Two-minute guide: Crowdfunding explained

Two-minute guide: Crowdfunding explained

Ever heard of BrewDog, the Scottish craft beer firm? You may not have but you’ve probably seen or drunk some of its famous Punk IPA (It’s quite strong and relatively expensive). Anyway, believe it or not the firm, which is now valued at somewhere around £1.7 billion, is largely crowdfunded.

Crowdfunding has become an extremely important source of finance for new companies over the last decade. It’s also a way for us individuals to invest in small firms and start-ups that could offer great growth potential, like BrewDog. But what is crowdfunding, I hear you ask?

Two-minute guide: Crowdfunding explained

Crowdfunding is a very simple idea: raise money through a large network of individuals – primarily via crowdfunding websites – to finance small and new businesses. It means investors like you or I can buy into unlisted companies.

That’s quite a departure from the traditional model, whereby companies would raise large sums of money through institutions such as banks.

Why crowdfund?

From the company's perspective, it could be that the bank may not loan the company the money they need or that the cost of borrowing the money is too expensive. Therefore they look to use alternative avenues to raise this money (to supplement the original loan or as a sole alternative).

Luckily, from our perspective, it gives us the opportunity to invest in brand new businesses, just as they’re starting out (a bit like Dragons' Den) and opens up a new type of investing that used to be entirely shut off to the public.

However, there are risks involved. The companies you’re investing in have no track record so it can be hard to tell how legitimate they are. Be aware - while these companies offer the potential of high growth and high reward they come with a high risk of losing your money.

The rise of crowdfunding

The rise of crowdfunding over the last decade has been unprecedented. According to the Cambridge Centre for Alternative Finance (CCAF), European online alternative finance volumes increased 41% from €5.4billion to €7.7 billion in 2015-2016 (with the UK accounting for 73% of all European volume). Indeed, one form of crowdfunding (equity-based) grew by around 300 per cent from 2015-2017. Although this is a sizable increase in the UK and EU, the volume in the market is still a long way off that of the US (at €35.2 billion in 2016) and China (at a staggering €205 billion in 2016). 

Different ways to crowdfund

There are many different ways companies can attract crowdfunding investors. Some of the most popular types are:

Peer-to-peer (P2P): the company pays to borrow directly from you at cost (a bit like you getting a loan from the bank). Although this may give you a higher yield than with a bog-standard savings account, it is subject to much higher risk. For example, if the company were to go into bankruptcy, there are no bank deposit guarantee schemes or investment protection schemes to protect investors from losing large sums, if not all, of their money.

Reward-based: The company offers rewards  to investors, such as exclusive access to pre-sale items, bonus levels in a game, subscriptions and so on.

Equity-based: In return for lending money to a company you get shares in the company (part-ownership in the company). It is very much a Dragons' Den-esque scenario (however – luckily for us – you don’t have to have a spare couple of thousand pounds lying around to get involved). For Crowdcube, a popular crowdfunding platform, the minimum investment is usually around £10. 

Benefits of crowdfunding

From a company's perspective, as previously mentioned, this gives them access to a vast source of alternative finance. 

For the investor, as previously mentioned, there is the attraction of high yields (albeit not without higher risk also). Moreover, you can benefit from the generous tax reliefs that come with investing in small UK government schemes (in particular those associated with Seed Enterprise Investment Schemes and Enterprise Investment Schemes).

However, this is not without its caveats; the availability of these types of tax reliefs – and others – is dependent on the circumstances of both the investor and the company concerned.

Risks of crowdfunding

As with any investment, there are risks to consider:

  • There could be large penalties (exit charges) if you want to get out of your investment

  • Potential to lose all your money

  • Lack of interested buyers could mean it is hard to sell you stake

  • Share holdings could be diluted if the company offers more shares

  • Outright scams and fraud are also a large issue in this area

  • Changes to regulation

  • Potential collapse of crowdfunding platforms

Do your homework

Crowdfunding has grown exponentially over the past couple of years, and because of this it would be easy to get lost in the euphoria of it all.

Success stories such as Brewdog most certainly show the benefit of this alternative form of financing for companies.

However, there are many caveats that should be addressed and considered – more so than with other investments, due to the infancy of these businesses.

There are a couple of ways that you can look to protect yourself. It is, as with any investment, important to understand the risk that you are taking, and the risk that you are happy to take.

Moreover, as regulation and guidance for crowdfunding platforms becomes mores stringent, the hope would be that scams will become much more unique.

As with any investments, the decision you take should be backed by your own homework and judged with eyes wide open.

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