Watchdog warns investors over risk of crowdfunding

Crowdfunding is gaining popularity as investors seek alternatives to volatile markets and low interest rates, and fledgling businesses hit by banks’ refusal to take on risky loans solicit other investors.

Many websites now offer members of the public small stakes in companies for investments of as little as £10. But some may not be properly safeguarding investors’ money, the Financial Services Authority (FSA) said.

“Many crowdfunding opportunities are high risk and complex,” the FSA said on its website. “We believe most crowdfunding should be targeted at sophisticated investors who know how to value a start-up business, understand the risks involved and that investors could lose all of their money.”

Many banks have reined in their lending to comply with new rules compelling them to hold more capital and invest safely in the wake of the financial crisis. With small firms consequently struggling to find financing, a string of alternative funding models have cropped up.

But start-ups can take a long time to generate a return and investors can’t easily sell on their shares, meaning that their funds could be locked up for a long time, the FSA warned. A high proportion of new businesses fail, meaning there is also a risk people lose their money completely, it said.

While alternative sources of funding also involve risk – such as ‘peer-to-peer’ lending, where members of the public can loan money to a firm – the parameters here are more clear cut, with the funds lent for a fixed time period and investors having the option to access their money at any point by selling early. Others, such as invoice financing which allows investors to boost a company’s cash flow by buying its invoices for a fee, are often only accessible to sophisticated investors.

The FSA said some crowdfunding firms may be handling both clients’ and investors’ money without authorisation and thus not properly protecting the latter. The implications of this were demonstrated by the collapse of MF Global last year which revealed the broker had improperly mixed client funds with its own money, leaving a customer fund shortfall of $1.6bn.

Fraud is also a potential problem, the FSA warned. Only one crowdfunding website, newly launched Seedrs, is currently authorised and regulated by the FSA.

None of the other sites are covered by the Financial Services Compensation Scheme, which covers deposits up to £85,000 if a regulated financial institution collapses, or by the Financial Ombudsman Service, which helps settle disputes.