Crunch time for crowdfunders as regulation looms

The money is piling up but will the regulators knock crowdfunding down? Jeff Belmonte

Crowdfunding has attracted the attention of regulators and may have to change its ways. As it finds itself at the centre of a Financial Conduct Authority consultation, those in the game are wondering if the beady eye of regulators kill off the trend or make it stronger.

While crowdfunding is not completely unregulated, this is the first time the emerging field has faced real interrogation. The FCA acknowledges in its consultation that its current rulebook was not developed with this particular investment mode in mind.

The consultation covers both loan-based and investment-based crowdfunding and states that investing through these online platforms tends to be riskier than more traditional methods.

Rising star

Crowdfunding is a collective effort. Anyone with an art, technology or community project can post information about their plans and ask others to invest or donate. Sites such as Kickstarter, GoFundMe and Funding Circle all offer an alternative to traditional financing for operations looking to try something new. Those seeking funds post a short description of their project, set a target for funding and a time limit to raise the money. The general rule is that if the funding target is not reached, the money is not collected. But there are many different options on the table in the cases of projects that are successful.

The trend has been particularly important in the development of videogames and scientific research. Games developers have cashed in on the eagerness of fans to take an active part in the industry and have experienced huge success. The most successful crowdfunding project of all time is computer game Star Citizen, which has so far raised $24 million.

Scientists on the other hand, are increasingly turning to the public to fund their work through sites like Microryza, often after struggling to access grants. The public are in turn excited by the chance to support what could potentially be the next big breakthrough in cancer treatment or other areas of medical research and are willing to punt small amounts of cash to support the cause.

Uncharted waters

Yet crowdfunding is still in its infancy. The novel nature of the funding mechanism has thrown up all kinds of questions. What happens if there are problems with a project? What if there are unmet expectations? What if copyright disputes emerge? Crowdfunding is evolving to meet these challenges but there have been problems.

In its many forms, crowdfunding often straddles boundaries between different regulatory approaches and frameworks. This is particularly true in Europe, where common regulatory approaches to financial intermediation have displayed a marked tendency to lag behind the establishment of the common market itself. Both crowdfunders and fundees might find themselves in a “no man’s land” between different jurisdictions where there are few precedents.

The world of crowdfunding already has internal regulatory mechanisms, such as the code of practice launched by the UK Crowd Funding Association in March. But it was only a matter of time before something more formal became necessary. Currently, the FCA and the US Securities and Exchange Commission are aiming to bring in a regulatory framework in 2014.

Who owes who?

It is obvious that when you make promises about a project and subsequently win crowdfunding for it, you need to make good your claims to new investors. But what about those who have supported and developed your idea in the past and are not part of the new funding crowd? This can be a difficult set of relationships to manage, but it is critical to get it right. Reputation is everything in online funding. If you let investors down on a project, you jeopardise future attempts to win crowdfunding.

Nevertheless, even though large amounts of money can be raised through crowdfunding, the idea is that individual commitments are small. So while these projects are risky, investors are generally not risking their life savings in the hope of return. In the spirit of so many kinds of internet exchange, they are often simply keen to support an idea that they find interesting.

But there is also the question of when your responsibilities towards your investors end. Few projects simply “end”, especially the successful ones, so where is the line to be drawn? Books may go on to become films, novel treatments may go on to become blockbuster drugs. What are the ongoing rights in these cases?

What about technical projects that need significant rounds of new funding to get to next stage? If you go for a second round of funding to scale up or commercialise your product, what are your responsibilities towards the original funders?

It is possible to appear successful, and get a project off the ground, but what if you need more money for to take a product to the next level? If you have fragmented the equity by offering small numbers of shares to many people, then you may not be in a position to trade equity for an investment from a business angel or a venture capitalist with enough funds to support significant expansion. Potentially, this could make the product uninvestable; similarly, a wide disclosure of the idea could compromise the intellectual property position, which again might discourage serious investors coming in down the line.

It is early days for crowdfunding so there is little precedent. Crowdfunding can be fun but as it becomes more regulated, players on all sides should think carefully about their investments, particularly in the long-term. We are operating in unknown territory, but, sooner or later, someone is going to want their share of a crowdfunded project that made its creator a millionaire.