Crowdfunding has been hailed by creatives as an exciting new way to raise capital for self-generated projects, allowing entrepreneurs to crowdsource investment from friends, family and third-party investors. But some industry professionals are warning that crowdfunding is a legal disaster waiting to happen.

During the dot-com bubble of the late-90s, hard-nosed investors piled in money thinking that if one in a hundred companies struck gold, they would have been succesful. Less street wise people were encouraged to invest in companies which often lacked basic financial and even legal underpinnings, and many lost their shirt.

With crowdfunding, once again, the risk of companies failing is fairly high, and the legal standing of investors is not wholly clear. The issues have been thrashed out to some degree in the US, but crowdfunding in the UK is still relatively nascent.

Earlier this month, Kickstarter – one of America's leading crowdfunding services – announced plans to launch in the UK on 31 October. Kickstarter allows entrepreneurs to set up a web page with a deadline and a goal minimum of funds to raise, and anyone can pledge to invest in the company.

Entrepreneurs will often offer something in return for the pledge, such as a credits right on a creative project or early access to a product.

Since launching in 2009, Kickstarter has had more than $230 million pledged, and more than 23,000 successfully funded projects. Back in August, for example, an Android-based game console called Ouya brought in nearly $8.6 million (£5.8m) from more than 63,000 backers.

The price of failure

However, Kickstarter represents a small funding pool, and the majority of projects on the US version have failed to meet their funding requirements. According to Jason Stockwood, CEO of Simply Business, this is largely due to a “funding Catch 22”:

“The projects that do best tend to be those with high levels of public awareness - and for small, new businesses this can be hard to generate without some capital,” he said.

Meanwhile, those that do achieve exposure do not necessarily fulfil their potential. Last week it was reported that a video game called "Haunts: The Manse Macabre", which raised $28,739 on Kickstarter to fund completion of the game, has been forced to stop development after all its programmers quit.

Rick Dakan, head of Haunts creator Mob Rules Games, has promised to refund any backer who wants their money back out of his own pocket. However, Bryan Sullivan and Stephen Ma, attorneys with Early Sullivan Wright Gizer & McRae, warn that in most cases this will not be possible.

“Such business failures will inevitably result in litigation as people attempt to recoup whatever money they can from a failing crowdfunding entity,” Sullivan and Ma wrote in an article for Forbes magazine.

“When they accept the inability to recover from the judgment-proof (due to lack of personal funds) individuals behind the crowdfunding entity, crowdfunding losers may target the US government and the JOBS Act for remuneration.”

The US government's JOBS (Jumpstart Our Business Start-ups) Act was passed earlier this year, to encourage funding of small businesses by easing various securities regulations. One of the provisions of the act is that start-ups do not have to disclose financial statements until they have raised over $1 million.

William Galvin, Secretary of the Commonwealth for Massachusetts, warned in a letter to the US Securities and Exchange Commission that this exemption could become a tool for financial fraud and abuse, claiming that “unscrupulous penny stock promoters have used misrepresentations to market obscure and low-value stocks to individuals”.

There is currently no equivalent to the JOBS Act in the UK, but Downing Street is working with the LSE on a new set of IPO regulations, designed to encourage internet and technology companies to float in the UK.

These regulations emulate the JOBS Act in several ways. For example, it has been proposed that high-growth companies should have to present accounts for fewer past years than they do now, and there will be less stringent criteria for the composition of their boards.

None of these measures are yet set in stone, but Vanessa Barnett, technology and media partner at City law firm Charles Russell, predicts that there will be a steep learning curve in the UK as people get used to the crowdfunding model.

“It's not the same as normal 'investing' because you're making a pledge of support. But it's not like a charity either, because you could derive a benefit from it,” she said. “The legal position of this model in the UK isn't yet clear, particularly the tax treatment of the pledge or the benefit.”

Crowdfunding is for the risk-aware

Most crowdfunding is now regulated by the Financial Services Authority (FSA), but there are rumbling arguments about the legal frameworks for this new form of finance. The FSA itself advises that 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.

“We want it to be clear that investors in a crowdfund have little or no protection if the business or project fails, and that they will probably lose all their investment if it does,” the FSA states on its website.

It would be a shame to dismiss crowdfunding out of hand. The UK does not have as mature a start-up market as the US, and funding can be hard to come by. Websites like Kickstarter enable firms to connect directly with their potential customers, helping to remove the financal middleman.

However, small businesses and investors alike needs to be aware of the risks, and should ensure that they fully understand their legal position before they seek finance.