What is crowdfunding and should I invest in it?
Updated 03 December 2020
5min read
Monzo. BrewDog. PopSockets. Today, all are well-known brand names. What they all have in common is that they were once tiny enterprises that grew with financial support from crowdfunding. So is it worth investing your own money in a crowdfunding venture – and what are the potential rewards for you?
What is crowdfunding?
Crowdfunding is a way for businesses, charities and individuals to raise capital without the need for bank loans or traditional sources of private equity. Instead, businesses invite a large number of people to put up relatively small amounts – perhaps in return for some equity, or special perks… or just a warm fuzzy feeling.
Spend more than a few minutes on social media and the chances are that you’ll see at least one link to a crowdfunding project. This link usually takes you to overview of a new product or business idea, along with a funding target and a bar indicator of money raised so far. Crowdfunding is that simple: a shout-out to the world that someone needs money for a venture. Though usually associated with start-ups (where donors might receive something in return, such as a share of profits) it may also be a way simply to raise money for a good cause such as a person in need, without any offer of reward.
We’ll focus on the use of crowdfunding as a source of business capital, as this is where you the investor might see some returns or benefits from your money.
How does crowdfunding work?
There are three different types of crowdfunding for business, where you could see some benefit from investing your money.
- Equity or investment-based crowdfunding
Here you invest money in a business in return for equity, i.e. a share in the business. Investors typically receive equity in proportion to the size of their investment. Exactly how this works will be up to the business owner – you’ll need to check that the potential return justifies the risk you’re taking with your money.
- Rewards-based crowdfunding
Instead of equity, you as investor may receive a reward(s) linked to the project you support. For example, if the business is looking to produce healthier pet food, they might be offering free supplies of the food to those who backed them initially. Symbolic rewards often prove popular too, such as products named after funders – vanity alone is reason enough for some people to invest!
- Loan-based crowdfunding
Also known as peer-to-peer (P2P) funding, you can lend money to businesses indirectly via P2P platforms. Your interest rates are usually more generous than you’d receive from a bank, and it’s generally less risky than loaning the money directly. Find out more about investing via P2P lending.
To safeguard investors, crowdfunding platforms usually hold onto the money (in a separate dedicated bank account) until the funding target is reached. This means that investors should get their money back if the venture has to be called off due to insufficient funds. It’s by no means a foolproof safeguard, however, as the crowdfunding platform can’t guarantee that the money will be used for the purposes stated. Bear this in mind before parting with your cash.
What are the advantages of crowdfunding for an investor?
Depending on the type of crowdfunding, you could potentially earn returns on your investment via equity (growth in share value) or interest (if using P2P lending), or you might simply receive other perks or benefits. At best, you could generate higher returns than you might via other financial platforms; at worst, you might not see any of your money ever again.
However, maybe earning a return is less of a priority for you than the simple thrill of backing a promising project. For example, fans of a book might flock to a project aiming to bring that book to the big screen, and offer their money with little hope of any financial return simply because they really want to see this film. Then, if the film does get made, there is still the prospect (however small) that they might make some money from it anyway.
Tax benefits of equity crowdfunding
Investing in equity crowdfunding can also bring tax benefits. Through the Enterprise Investment Scheme and the Seed Enterprise Investment Scheme, you can claim tax relief on a percentage of your investment amount, thus reducing your tax bill. However, you do need to meet certain criteria, such as keeping your investment for a set amount of time.
What are the disadvantages of crowdfunding?
As with any investment, there is a financial risk involved. For crowdfunding, the biggest risk is losing your money should the business or venture fail. Crowdfunding comes at the top end of the risk spectrum, where both gains and losses can be highest.
Crowdfunding projects typically involve new, unproven businesses, so in many ways they are a gamble and a leap into the unknown. For this reason, crowdfunding thrives more on people’s optimism, goodwill and passions than it does on investment strategy. People who invest in crowdfunding generally choose their projects more because they agree with the ethos and the goal, than because they expect to make money. That said, there is still money to be made if you think like Warren Buffet.
Remember that your money will not be protected by the Financial Services Compensation Scheme, so if the business or project does flop, you’ll lose your money and not get any compensation. In addition to losing money, other risks include:
- Trouble selling shares
With small businesses, the shares are normally unlisted, which means they’re not as easy to sell as shares in larger businesses on the stock market.
- The crowdfunding platform could go bust
This has happened to some P2P lending platforms in the UK, like Lendy. If the crowdfunding platform you put money into goes bust before the business receives it, you could lose your investment. However, most crowdfunding sites – excluding donation and rewards-based sites – are regulated by the Financial Conduct Authority (FCA). This means they’re obligated to keep your money in a ring-fenced bank account outside their own, offering you some protection against this.
How can I invest in crowdfunding?
There are over 250 live crowdfunding platforms in the UK, including Crowdcube, Seedrs and SyndicateRoom – three that have long facilitated lots of deals in the UK. There’s also Indiegogo, Funding Circle and Kickstarter. Each platform offers something different: Seedrs focuses on start-ups, while Kickstarter is popular for music and arts projects.
If investing in crowdfunding appeals to you, here are the steps to follow:
- Decide which type of crowdfunding you want to invest in: equity-based, loan-based or rewards-based (or donation-based for charities and good causes).
- Decide what you want to invest in: a business or product. Use the search function on crowdfunding platforms to find promising projects.
- Read the project overview in detail. Then do your own extra homework to see if the venture has merit. Make sure you understand all the project timelines, returns and risks.
- Chat to your independent financial adviser (IFA) and decide if investing in crowdfunding aligns with your risk appetite and investment goals. Strive to have it be part of a balanced investment portfolio, to help manage risk.
- If the idea still appeals, put money into the project, track its progress and keep your fingers crossed.
What successful businesses have been crowdfunded?
As mentioned, Monzo is one of the greatest crowdfunding success stories in the UK. In 2016, Mondo (as it was then known) raised £1 million in just one minute and 36 seconds for its digital bank concept, according to Crowdcube. Two years later, in 2018, this grew to £20 million raised in two days, from 36,000 investors. That year, its shares rose 25 times in value, and in 2019 investors were eyeing a three-year return of 6,300%.
Another Crowdcube success story is Camden Town Brewery, which raised £2.75 million from 2,173 investors in 2015. Just a few months later, it was acquired by Anheuser-Busch InBev for a rumoured £85 million.
Looking at UK crowdfunding trends in 2019, fintech businesses like Monzo stole the show, followed by artificial intelligence companies.
Should I invest in a crowdfunding business?
Anything can be crowdfunded, from movies to hotels and 3D printers. Like alternative investments, it is risky business, which involves a lot of homework, market insight and intuition on your part. You’ll need to find the projects, research them and track their development yourself. But if you’re willing to take the risk and put in the hard work, it can be a rewarding route. You’ll have the satisfaction of supporting something you believe in – and hopefully watching it grow. If you ever fancied being one of the Dragons on Dragons’ Den, crowdfunding might be an easier place to start.
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