What is crowdfunding and how does it work?

What is crowdfunding and how does it work?

Until recently, financing a business involved asking a few people for big sums of money. Crowdfunding is turning this idea on its head, using the internet to help entrepreneurs talk to thousands – if not millions – of potential funders that each contribute a small amount.

The idea is the latest in funding innovations. It means small business owners that are being turned down by High Street banks now have an opportunity to appeal directly to small investors. Equally, whereas investing in small businesses was previously the domain of the very rich, this new concept means anyone can reap the benefits of investing in fledgling start-ups – whether you want to risk £20,000 or £5.

The sector is not without its challenges. Industry pioneers are in discussion with regulators in an attempt to find a balance between protecting investors – many small businesses flop early on – while allowing for the creativity and freedom needed to make ventures a success.

Companies requiring huge amounts of start-up capital may continue to be funded in more traditional ways – venture capitalists, for example, are likely to carry on plugging the funding gap.

However, in the immediate term, crowdfunding is poised to alter the entrepreneurial ecosystem significantly – just like angel investing, venture capital, and private equity before it.

How does crowdfunding work in practice?

Crowdfunding is a fairly new sector that is still developing. While it is an exciting prospect for many – and gives small businesses access to funding opportunities like never before – it can be a confusing arena for most people because it is presented in such a wide spectrum of ways.

Investments or donations are usually made through online platforms, which then coordinate and administer the fundraising.

Projects will range from those helping to finance community-based projects for no financial return (but a fuzzy, warm feeling inside), to sophisticated portfolio-picking, purely for monetary gain.

You could also opt for something in the middle. Abundance Generation, for example, offer investors the chance to invest in green energy and even allow you to visit your windfarm, but is FCA regulated, has shares on the stock market and offers pension investment options.

According to the UK Crowdfunding Association (CFA), there are officially three different forms of crowdfunding: donation, debt and equity, which it lays out here:

Donation crowdfunding

People invest simply because they believe in the cause. Rewards can be offered such as acknowledgements on an album cover, tickets to an event, regular news updates, free gifts and so on.

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

UK Sites include: www.banktothefuture.com, www.buzzbnk.org, www.crowdbnk.com, www.peoplefund.it and www.gambitious.com.

Debt crowdfunding

Investors receive their money back with interest. Also called peer-to-peer lending or lend-to-save, it allows for the lending of money while bypassing traditional banks. Returns are financial, but investors also have the benefit of having contributed to the success of an idea they believe in.

Read This is Money’s lend-to-save guide 

Where crowdsourced money is lent to the very poor, most often in developing countries, no interest is paid on the loan and the lender is rewarded by doing social good. This is sometimes referred to as ‘microfinance’.

Sites include: www.abundancegeneration.com, www.banktothefuture.com, www.buzzbnk.org and www.trillionfund.com.

Equity crowdfunding

People invest in an opportunity in exchange for equity. Money is exchanged for a share in the business, project or venture. As with other types of shares if it is successful the value goes up. If not, the value goes down and you could loose your money completely.

Sites include: www.banktothefuture.com, www.crowdbnk.com, www.crowdcube.com, www.gambitious.com, www.microgenius.org.uk, www.crowdmission.com and www.seedrs.com.

Interested in finding out more? Watch this video guide by crowdsourcing company Trillion Fund:

What are the risks for investors and how can you realise a profit?

Let there be no doubt – crowdfunding can be a very risky business.

This is because there is no guarantee investors will receive a return. In fact, because the majority of start-up businesses fail you could end up losing all of your money.

While you may receive a share of a business or project, dividends are rare and your investment could be diluted if more shares are issued.

You must also take a long-term view to any returns – it can take a while before start-ups begin making the big bucks and investors should not expect instant returns on equity investments. Your stake will only become worth something when the business floats on the stock market, in which case it will have enjoyed many years of success, or if management buy back stakes from investors.

However, most crowdfunds are illiquid, meaning it can be difficult, or even impossible, to claim back money invested or have it converted back into cash – an issue to bear in mind if you are thinking of taking the equity route. There is no secondary market to sell your shares or crowdfunding investment.

Alternatively, lending money through debt crowdfunding – ala peer-to-peer lending – gives the option of regular income. There may also be the prospect of dividend returns and some projects will pledge to return ongoing profits to investors. For example Abundance Generation offers dividends where you will get payments every six months from the energy generated by a UK solar or windfarm.

But, in general, more ideas get financial support today than can possibly return capital so investors are advised not to risk more than they can stand to lose.

Unfortunately, where money is changing hands – and especially where it is all done online – there is a risk of fraud, so investors and donators should take care to protect themselves.

How is crowdfunding regulated?

According to Julia Groves, managing director of Trillion Fund and chair of the UK CFA, the biggest draw for most people is that the industry operates outside of traditional banking structures, meaning you have greater direct control over your finances.

But, at present, official regulation of the crowdfunding industry reflects the patchy range of platforms that operate under it.

Ventures looking for crowdfunding may want to think about how platforms are regulated before deciding on the one for them, as it may impact how many people want to invest.

FCA regulated firms include Crowdcube, Seedrs and Abundance Generation. Crowdbnk and Trillion Fund are both appointed representatives of an authorized firm – and are therefore also regulated by the FCA.

FCA regulation means the platform will have had to jump through a number of hoops to get accreditation, including how their IT systems work. It also means there is an official complaints channel and the company can be held legally responsible for any wrongdoing.

Remember, just because the platform is FCA regulated, this does not mean your money is safe – just like any high-risk investment. But it is protected in the event the crowdfunding company goes bust.

The UK crowdfunding scene this year has  established its own code of conduct through UK Crowdfunding Association.

They provide strict guidelines to vet platforms before giving their seal of approval – including making sure your money is ringfenced away from the main finances of the company in case it goes bust, and allowing you a ‘cooling off’ period in case you change your mind after making a donation/investment.

  • Read the full list of CFA regulated companies here and its code of conduct here

However, just because a crowdfunding platform is unregulated, it does not necessarily mean it is unsafe. Because companies are operating in fairly untested waters, they sometimes fall outside of  official channels regulated by the FCA or CFA.

Equally it could mean they have not signed up to safe practices. Take time to do your research if you are interested in a non-regulated platform.

Investors: Top tips

Crowdfunding can add an interesting dimension to a diversified portfolio, especially for sophisticated investors. Groves doles out some extra advice:

  • Make sure you sufficiently understand the business or project, how and when you might get a return, whether you will receive an equity share in the business or a regular dividend or interest payment, and the risks involved before investing in a crowdfund.Have you thought about tax breaks? Some platforms allow you to search for companies signed up to the Seed Enterprise Investment Scheme (SEIS) or Enterprise Investment Schemes (EIS) (Read below for more details).
  • Find out how your money is protected if the business, project or even the crowdfunding platform collapses – in particular check whether the business has appropriate cash reserves or even insurance supporting it if it fails.
  • Invest in what you know. If you work in IT or the food industry, for example, you can use your expertise to help make better informed decisions.
  • You might want to consider lending money to a company rather than buying a share, in which case risks may be lower, as will returns (don’t forget crowdfunding does not necessarily equal start-ups).
  • Do your research: Read through forum threads and work out what people are saying about a business model and ask your own questions.

How to make the most of crowdfunding if you are a business

There are thousands, if not millions, of people out there vying for start-up capital. Here are some top tips from the CFA’s Julia Groves to help get your idea noticed:

  • It may seem obvious, but your pitch is key. No-one will want to invest in your idea if it sounds rubbish.
  • Do the work. Make sure you have carried out in-depth research before you pitch your idea. Anticipate as many questions as possible, include them in your pitch, and use plain English not jargon.
  • People buy into a team or personality. Try and be as engaging and personable as possible – crowdfunding came from the creative industry originally, so people do expect you to have a passion for what you do.
  • Crowdfunding is a very involved process (certainly more interactive than dealing with a bank) and unless you can dedicate the time to respond to questions and speak to potential investors on an almost daily basis through the forum, don’t bother.
  • Get your friends and family on board. Potential investors are less likely to give you money if your funding arrow is stuck at zero. An initial boost of cash should help to get the ball rolling. Plus, if even your friends and family don’t want to support your idea, maybe it needs rethinking.
  • Openness is key. People will ask you questions – it’s all transparent and online so you need to be ready for an active process. Look out for platforms that help you to prepare your answers if you’re unsure.
  • At the end of the process your business should be all the better for it. Your idea will have been thoroughly examined and picked over by potential investors – try to see this as a positive process because it will most likely improve your overall end product.

SOURCE: This is Money

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