The pros and cons of crowdfunding

Katherine Denham
Live 8 Paris - Stage
Don't ignore the downsides to crowdfunding (Source: Getty)

People are divided about crowdfunding. While many investors and businesses see it as invaluable, it often comes with a number of caveats which shouldn’t be ignored.

Equity and debt-based crowdfunding methods are often used by entrepreneurs looking to start or develop their business. However, they differ in that equity-based lets you swap money for shares in the business, while debt-based (commonly known as peer-to-peer lending) means you loan money to businesses and get a return in the form of interest.

For investors

People have taken to this fresh-faced form of investment in the hunt for yield, which is particularly important when the returns for traditional assets look dreary. So while you would probably expect an average annual return of around six per cent for a “balanced” portfolio of equities and bonds, crowdfunding platform Seedrs has produced an annual return between 14.4 per cent and 49.1 per cent, once tax relief is taken into account.

Unlinked to markets

The other thing to bear in mind is these types of investments aren’t listed on a stock exchange, meaning they are not correlated to the markets. This can be good from a diversification point of view, because crowdfunding investments are not exposed to the same market wobbles.

Iain Niblock, chief executive of peer-to-peer comparison website OrcaMoney, says these types of assets are likely to perform better during an economic downturn when compared to listed products such as equities or bonds.

Not a vanilla asset

Another benefit of crowdfunding is that it lets investors and lenders take back control of their money by deciding where it’s invested.

Bruce Davis from the UK Crowdfunding Association (UKCFA) says investors see their money pumped directly into businesses and projects in the real economy. “The democratisation of investment allows smaller investors to properly diversify their holdings away from one-size-fits-all “vanilla” indices, and get much better information about the real fees associated with their investments.”

Risky business

While the returns can be strong, the first thing to bear in mind is that investing in shares in early stage companies is high risk, meaning you could potentially face losing everything you invested.

So obviously don’t throw your entire life savings into this sort of investment, and it’s probably unwise to invest more than 10 per cent of your disposable income.

Also make sure you only invest if you’ve got plenty of spare cash in the first place.

Different platforms, different risks

You also need to make sure investors understand the risks of different platforms. Davis advises investors to shop around for platforms which offer the investments that suit their needs and values.

For example, this could mean finding out if the platform has appropriate protections through a shareholders agreement. Rich Mason, business development director at Seedrs, warns that without this there is an increased likelihood of investors seeing a dilution in the value of their shares, and a reduction in their ability to make a return.

While peer-to-peer lending is seen as less risky compared to equity crowdfunding, there is still the danger that borrowing firms will fail to repay the loans, so bear this in mind before you start investing.

Speed of returns

Shares in early stage firms are “famously illiquid”, says Mason, with returns only being realised when a company is bought or listed on a stock exchange. As a result, it can take a long time for investors to get a return, which can be mitigated by choosing the right platform.

For businesses

Instead of going down the traditional financing route through high street banks, crowdfunding is another channel that allows firms to fund their business. “Previously, access to alternative finance was a question of who you know and your golf handicap,” says Davis. “But now you can go online and get a swift decision to fund your business or bring a wide range of investors into your project.”

But he warns that you shouldn’t see it as a “soft” option compared to banks. “The due diligence and credit checking will be the same as banks, but the process will be more transparent and efficient because crowdfunding and peer-to-peer platforms are not held back by bureaucratic legacy systems.”

Range of requirements

Be aware that crowdfunding platforms have different requirements for businesses to join, such as proof of a minimum number of years of trading.

In order to secure a loan or raise equity, companies must also have a clear business plan in place, including financial projections, and should be prepared to answer queries from potential investors.

Life after the fundraise

Entrepreneurs need to consider the implications of life after they’ve raised their funds. Mason has a warning for businesses considering cutting corners. “Without a proper structure in place, and a platform that provides support post-fundraising, the complexity and administrative burden of managing a crowd of investors can be a very real drain on time, money and resource for companies.”

Platforms like Seedrs aim to solve this problem through the use of a “nominee structure”, which removes the need to deal with scattered investors by centralising communication with investors through a portal.

So while crowdfunding may not be perfect, there are plenty of reasons it might be a good option if you’re looking for an alternative way to invest or to build your business.

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