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Back to basics: what is crowdfunding?

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Crowdfunding has been growing rapidly over the past few years. We go back-to-basics to find out what the industry is all about.

What is crowdfunding?

Crowdfunding is a way of marrying up investors or savers with small businesses and start-ups that need a vital capital injection to grow or get an idea off the ground.

It is still a relatively new sector but it has enjoyed, and continues to enjoy, rapid growth thanks to the internet and the low interest rate environment.

What has sparked the recent surge in interest in crowdfunding?

Since the financial downturn, traditional lenders have become stricter with their lending criteria. As such, small firms and start-ups have increasingly turned to crowdfunding to help with their financing needs.

Crowdfunding cuts out the middleman between lenders and borrowers and removes any extra charges or overheads associated with borrowing from a bank.

For savers, crowdfunding sites tend to offer more favourable rates than high street banks.

How does crowdfunding work?

Typically, those seeking funds will set up a profile of their project on a crowdfunding website. They then use social media, alongside traditional networks of friends, family and work acquaintances, to raise the capital they need.

There are three different types of crowdfunding: debt, equity and donation. Here are the definitions according to the UK Crowdfunding Association:

Debt crowdfunding

Commonly known as peer-to-peer (p2p) lending, investors receive their money back with interest.

Returns are financial but investors benefit from knowing they have contributed to the success of an idea they believe in.

Equity crowdfunding

People invest in a start-up or small business in exchange for equity. Typically, money is exchanged for shares, or a small stake in the business, project or venture only.

As with investing in other types of shares, if the buisness is successful your stake goes up. If not, your stake goes down.

Donation/Reward crowdfunding

Investors put their money in simply because they believe in the cause. Rewards can be offered (often called reward crowdfunding) such as acknowledgements on an album cover, tickets to an event, regular news updates, free gifts and so on.

Returns are considered intangible. Typically, reward investors tend to have a social or personal motivation for putting their money in and expect nothing back, except perhaps to feel good about helping the project.

What types of business can you invest in via crowdfunding sites?

You will come across all types of business on online platforms ranging from a Somerset-based fruit crumble manufacturer to a south London climbing centre and an HR software provider.

Most platforms offer an equal mix of start-up, early stage and growth companies.

What are returns like?

Crowdfunding is still in its infancy so there is little data on actual return rates, although angel investing, which is comparable, has been found to produce, on average, an annualised rate of return of 22%.

How long do ‘campaigns’ last for?

Typically, a campaign can run over a period of weeks. However, projects or ventures that hit the right note with certain investors tend to raise capital very quickly or raise more than they originally expected.

Over the page: the risks, crowdfunding in ISAs…

What are the risks?

Crowdfunding is a high risk investment and there is no guarantee you will receive a return. Business experts also point out that the majority of start-ups tend to fail.

The most immediate risk to your capital is if a borrower fails to repay what you have lent them, so you should not put in anything you cannot afford to lose.

And while you may receive a share of the business or project you have invested in, dividends are practically non-existent and your investment could be diluted if more shares are issued later.

These types of investments also need to be held for a long time in order to benefit from returns later on, and investors’ stake will only be profitable if the company floats.

Most crowdfunds are illiquid, so it will be difficult to claim back money invested or have it converted back into cash. There is also no secondary market to sell on your shares or crowdfunding investment.

As it stands, money put into a business through a crowdfunding site is not protected under the Financial Services Compensation Scheme.

However, most of the bigger crowdfunding sites manage risk in different ways and investors should read what mesuares they have in place before they invest.

Is crowdfunding regulated?

At the moment, crowdfunding platforms are not regulated by the Financial Conduct Authority (FCA).

However, the FCA recently announced it is looking into regulating the loan based and investment based parts of the crowdfunding industry.

The watchdog said investors willing to lend money to companies through peer-to-peer crowdfunding websites will receive explanations of the key features of the loans as standard.

They will also benefit from an assessment of the creditworthiness of borrowers before granting credit, and crowdfunding sites will need plans in place to ensure loan repayments continue even if a crowdfunding company collapses.

A 14 day cooling off period will allow both borrower and lender to withdraw without penalty from the agreement if either changes their mind. New prudential requirements will also be phased in.

More is expected on this in the New Year.

Is it true that crowdfunding is allowed in ISAs?

The Chancellor is set to launch a consultation on allowing investors to include loan-based crowdfunding investments in their annual ISA allowance.

This move will no doubt boost finance for SMEs, and make it more attractive for investors.

Equity-based crowdfunds, where investors take a stake in a start-up, already benefit from Enterprise Investment Scheme reliefs (EIS &SEIS) but could be considered too risky for ISA status.

Including loan-based crowdfunds into an ISA will boost an investor’s end return, while driving up the amount invested in SMEs through alternative finance.

What are some of the best-known crowdfunding websites?

The list is very extensive, but some well-known names include Seedrs, RateSetter, Funding Circle, Zopa.

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