What is crowdfunding and what are the risks?
8th September 2017
For investors, crowdfunding websites offer the chance to make money by investing in small fast-growing businesses. For entrepreneurs, they can be a great way to raise a business’s profile - and cash. But, if you are tempted to get involved you must be aware of the risks.
What is crowdfunding?
Crowdfunding sites enable small businesses to raise funds from investors - “the crowd” - who all invest small amounts in the business. It started as a way to fund creative projects such as films, theatre projects and music recordings. However, it now allows enterprises of all types to raise money from friends, family or complete strangers. In return, investors might get shares in the business, discounted goods or freebies.
What are the risks?
In December Britain’s financial regulator warned that it is difficult for investors to understand the risks and returns of crowdfunding. It added that marketing material was sometimes unclear and misleading.1
The biggest risk is that the business you invest in goes bust. You could lose all your money. It has happened before. In February last year  the claims management company Rebus collapsed after raising more than £800,000 on the crowdfunding website Crowdcube.2
How many businesses go bust?
Rebus wasn’t the first business to go bust after raising money on crowdfunding websites, and it won’t be the last. Research by AltFi Data suggests that nearly one in five of the investments have failed.3
Crowdfunded investments are not covered by the Financial Services Compensation Scheme, meaning that investors can lose their entire stakes.
Can I withdraw my money?
You cannot pull out your money when you want. Once you have put money in it can be tied up for a very long time. Crowdfunding is not a get-rich quick scheme. You will only get your money back, including any return on your investment, if the company floats on a stock exchange, is bought by a larger company or if the management buys back your shares.
What are the returns?
It is too early to say, as very few crowdfunded companies have been sold or floated on the stock exchange to give investors a return. According to AltFi’s research, there have so far been only five “exits” in the UK.
What is the benefit for businesses?
Crowdfunding offers a way to raise money to grow your business and its profile. It is often easier than seeking loans from a bank or raising funds from specialist venture capital investors.
Bookmygarage.com, a car servicing and MOT comparison website, raised £660,000 in December 2016 through the crowdfunding site Seedrs. Some 120 people, from garage owners to overseas investors, invested stakes ranging from £15 up to £100,000.
Douglas Rotberg, the firm’s chief executive, says that crowdfunding was the best way to raise funds at this stage of the business’s growth. A serial entrepreneur, he set up Bookmygarage in 2013.
Douglas says: “For us, crowdfunding made life a lot easier. It took us about a week to do everything. That included the due diligence required by Seedrs, which wants to make sure what you are saying is absolutely correct.
“Crowdfunding has provided us with the backing we needed to accelerate our growth. If we return for more growth capital, we will be a more mature business, so we will probably go down the venture capital route.”
Should I invest?
Most crowdfunding sites require you to fill in an “appropriateness test” confirming that you are “sophisticated or high-net-worth”, or will not invest more than 10 per cent of your investments in the scheme. And remember, if anything goes wrong you are not protected by the Financial Services Compensation Scheme.
If you do decide to go ahead choose your website with care. Platforms regulated by the Financial Conduct Authority offer investors a higher level of protection. You can check if a business is regulated here https://register.fca.org.uk.
Make sure you spread your risk by investing in a variety of businesses. Even so, be prepared for some losses. If you can’t afford to lose money then do not invest.
1. Financial Conduct Authority: FCA publishes interim feedback following a call for input to the post-implementation review of the rules for crowdfunding, 9 December 2016.
2. Financial Times: Rebus becomes largest crowdfunded failure, 3 February 2016.
3.Altfi: Where are they now? 2016, November 2016. Altfi’s research tracked 955 fundraisings and found that 88 firms have gone bust and 79 appear to be heading in the same direction.