Never has Aristotle’s assertion that nature abhors a vacuum been truer than in today’s business funding market.  With bank lending to small businesses in freefall since the economic downturn, many companies – faced with cashflow issues and limited backing to fund growth – have turned to crowd-funding to fill the void.

British investors provided an impressive £480m in loans and bought £28m in unlisted securities in 2013, 150% more than in 2012.

But entrepreneurs beware. Crowdfunding, or peer-to-peer lending using the internet and social media, may have captured the public’s imagination, but it is not the fundraising panacea it may at first appear.

We explain the top 10 potential pitfalls…

There are four categories of crowdfunding: donation, reward, debt and equity. The first two offer a token reward (such as a free sample or discounts); debt crowdfunding offers interest on the amount lent; and equity crowd-funding allows the investor to formally become a shareholder in the business.

  1. As it is still in its relative infancy, tax and accounting rules and regulations around crowdfunding can be a distinctly grey area, creating a confusing landscape for entrepreneurs to navigate. There are several overlapping layers of legislation, including European law, companies legislation and financial services rules, that you will need to comply with.
  2. Using a wide pool of investors may mean that you have to sacrifice an ownership stake in exchange for funding and that your multiple owners may demand a say in how you run your company.
  3. With some crowd funding sites like Kickstarter, you have to hit your total target investment to access any money. Failure to do so could reflect poorly on your brand and be damaging further down the line in terms of raising capital or getting investment from banks or Venture Capitalists.
  4. Conversely, a crowdfunded investment round could raise the valuation of your company, making it subsequently less attractive for larger investors.
  5. If you an inexperienced entrepreneur, you could quickly spend your way through a funding round without achieving demonstrable results. If your business subsequently fails, you will have a lot of people to answer to in the glare of the very public eye. Brand advocates once so supportive of your inspired new product idea can easily become turncoats if they perceive that you have failed to deliver on your promises to them.  Social media can fan the flames very quickly creating an online PR disaster which again can have negative implications for future funding options.
  6. Beware the costs at payback time. In the heady rush to achieve your capital goal, it is easy to over-promise to prospective crowdfunders and overlook hidden margin-killing costs such as the postage and packaging involved in getting products to them.
  7. The pool that crowdfunding companies can fish in has just potentially shrunk dramatically. The Financial Conduct Authority recently (March 2014) published rules that aim to protect more vulnerable ordinary investors by limiting their investment through crowd funding to no more than 10% of their savings. From 1 April, companies will only be able to offer unlimited shares to savers who are in the care of professional financial advisers or who are linked to corporate finance, venture capital firms or certified as high net worth.
  8. Putting a very public spotlight on all the details of your business plan can leave you vulnerable to better funded competitors mirroring your ideas first if you haven’t protected it with a patent or copyright.
  9. Crowdfunding can force a fledgling company’s hand too early. Instead of taking the necessary time to iron out bugs and fine tune a concept, a start-up that owes possibly thousands of people a return on their investment can feel pressurised to start shipping a product too early rather than building up the business first.
  10. Crowdfunding takes time and effort to both promote your project initially and then to keep up interest and report back on progress to interested parties.

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This article provides general information to be used for your reference only and is not intended as a substitute for financial advice specifically directed at your business and taking account of the particularities of your situation.