Crowdfunding 101 – The Basics Explained

Crowdfunding is an alternative investment phenomenon sweeping Britain, the US and Europe that allows companies to fund start-ups and raise capital to finance growth from a pool of investors.

New investors need to understand how crowdfunding works before staking any cash, because some pitches do not fully explain the terms and conditions.

For investors three types of crowdfunding are on the table. Each has different risks and returns, but are attracting investors because they offer better returns than low interest rates offered by the banks.

Reward crowdfunding

This is crowdfunding for fun. Investors stake a few pounds to a project. In return, they get a warm thank you generally in the shape of a T-shirt, mug, web site mention or discount voucher.

With reward crowdfunding, the cash is a donation not an investment. Investors will never see their money back and have no say about how the pitcher spends the cash.

Equity crowdfunding

Equity crowdfunding is not a new concept, but the online platforms that promote and manage the deals are.

Business angels and private investors have been around for years, but crowdfunding platforms now take the concept to a broader audience.

Investors buy a share in the company with the expectation that sometime in the future the shares will generate a dividend and will grow in value.

In the UK, many crowdfunding startups are wrapped in a Seed Enterprise Investment Scheme (SEIS) wrapper that offers tax breaks to investors.

Debt crowdfunding

Again, debt crowdfunding is not a new concept – businesses have borrowed from banks for centuries. It’s the online platform that has revolutionised the market by connecting willing lenders with willing borrowers.

Another name for debt crowdfunding is peer-to-peer lending

Small investors pool their cash and lend direct to a company, which pays interest over a fixed term and returns the original capital.

Crowdfunding risks

Crowdfunding is not a quick profit fix. Expect to tie up any cash for at least three years – especially if you are buying shares through SEIS.

Crowdfunding is unregulated investment, which puts the deals outside the Financial Services Compensation Scheme in the UK. Investors are on their own if something goes wrong, without any recourse to an ombudsman.

Watch out for clauses in contracts that allow equity crowdfunded schemes to issue more shares during the investment term – this can dilute the value of a shareholding

Startups have a high attrition rate, so spread the risk and do not expect to profit from more than the odd one or two deals in every 10 you make.

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