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Crowdfunding - should you be getting involved?

View profile for Danielle Isaac
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Crowdfunding is the buzz word when it comes to raising funds – whether that be for an exciting new product, a kidney transplant or a new film. So, is this something we should all be getting involved in?

Historically, financing a new enterprise meant pitching an idea either to the bank manager or going out on the road to seek funds from individuals or venture capital funding. The sale of shares to the general public is heavily regulated and very expensive. However, you can avoid those regulations if you restrict your share offer to high net worth individuals or sophisticated investors, often referred to as angel investors. The internet has opened up the opportunity for people to connect with angel investors or raise funds for things other than shares. As a result individuals and businesses can reach many more potential investors and it is now possible to ‘talk’ to dozens, hundreds, even millions of these backers. Equally, investors are able to take part in exciting new projects from the start.

There are different types of crowdfunding available depending on what form suits the project or the person asking for funds best. Examples of the most popular types are:

Equity based: where a business owner seeks investment and in return is willing to give up a percentage in the ownership of the business.

Loan based: also known as peer to peer funding. This is where investors pledge money with the expectation of not only getting their money back but also making a monetary return on their investment, usually by way of charging interest on the sums loaned.

Rewards based: rewards may be offered to investors who back projects with this type of funding structure. The rewards can simply be a pre-order of the product to fund the manufacturing, but are not always proportionate with the monies invested and examples of rewards may include acknowledgements in the credits of a film/on an album cover, tickets to events etc.

Donation based: this type of funding is popular with those raising money for charitable causes, popular platforms are www.gofundme.com and www.justgiving.com

Crowdfunding is not a new concept, the publication of books using this type of financial support has a history spanning centuries. However, online crowdfunding is a comparatively new form of raising money. It is relatively straightforward to set up a profile on a crowdfunding platform and for investors to peruse these profiles in search of ventures that pique their interest. Typically, crowdfunding platforms take a commission of approximately 5% of the money raised, however, the commission is usually higher for equity based and loan based crowdfunding where the regulations are stricter. So successful enterprises may be just a click away!

In light of the increasing popularity of crowdfunding the Financial Conduct Authority (“FCA”), which oversees and regulates equity based crowdfunding and loan based crowdfunding (it does not regulate rewards or donation based crowdfunding), set out specific rules and guidance in 2014 in relation to this type of financing. The people running the crowdfunding platforms must be approved by the FCA, which means that they have to have certain capital resources and take responsibility to ensure that the information provided to potential investors is fair, clear and not misleading. Promotion of investments is usually restricted to high net worth and sophisticated investors, however, online crowdfunding opens the investment playground up to an additional audience and platforms are able to promote to ordinary investors who confirm that they will not invest more than 10% of their net assets in crowdfunding or similarly risky investments per year.  

Whilst these rules won’t necessarily stop a venture or business from failing, they should prevent a rogue trader from running a platform and ensure that investors are warned of the risks such as

  • Repayment:  The main risk is non-repayment of capital and/or interest, this may be due to borrower default, fraud or failure of the platform. Additionally, lenders are usually required to loan the sums for the full term under the arrangement, meaning they cannot ordinarily seek early repayment. It may be possible to assign the loan, however this may mean selling the investment at a reduced sum.
  • Capital: There is a risk that, on exit, the value of the company will be less than what the investor initially paid in. In fact, research indicates that around 50% to 70% of business start-ups fail completely. So those investing in these types of companies should understand that it is likely that they will lose 100% of sums invested. There is also a risk that they may never receive a return on their investment of the directors running the company decide not to pay dividends.
  • Default: investors should carry out due diligence to reassure themselves as to the security of their money. In loan based crowdfunding there is a risk that the business/individual may not be able to make the repayments on their debt.
  • Liquidity: There is a possibility that investors may not be able to exit the investment (because of the lack of investors willing to take assignments of loans or investors buying equities) in time to cover other financial demands.

The FCA’s message is clear; you should only invest money that you can afford to lose! However, provided precautions are taken, this should not put off those with an exciting blueprint or an inspired invention or, indeed, those with cash to invest and the vision to bring a plan to fruition.

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