The City watchdog has warned of their complexity and risks, but crowdfunding schemes allowing investors to help finance start-ups are enjoying a surge in popularity.
The concept is relatively new in the UK, but fledgling firms trying to raise funds amid the ongoing lending squeeze are turning to private investors to help them get their venture off the ground.
In return, investors get the chance to both be part of a funding community and potentially reap decent profits.
So how does it work? In a nutshell, crowdfunding websites are used by new and would-be businesses to set out to potential investors what they want to do and how they’re going to do it, in a bid to attract “seed” or start-up funding.
Investors choose their level of involvement and often get shares in the business they’ve helped fund. There’s also the prospect of returns outstripping those currently on offer from mainstream assets – as well as the possibility of losing the lot.
Equity-based crowdfunding aims to meet the needs of both start-ups and investors, said Iain Wishart, of Edinburgh-based Wishart Wealth Management.
“Many of the firms seeking finance this way will have been turned down for finance via the traditional routes such as banks,” he said. “For the investor there is a thrill of being in on something from the start – join an investment community – and to know they made something happen.”
The first big crowdfunding site, Kickstarter, was launched in the US in 2008, while the best-known in the UK are Crowdcube, Scotland’s Bloom VC (reward rather than equity-based; see box for more) and Seedrs.
Crowdcube, the UK’s biggest crowdfunding site, has attracted investments of between £10 and £100,000, helping raise some £4 million for small businesses (around one in ten of which hit their funding targets).
A more recent launch, Seedrs has funded four start-ups since opening for business earlier this year and aims to help some 400 businesses raise cash from private investors each year. For their part, investors can put between £10 and £150,000 into a business, which has a fund-raising target to meet.
If they fail to meet the target, the money is returned to the investors. If they do meet it, the investors get shares in it but, having not had to pay anything upfront, face a 7.5 per cent charge on any profits. If the target is met but the venture later fails, the investment is lost altogether. As with any high risk investment, the returns can be impressive, while there are also tax advantages (which we’ll come to later).
The success of peer-to-peer lending websites such as Zopa – which allow borrowers and savers to skip the middleman (the banks) and lend to each other – suggests there’s an appetite for such alternative investments.
As the crowdfunding market grows, however, the regulatory scrutiny increases. And the Financial Services Authority (FSA) has expressed concerns that in the current low growth environment, the prospect of good returns could blind some investors to the risk they face.
Crowdfunding should be targeted only at “sophisticated investors who know how to value a start-up business, understand the risks involved” and realise they could lose all of their money, said the Financial Services Authority.
The City watchdog also warned that any shares held in a start-up may be difficult to sell.
It’s intervention was timely and Seedrs – which has the regulator’s full approval –agreed that investing in start-ups should be considered a high-risk investment alternative.
It claims to have put steps in place to protect individuals from bad investment decisions.
Martin Campbell, spokesman for Seedrs, said it seeks to make the risk and potential rewards “very clear” to investors.
“You could not invest in Seedrs without understanding the various risks involved and the timescales you should have in mind,” he said. “Indeed, you have to pass a short online test to prove you understand the risks and nature of investing in start-ups before you can even see the actual start-ups listed on Seedrs available for investment.”
Those risks are very real. The most obvious is that the chances of a start-up actually succeeding are slim..
But Campbell argued that for those comfortable with the risk, the low £10-per-start-up entry level means investors can look at crowdfunding as additional to a diversified portfolio.
“A minority succeed and take off and the net effect – if you are properly diversified – is a total overall return that will beat almost any other asset type,” said Campbell, who pointed out that the low maximum investment gives ordinary investors a chance to circumvent the often onerous costs of investing in start-ups.
There are tax benefits too. Most investments on Seedrs, for example, are eligible for the Seed Enterprise Investment Scheme (SEIS), which offers income tax relief at 50 per cent in a government ruse to encourage more investment in early stage firms. But the tax tail should not be allowed to wag the investment dog. The investment appeal of crowdfunding lies largely in the participation aspect, with investors taking an interest in specific start-ups and in a position to reap the rewards of any successes.
If you do think you can stomach the risk of losses and you fancy backing a new venture, remember that you’re not protected by the industry safety net if it all goes wrong, as the schemes are not covered by the Financial Services Compensation Scheme.
As the FSA has said, crowdfunding should be the preserve only of sophisticated investors who understand what they’re getting into and can easily absorb any losses.
“This is a high-risk micro investing market with often no after-market (buyer) for your investment liquidity, while new start firms are inherently risky with no track record to look back on,” said Wishart.
“You might hit lucky, though, and do well – or you might lose everything. Hence, only commit money to something you really believe in and only if you can afford to lose it all,” he added,
A HELPING HAND…
Bloom is a reward-based crowdfunding platform, which means that project owners offer perks or treats to backers in return for their donations. The project owners retain 100 per cent ownership of their company, and the backers aren’t entitled to any dividends or share of profits
Our backers get involved for a number of reasons: they had a helping hand when they were just starting out and like to do the same for someone else; they love the idea/business and want to support it; they love the rewards and want to have what’s on offer; they’re buying (project owner pre-selling) something that they’ll be the first to have or to be the only person to have (unique rewards); and some simply do it for the feel-good factor.
We have a good number of backers who don’t actually choose a reward when donating to a project, they just give the money.
Our average donation is £40, which is high considering the average donation on (US funding platform) Kickstarter is $25, and our average project size is between £2,000 and £5,000, although we have had more and less succeed on the platform also.
One of our project owners – Bonnie Bling – has actually secured private investment on the back of her crowdfunding campaign, which closed successfully in June. You can read about her success here: www.bloomvc.com/blog-post/bonnie-bling-crowdfunding-success-story
And crowdfunding isn’t all about the money – even unsuccessful projects can benefit from the process. A crowdfunding campaign helps you test the market, demonstrate market appetite, fill an order book (by pre-selling your product/service as a reward), build brand and profile, build an online community, build a customer database of incredibly loyal ambassadors (people who like your business so much they’re prepared to pay you to start it) and gain media coverage.
In all, these particular elements can help a business become more “investor-ready” in preparation for a further round of funding from more traditional sources such as banks, angel syndicates and venture capitalists.
• Michelle Rodger is chief communication officer at Bloom VC