There is an increasing level of comment in magazines and blogs about crowdfunding, and the increasing number of websites offering to connect entrepreneurs with potential funders.

As its name implies crowdfunding aims to secure funding by persuading many investors (the crowd) to put up small amounts of cash. Entrepreneurs can set up a profile on a crowdfunding site that explains how much money they’re seeking and what it will be used for. Investors pledge amounts over the web, often paying using PayPal. Funds are usually only released by the web site to the company once the full amount asked for has been received. If the full amount is not secured, the funds are returned to the would-be investors. The sites make their money by taking a percentage of the investment.

The idea evolved in the USA, with sites such as ProFounder.com, Peerbackers.com, Kickstarter.com and IndieGoGo.com offering ‘perks’ to individuals willing to fund a creative project. In return for ‘donating’ money to the projects, individuals would receive tickets to the event being promoted, advance copies of a book being written, or one of the products being produced. Relatively small sums of money were involved, ranging from as little as $1 to a thousand or two.

While most projects look for modest sums, some have generated huge interest and have been well oversubscribed. Joshua Harker was seeking £500 to develop his skull sculptures. To date he has secured £52,611. Tom Gerhardt and Dan Provost wanted $10,000 to produce their tripod mount and stand for an IPhone. They secured $140,000, while Scott Wilson secured $80,000 in one day, and just under a million in 30 days, to launch what is now a global branded product, TikToK. Originally Scott asked for just $15,000. All that funding, and no equity dilution, just people paying in advance for products yet to be created.

Increasingly, crowdfunding sites are offering the opportunity not just to donate to a project in return for early access to a product, but to make real investments through the purchase of real equity in a business.

As UK based Crowdcube puts it “We want to give ordinary people the opportunity to become an armchair Dragon and build their own investment portfolio supporting exciting new British businesses”, and “By attracting lots of investors who invest smaller amounts of money into a person, company, product or idea you can bypass the traditional ways of raising venture finance.”

Crowdcube appears to offer EIS tax relief on at least some of the investments it lists, provided the regulatory minimum £500 is invested.

This has led to some speculation about the legality of offering ‘real’ equity investments on a crowdfunding basis, particularly in the UK and the USA where on the face of it there are significant problems under Financial Services regulations. The Crowdcube website gives some insight into how they have found a way to work around the regulations (http://forum.crowdcube.com/viewtopic.php?f=8&t=186).

In the USA the Entrepreneur Access to Capital Act which has just been passed in the House would make it legal for small businesses to raise capital through crowd funding. The legislation allows businesses to use crowd funding to sell unregistered securities as long as the total amount raised is $2 million or less. The bill also limits individual investments to $10,000 or 10% of the investor’s annual income. Intermediaries will need to register with the SEC and undertake background checks on those raising money as well as certifying potential investors and educating them as to the risks. The Federal bill, if it passes the Senate, will pre-empt state regulation.

Perhaps however the present and understandable focus on the legality of the process is diverting attention from more fundamental issues about the impact crowdfunding may have on the future prospects of high growth potential companies. After all, for many businesses attracted to crowdfunding platforms it’s really just an efficient extension of the traditional method used by the vast majority of start ups to obtain cash from friends and family.

The real issue may however be what happens next? If it is found that the company really is of high growth potential, and needs to go for further significant funding rounds, will the existence of initial crowdfunding within it cut it off from angel or VC funding?

A company that recently secured equity funding through Crowdcube stated that “we raised £75k from 82 investors”, while another company has stated elsewhere that it intends to secure £225k over the next two years, from a minimum of 90 investors. How are angel and VC investors likely to react when they are faced with such a large pool of shareholders, all of whom, as owners, will presumably expect to be consulted over any new investment? How do you get hundreds of people, possibly from many different countries, to sign up to an investment agreement, agree to short notice periods for meetings or secure a quorum for a meeting?

Small companies can have fairly large numbers of individual investors. Most companies securing angel funding in Scotland end up with a syndicate of angel groups supporting them, with each group potentially having a dozen or more investors. However these groups have internal mechanisms for managing their members, and all commit to a well understood investment agreement containing all the usual investor controls, minority protections and management warranties. It is of course the possibility of perhaps being able to avoid the negotiation of such terms, as well as the justification of the valuation and being subjected to a process of due diligence, that appears to make crowdfunding so attractive to would be entrepreneurs. Unfortunately the lack of such documents appears likely to be most off-putting to investors at future rounds of funding.

There are some great things happening with the help of crowdfunding around the world, and many more entrepreneurs will hopefully be able to see their dreams and ambitions fulfilled as a result. It is not however an alternative to angel or VC funding for high growth potential companies, but rather a new channel for those for whom such funding sources are not, and never have been, appropriate. Those very few companies who have the potential to become companies of scale, and are likely to need access to larger amounts of funding, need to consider very carefully whether they really should take what may appear at first sight to be the easier path, but which may well lead them to the dead-end of an uninvestable proposition.