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by prc1333

The origins of crowd-funding

 
Crowd-funding is an internet-inspired means of raising money for a project or business from the mass market.  It is a relatively recent concept that has its origins in community and arts-based projects which members of the public are inclined to support for benevolent reasons. 
 
For example, a crowd-funding internet site might seek to raise £100,000 over a period of 30 days to help fund the making of a film.  If the website users subscribe the cash, they would receive acknowledgement that reflected the scale of their contribution – a £200 donation might be rewarded with tickets to the premiere and a £1,000 donation might lead to dinner with the director.
 
This “charitable” crowd-funding model has gathered pace and the sums of money raised have caught entrepreneurial eyes that see the potential for crowd-funding to explode into a major socio-economic phenomenon.  The key to unleashing such an explosion is through returning financial rewards to investors for their money.
 
Crowd-funding as an investment model
 
Different crowd-funding investment models are evolving, creating a new breed of retail “armchair dragons”.  The investment models can either take the form of debt (where the website user lends money to a crowd-funded business) or equity (where the investor becomes a shareholder in the crowd-funded business).
 
The crowd-funding investment model provides a greater rate of return than retail investors are likely to receive from investing in listed bonds or shares. It is also cheaper for the businesses than bank borrowing or institutional investment.  The investors can remain passive, as the crowd-funding website operator attends to investor protection issues, such as debt recovery and vetting the underlying business.
 
Barriers to crowd-funding investment
 
Crowd-funding as an investment model faces challenges in the form of existing consumer protection regulation.  The UK Government has signalled that it is interested in reviewing legal and regulatory barriers to crowd-funding. However, any relaxation of consumer protection measures will be subject to careful scrutiny to mitigate against the increased risk of public scandals resulting from fraud or poor book-keeping.
 
The obvious subject of a crowd-funding regulatory regime is the crowd-funding website operator.  As lending to non-consumer businesses is not regulated in the UK, the debt-based investment model escapes the majority of financial services regulation.  However arranging equity investment constitutes activity that is regulated by the Financial Services Authority (FSA) – soon to become the Financial Conduct Authority. 
 
Operators of equity-crowd-funding websites will therefore generally need to comply with financial services conduct of business requirements, such as assessing the appropriateness of investments for investors and holding client money in segregated accounts.  Whilst there are structures that enable operators to avoid becoming authorised, such structures can place significant technical and reputational restrictions on the operator’s ability to develop.
 
Even where the website operator seeks authorisation from the FSA, the current regulatory regime does not permit the promotion of crowd-funding “projects” to the general public, where the project concerned is not housed within a corporate structure.  For example, an authorised crowd-funding website operator could not arrange investment by the general public into a computer game, where the investors would receive a share in the net profits generated by games sales.  This is because of the prohibition on promoting “unregulated collective investment schemes” (more commonly referred to as “investment funds”) to the public.
 
The existing regulatory culture of assessing the individual circumstances and knowledge of investors does not sit well with an objective to open up the equity-based investment model to the mass-retail market.  This arises from the difficulty firms face in devising cost-effective processes that adequately vet individuals making micro-investments of, say, £10.

See more on this UK Law Firm

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