Equity crowdfunding investors: Five key tips before you take the plunge

 
Jean Miller
7-11 Celebrates Its 75th Anniversary
Pick ‘n’ mix: A varied portfolio will help reduce the impact of the firms that fail (Source: Getty)

The most recent figures from innovation charity Nesta show that equity-based crowdfunding is one of the fastest growing models of the alternative finance sector. Since 2014, it has grown by 295 per cent to £332m.

Equity crowdfunding is not only providing investment for startups, early-stage growth companies and even those already eyeing a flotation on the stock market, but it is also giving investors the opportunity to make proper returns on their investment.

This nascent sector therefore offers a great opportunity for investors and businesses alike. However, it is important to remember that all investing carries risks – and this is no truer than when you’re dealing with very young companies. Therefore, there are a number of key considerations which should be made before committing any capital to mitigate the risks involved.

Diversification

When it comes to investing in early stage businesses, the biggest threat is the risk of the business failing, which would result in loss of capital. Most startups do fail, but if you choose correctly and the company goes on to become a success, the return can be significant. Early-stage investing is all about hunting for those winning deals, and the best way to maximise the chance of investing in a winning company is to build a portfolio of several investments.

Although most of these businesses are statistically likely to fail, by building a varied portfolio you increase your chances of finding that one success story. And if it pays off, you will have reduced the impact of the companies which have failed and stand a better chance of enjoying profitable returns overall.

Check the tax reliefs – they are generous

Of the companies listing on equity crowdfunding sites, 95 per cent are eligible for some form of tax relief, usually in the form of the Enterprise Investment Scheme (EIS) or Seed Enterprise Investment Scheme (SEIS). Investments under the SEIS attract a 50 per cent income tax credit, no matter what your income tax rate is. This means that, come the end of the tax year, you can deduct 50 per cent of your investment from your tax liability.

The maximum you can invest in an SEIS scheme is £100,000 in any one tax year. EIS investments award a 30 per cent income tax relief and up to £1m can be invested in EIS in any one tax year. But remember that you cannot reclaim more tax than you owe. Additionally, shares in unquoted companies are generally free from capital gains tax (CGT) if you hold on to the shares for three years or more.

Any gains you realise within that time can be reinvested in another EIS or SEIS scheme, which defers any CGT liability and means that you are effectively receiving combined tax relief of up to 78 per cent: 50 per cent income tax credit and 28 per cent CGT relief. Even if the company in which you have invested goes under, you can qualify for loss relief, which is calculated at your marginal tax rate.

So if you invested £10,000 into an EIS qualifying company which then folded, you would receive up to 30 per cent of the investment back (£3,000) through a tax credit, and up to a further 40 per cent of the remaining £7,000 loss – equating to £2,800. So in a worst case scenario, you could still recoup up to £5,800 of a £10,000 investment even if the company went bust, if you invested through EIS. The SEIS tax reliefs are even more beneficial.

Understand the company you’re investing in

You are committing your own money to fund the growth of a business, so it is crucial that you learn and understand what its plans and prospects are to help decide on whether or not it’s the right investment for you.

Instead of just focusing on the initial business description pitch, you should also look at the company’s current achievements, exit strategy, intellectual property, management team and financial data to get an overall picture of the business.

If a company is looking for investment armed only with an idea but no track record, no revenue and no profit, it is clearly more risky than one which is up and running. It’s easy to get sucked in by an attractive pitch or the backing of a celebrity figure but, generally speaking, it would be wise to avoid companies that are relying on celebrities to help draw investments.

Preserving the value of your money

Many investors don’t understand that most early-stage companies will need several rounds of fundraising, and that the one you are looking at on a crowdfunding site might be the first round of many. More fundraises can have a severe dilution effect on your investment because it means the company will issue more shares to more investors, reducing your percentage ownership of the company.

If you don’t have pre-emption rights with your shares, a common omission on crowdfunding platforms, you may not get the opportunity to participate in future fundraises to retain your current percentage ownership of the firm. This is not always a bad thing, as although your percentage holding may be reduced, the actual value of your shares may still increase if the business is progressing well.

Nonetheless, it is a factor which could affect your investment further down the line, and it’s vital that you familiarise yourself with a platform’s rules around it so that you know what your options are.

The importance of voting rights

Many shares being offered don’t have voting rights – or, if held through nominee accounts, they won’t have voting rights other than collectively by the assigned nominee.

If a company hasn’t defined an exit strategy and the shares are illiquid, as many early stage shares are, then you will have no way of influencing how you will get your money out. Without a vote to guide the company to push on for an IPO or sell up so people can realise their gains, you may never see the returns you are due.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

Related articles