Advent of crowdfundingOne of the main innovations in both finance and technology over the past few years has been the advent of crowdfunding. Crowdfunding is a way of raising finance by asking a large number of investors each for a small amount of money.
In the past, financing a business, project or venture typically involved asking a few investors for large sums of money. Crowdfunding switches this idea around.
If it appeals to you, you’re debt-free, willing to increase your risk tolerance and put money away for a longer term, then the best way is to start by dipping your toe in the water.
Main ways of crowdfunding
There are three different types of crowdfunding: equity, debt and donation.
•Equity crowdfunding involves a company raising finance by selling a pre-determined amount of equity in a business to investors for a certain sum of money.
•Debt crowdfunding is when a company raises money by way of loan to investors who do not receive any equity in the business but do receive a pre-agreed rate of return on the money invested.
•Charitable crowdfunding involves no equity or debt investment; charities raise money for projects from large groups of investors to support their causes.
Funding gapThese investments do not include the same security of capital, which is afforded with a bank account. Since the financial crisis, it has become difficult for smaller businesses to raise the money required to expand and grow. As high street banks have withdrawn from corporate lending, a ‘funding gap’ has emerged that has in part been filled by the meteoric rise of crowdfunding. Additionally, with interest rates at rock bottom for the past six years, investors have been seeking unique returns and are more prepared than ever before to invest money into new types of investments in the hope of achieving a return higher than that offered by their bank account.
High riskHowever, crowdfunding is still a very high-risk venture. As with all forms of investment, it comes with no guarantee of success or even return of capital. Among the main reasons to exercise caution is the price the investor pays for the equity. When a large business seeks to raise money, the numbers used to calculate the value of the business will have been audited and verified by an independent valuer.
High growthAnother key risk that investors need to consider is one of dilution. Many of the companies raising money on the equity crowdfunding platforms are high-growth businesses expected to go up in value significantly over a very short period of time. To fund this expansion, it’s inevitable that they’ll need to continually raise further funds to maintain their level of growth.
Capital lossCrowdfunding is undoubtedly a welcome addition to the options available for companies looking to raise money. The effect that this has on the level of enterprise in the UK is a very positive development. For investors, however, it’s clear that great levels of caution should be taken when making any form of crowdfunding investment. A reliance on the tax benefits will not be enough to offset the real risk of capital loss.
The Financial Conduct Authority does not regulate some aspects of crowdfunding. Information is based on our current understanding of taxation legislation and regulations. Any levels and bases of, and reliefs from, taxation are subject to change. The value of investments and Income from them may go down. You may not get back the original amount invested. Past performance is not a reliable indicator of future performance.