Due Diligence. An informal way of raising funds

If you are active online, chances are good that you were solicited for funding a cause or venture. Crowd-funding, the new buzz on the block, is where funds are collected from a large number of people to meet a goal.

This is catching up thanks to the low expenses involved in fundraising by reaching out to a lot of people online. On the other end, it’s appealing for investors too, as they get to participate in a project with even a nominal contribution.

Here is what you should know about crowd-funding before financing other people’s dreams.

There are two broad groups under which crowd-funding falls. The first is non-profit and the second, return-motive. The latter is regulated. You can think of giving money for non-profit ventures through crowd-funding as donating to charity. The payoff is only social and, possibly, tax exemptions.

One recent example of such an initiative, besides the globally famous ice-bucket challenge, is the one to fund boxing champion Mary Kom in setting up a boxing academy.

In some cases, such as funding a local artist or a drama group, you may receive tickets or discounts in return. These are typically not regulated by any agency. You may also pay advance to a start-up for goods to be delivered. One example is the funding received from 200 customers by lingerie start-up Buttercups.

It is when you participate in a funding with the objective of returns that regulations kick in. SEBI is working on new regulations to cover all crowd-funding platforms. For-profit schemes fall under two groups – equity and debt.

In equity-based schemes, the money you put in gives you a stake in the company. In debt-based schemes, your funds are typically lent out to borrowers and you earn returns in the form of interest. Currently, they fall under the Companies Act, Depository Act and the Alternative Investments Fund Regulations. The new proposal mandates that crowd-funding platforms can be provided by SEBI-registered entities only. So, be sure to check if the crowd-funding initiative falls under the regulated category.

Apart from running a check on the funding platforms, pay attention to the project as well. Not all for-profit projects can be crowd-funded.

For example, if you are asked for money to fund a hot realty firm, give it a pass. SEBI has barred real estate and financial sector businesses from tapping this route. Entities associated with business groups having a turnover of over ₹25 crore or those in existence for four years or more, cannot raise money through crowd-funding. There is also a cap of ₹10 crore that can be raised by an entity in a 12-month period using crowd-funding.

Even if the firm meets the eligibility criteria, you have to be an ‘accredited investor’ to participate. As an individual, you have to be an HNI (net worth of at least ₹2 crore) or a financially-secure retail investor – one with an annual gross income of ₹10 lakh – to qualify. The maximum investment of retail investors is also capped at ₹60,000 or 10 per cent of net worth, whichever is lower.

Crowd-funding can be quite risky as you may have only ‘virtual’ contact with the group asking for funds. Even when you are only donating and not expecting any returns, being cheated is surely not what you want.

“The one key element to check is the cause itself as well as the integrity of those running the drive,” says Ashish Morone, Head of Marketing, Edelweiss Tokio Life Insurance, which has initiated a funding drive to build infrastructure for Mary Kom’s boxing academy in Manipur. An important check you can easily make is whether the receiver has certification to offer a tax deduction for donations under Section 80G.

Crowd-funding, especially for-profit, carries the additional risk of financial loss. Unlike an initial public offering, you are likely to get only limited disclosures from the entity. Hence, there is also a risk that you are inadvertently funding a shady venture.

It is therefore important to tread with caution and take legal help, especially with regard to your liability. You must also ask the company to commit to periodic updates on financials and progress.

If the money is raised by a third-party platform, be sure to look into the credentials of the platform provider, charges and protection of personal information. Look for disclosures provided by the platform, such as how they ensure the authenticity of the projects they promote, listing of fees and commissions.