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INSPIRE: Peer to peer Lending and Crowdfunding

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Peer-to-peer Lending and Crowdfunding are, respectively, the new high(er) interest investment return and start-up funding phenomena that have attracted sufficient interest from city watchdog, the Financial Conduct Authority, for them to become a regulated investment as of April 1st this year. How attractive an investment are they though – and just how risky?

Firstly, what is crowdfunding? Quite simply, it is internet-based lending which matches people who need to borrow money with people who want to lend money. It is for businesses, organisations and individuals that need to raise money but do not want to rely on banks, venture capitalists or any one, large stakeholder: this is investment-based crowdfunding. It is also for individuals willing to lend – with interest rates still in the doldrums at 0.5% it is possible to make a good return on your money: this is peer-to-peer lending (or loan-based crowdfunding).

The mechanics: money loaned is pooled through a website, which is also known as a platform.

Equity investment crowdfunding: typically used for start-up businesses, offering investors shares or a stake in the business in exchange for sufficient cash to give the business a headstart.

Peer-to-peer lending: between individuals, allows money to be loaned and borrowed with the website as the middleman holding the ‘IOU’. Returns for lenders can vary with some interest rates as high as 7%.

As the financial crisis wore on, the business of actually finding the funding for start-ups became increasingly difficult. The days of pre-recessionary ‘easy money’ – when banks, venture capitalists and private investors were much easier to part from their cash in backing the next brave new technology venture – are a distant memory. Now, investment seekers have to leave no stone unturned as we all emerge, blinking, into the post-recessionary economic cycle.

Surprisingly, it is the new crowdfunding solution that those people seeking investment (or who simply want a better rate of return on their money than 0.5%) are, increasingly, turning to. Surprising, because at first glance crowdfunding can seem a disconcertingly informal, unstructured way to raise finance, or to borrow money.

In fact there are many layers to the crowdfunding onion – peel away the top few layers which represent the ‘fund me in self-publishing my book’ type of scenario (whereupon you will receive a signed copy / dinner with the author / one-on-one creative writing tutorial, depending on whether you gave £5, £25 or £50) – and you’ll get down to the serious capital raising projects.

It is precisely this category of projects that facilitated £939 million in funding to individuals and businesses in 2013, up by 91% on 2012, according to national innovation charity and think tank, Nesta (formerly NESTA: National Endowment for Science, Technology and the Arts). Nesta predicts crowdfunding (what it calls the ‘alternative finance market’) will grow to £1.6 billion this year, 2014, providing £840 million worth of business finance for start-ups and SMEs.

Inevitably, such figures and rate of growth have attracted the attention of City watchdog, the Financial Conduct Authority (FCA). Some commentators have described this as unwelcome attention, arguing that fiscal regulation will slow the spontaneous free-flow of funds that is the defining characteristic of crowdfunding.

The fact is that very few crowdfunding platforms are covered by the Financial Services Compensation Scheme (FSCS), which pays money back to consumers if a regulated company goes bust. The first lesson is – be quite clear before you invest in a start-up via a crowdfunding platform: whether authorized or not, if it fails you will not get your money back through the good offices of the FSCS.

The second lesson is – do the research. Be certain you feel comfortable with where your money’s going – do you know enough about the particular start-up you’ve decided to go with? Remember there are no standard rules on the information that crowdfunding platforms have to provide on the companies they promote for investment; furthermore the FCA has said it will not dictate how start-up companies should disclose the risks inherent in investing in them. Do not expect regular reports either on how the company you have invested in is performing – for the detail, you will just have to do the spadework yourself.

In the same vein, for peer-to-peer lending there is no requirement for those platforms to chase borrowers who fail to make loan repayments – though some do guarantee payments should a borrower default.

So what exactly are the FCA’s new rules and regulations, and do they make crowdfunding less of a risky option?

For peer-to-peer lending the new rules stipulate the level of reserves lending platforms must have supporting their business – at least 0.2% of the monies they lend out, up to the first £50 million of loans. Operators will also be obliged to provide for investors demonstrably robust plans for collecting loan repayments should their platform fail.

FCA-authorised crowdfunding platforms will be required to have a minimum of £20,000 in capital… rising to £50,000 in 2017. However for investment crowdfunding, the FCA has decided to keep crowdfunding investment platforms out with the remit of the FSCS (if they are not already covered by it), so that new companies will not be burdened by having to contribute to the scheme. It has committed to reviewing crowdfunding again in 2016 together with its position on the FSCS.

In summary, the old warning applies: caveat emptor – ‘let the buyer beware’. Be prepared to make a loss. Two-thirds of start-ups fail within the first three years. The new rules and regulations have indeed made the risk clearer in what you are potentially getting into with crowdfunding – but they are also clear that you’re on your own if it all goes belly-up.

Please note that the information and opinions contained in this article are not intended to be comprehensive, nor to provide legal advice. No responsibility for its accuracy or correctness is assumed by Pearson Solicitors and Financial Advisers Ltd or any of its members or employees. Professional legal advice should be obtained before taking, or refraining from taking, any action as a result of this article.

This blog was posted some time ago and its contents may now be out of date. For the latest legal position relating to these issues, get in touch with the author - or make an enquiry now.

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