  However, it is not hard to envisage a world of “on-line” pitches on You Tube and the regulators are going to find it increasingly hard to keep up with the reality of what is happening in the “lawless” world of the Internet.

We are also seeing parallel developments in “peer to peer” lending with new websites such as www.wonga.com and www.zopa.comwhich are attempting to dis-intermediate the banking system.  With a continuing squeeze on credit from conventional sources, it is just possible that they might start to catch on and become part of the main stream.

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