Participants can often chip in both small (as little as £10) and large sums (the sky's the limit) – with many schemes offering investors the chance to spread their money across several companies.
But investors need to be careful, a new warning from the Financial Services Authority states. While it is easy to put your money in, it may be far more problematic to exit the target company.
Investors and businesses meet online
Crowdfunding in the UK is still small. And while it can be a great way for investors and entrepreneurs to meet each other, there are drawbacks. These can range from a company failing to live up to its promise to crowd-sourcers who simply take the money and run.
The FSA says it is not warning against crowd sourcing which can offer rewards far in excess of conventional assets. But it suggests that this is for more sophisticated investors who are aware of the pitfalls as well as the potential profits – and who can afford to lose some or all of their money. Crowdfunding is unregulated so there is no compensation fund although that does not prevent participants suing promoters.
Investors should be cautious – most crowdsourcing schemes are open for some time so there is no need for haste. Here's some basic questions.
- Does the company have a specific cash target which must be met before any investment is made? The majority require a stated amount to be reached during the fundraising period before the money is passed to the business. If the sum is not achieved, investors get a full refund. However some schemes are on a "keep it all" basis so there is no refund even if targets are missed. That can mean investing in an under-funded scheme which has less chance of success.
- Who am I investing with? Crowdsourcing platforms are not obliged to carry out due diligence on potential investments although many do. Check out the principals – whether they are listed as directors or not. Ask for their past record although past success is not guarantee of future profits while many learn from previous failures.
- Does the platform have FSA authorisation? The regulator is worried some firms involved in crowdfunding may be handling client money without our permission or authorisation, and therefore may not have adequate protection in place for investor. It is easy for unscrupulous crowdsourcers to run off with cash.
- How will I be rewarded if the firm is successful? Some firms may offer dividends or interest payments on investments. Others will rely on shareholders selling out some time in the future. The FSA says that normal risk and return rules apply – the greater the possible return, the greater the risk of losing. The majority of start-up companies fail.
- What stake will I have? Investors in crowdsourced companies cannot hope for the same degree of corporate governance as in a FTSE 100 company. But they need to know what their holding is in relation to others. Minority shareholders in small companies need to place trust in the main participants.
- What about dilution? An investor who starts off with a significant 10 per cent ownership stake could end up with less if the company decides to issue more shares – perhaps to raise fresh funds or to acquire other companies, ending up with a virtually meaningless percentage. Many crowdfunding opportunities are high risk and complex, the watchdog warns.
- What is the exit route? Investors in crowdfunded opportunities have to accept that results will take time – often years rather than months. But they do need to know, as early as possible, how the directors expect shareholders will be able to cash in on their stake. This is unlikely to be via a flotation – more probably through selling the company to another or replacing the crowdfunding with a venture capital source. Most crowdfunds are illiquid, so it can be difficult or even impossible to claim back money invested or have it converted back into cash. There is also no secondary market to sell your shares or crowdfunding investment.
These questions apply to almost all investments in start-ups and small businesses – but with the nature of online investment can persuade people to make spur of the moment decisions.
Not for the novice
The FSA says: "We believe most crowdfunding should be targeted at sophisticated investors who know how to value a start-up business, understand the risks involved and that investors could lose all of their money. We want it to be clear that investors in a crowdfund have little or no protection if the business or project fails, and that they will probably lose all their investment if it does."
Seedrs, an online platform joining those with money to invest with those who need capital for their project promises to "raise capital for your startup from friends, family and the crowds." It is one of the comparatively few platforms authorised by the regulator.
Chief executive Jeff Lynn welcomes the FSA statement. He says: "This is a welcome contribution to the information that's available: all of the risks they highlight are the same ones that we emphasise strongly when investors use our platform, and we agree entirely with their statement that this type of investing can make sense for investors who understand the risks as part of a diversified