Nowadays, everything is about the power of the crowd - whether that's booking holiday accommodation through Airbnb or finding out the latest news on Twitter. It's tipped over into investment too, and now anyone can invest in a start-up venture through crowdfunding.
Crowdfunding - also called democratic finance - works by pooling small amounts of money from multiple investors to invest in small businesses or projects on an online platform, usually in return for equity in the company or a perk. Given cash returns are languishing, it’s hugely popular: last year more than £1,700 was raised every hour, according to the UK Crowdfunding Association.
What is crowdfunding?
Crowdfunding is exciting, can offer stellar returns and is growing rapidly but it also comes with a huge amount of risk. Innovation charity Nesta predicts the alternative finance industry will grow to £4.4 billion this year, according to its 2014 Alternative Finance report.
There are four main types of crowdfunding options. Probably the most familiar is the rewards-based scheme - epitomised by the likes of Kickstarter - where contributions are swapped for future services or products. Perks can range from loyalty cards to free products - past ventures have given away anything from free coffee or T-shirts to having your name credited on a fi lm.
Donation-based giving does exactly what it says on the tin - it's purely philanthropic, and all you'll get is a warm, fuzzy feeling of giving to a venture you believe in.
If you're looking for a return from crowdfunding, then there are two main options: equity- and debt-based schemes. Equity-based schemes involve investing in small, unlisted businesses in return for a slice of future profits - as well as a possible perk as a sweetener. Current projects on platform Seedrs range from: investing in a French vineyard, in return for around 30% of shared equity and membership of an exclusive wine club; a company making steel bike frames in return for around 14% equity; and an online property portal for 5% of stock.
An estimated £84 million was raised through equity crowdfunding last year, according to the Nesta report, with two-thirds of investors investing more than £1,000. The report also found that the average investor had a portfolio size of £5,414, spread across 2.48 ventures. Debt-based crowdfunding - also known as peer-to-peer lending - involves investors lending money to both individuals and businesses in return for a regular income. This crowdfunding sector is growing particularly quickly, with £1.2 billion lent last year, according to the Peer-to-Peer Finance Association. Around 30% of people will lend between £1,000 and £5,000 to businesses in this way, with almost 23% lending between £20,000 and £100,000, according to Nesta.
How can you invest in a crowdfunded project?
There are many online crowdfunding platforms, catering to all kinds of schemes and projects.
Kickstarter and Indiegogo are pure donation- and rewards-based platforms. Since Kickstarter's launch in 2009, more than 83,000 projects have been successfully funded using the power of the crowd, with a total of more than $1.6 billion (£1 billion) donated.
CrowdCube and Seedrs are equity-based platforms, offering investment in a start-up business in return for future equity. Schemes available on these platforms can range from frozen yoghurt companies, through craft breweries, to estate agencies. CrowdCube also offers mini-bonds as a crowdfunded investment - food chain Chilango raised money on the platform last year, paying 8% a year plus free burritos - which offer investors a fixed rate of return over a set period, plus initial capital, although the companies are unlisted and therefore much riskier.
Meanwhile, Funding Circle and Lending Works are debt-based schemes, or peer-to-peer lenders, and are typically choosier about who raises money on their platforms. Funding Circle recommends investors lend to at least 100 companies, so no more than 1% of your capital is with any one business. Lending Works is very similar and will match investors with creditworthy businesses for a fixed return.
The minimum investment varies from platform to platform but some start from as low as £5 - meaning you can effectively spread your capital around many crowdfunded projects at once.
What are the risks?
There's no getting around the fact that crowdfunding is a risky investment route. The nature of investing in an unlisted start-up business means that many are likely to fail and even if they are successful, returns can take years to realise. Jeff Lynn, chief executive of Seedrs, estimates that investors will wait on average between five and seven years to see a return from an early-stage business.
Lending to a company through a debt-based scheme is less risky, as many peer-to-peer lenders have a slush fund that kicks in if a company is unable to meet payments. Figures from the Peer-to-Peer Finance Association estimate that the lifetime bad debt rate of money lent through these platforms is 4.2%.
These debt-based platforms usually insist on strict controls to ensure only the best businesses, or individuals, are allowed to borrow. Some equity-based schemes will do this to some degree but many will leave the decision about whether or not it's a sound investment completely down to the investor. Platforms will make it clear that investing in start-up companies is incredibly high-risk, though - Seedrs says on its website that business failure is "more likely to happen than not", for example.
It's a "high-risk, high-return" asset class, according to Seedrs' Jeff Lynn. "You should only invest if you can afford to lose the money invested but at the same time, you stand the chance of significantly outperforming other types of investments," he says. "The key thing to remember is diversification: you shouldn't invest in just one or two businesses. You should look to build a portfolio over time of 20 or more investments."
One important point to note about equity crowdfunding is that as the industry is so young, it's hard to quantify default rates, losses and average returns. While projects will usually detail the equity return, it's not an exact science, and Nesta notes in its report that "most equity crowdfunding investors are yet to see what returns their investments can bring".
There's also a limited secondary market for these businesses, and even if a business is successful, it can be more difficult to sell the shares on if the company is unlisted. And while debt- and equity-based crowdfunding platforms are regulated by the Financial Conduct Authority, neither are covered by the Financial Services Compensation Scheme, which would usually pay out if a company goes bust.
"For first-time investors, the prospect of earning returns greater than 5% looks great but putting money in start-up firms brings its own risk," says Emanuela Vartolomei, chief executive of crowdfunding research firm All Street. "Don't invest more than you can afford to lose in early-stage companies, diversify your investments and get as much information as possible before making a crowdfunding investment decision."
What the the benefits?
Alongside blockbuster returns if the company is successful, the promise of a free perk from the business you're investing in is a huge benefit, especially if it's something you use often. Equity-based platforms don't tend to offer regular perks - although when available they can be anything from discounts on wine and beer to nursery equipment - while rewards-based platforms such as Kickstarter offer perks instead of a financial return, and they can range from having an ice-cream flavour named in your honour to having a song written for you to use. While they are clever incentives, treat it as a sweetener rather than a reason to invest.
Plus, there are tax benefits. Equity-based crowdfunding is eligible to be included in a Seed Enterprise Investment Scheme or an Enterprise Investment Scheme, where investors can claim back 50% of their investment back in income tax relief. A general rule of thumb is to never invest more than around 10% of your portfolio in crowdfunded ventures and stretch that across as many places as possible.
Patrick Connolly, a certified financial planner at Chase de Vere, agrees: "For those who want to utilise crowdfunding, for most people this should be only for a small part of their overall portfolio. Any investment that promises higher returns usually comes with greater risk and so it would be a mistake to directly compare crowdfunding with bank and building society accounts."
While it might be tempting to plough your life savings into a crowdfunding venture that gives free beer/tea/ice cream for life, it's wise to consider the risks, and heed the old adage: never put all your eggs in one basket.
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser