Crowdfunding is a way for individuals and organisations to raise money from a large number of people. It can be an alternative to using a bank or investment firm.
Thinking about becoming a funder? We’ve explained the four main types of crowdfunding, with a focus on investment.
Remember, this is just a guide. Always do your own research and speak to an independent financial advisor before investing!
Loan based crowdfunding
Donation crowdfunding is used to raise money for a cause. It’s not just charities who can do this – groups and individuals can also start crowdfunding projects, for example to pay for a community centre or a child’s surgery. As a funder, you may receive a token gift or thank-you letter. But usually, the reward is a chance to support a cause you believe in.
This type of crowdfunding isn’t regulated, so research any project before funding it to make sure it’s legitimate.
This involves funding a project for a set reward. For example, you might give money to help a band record its music and get their album in return. The reward may vary depending on how much money you give. For example, if you gave £20 you might get the album, but if you gave £50 you might get the album and a t-shirt.
Again, this type of crowdfunding isn’t regulated, so it’s worth doing your research. Bear in mind, you may not get your reward – or your money back – if the project misses its funding target.
Loan based crowdfunding
This is also known as ‘peer-to-peer’ (P2P) and ‘peer-to-business’ (P2B) lending. You’ll lend a certain amount of money, which should be repaid to you with interest over time. So, the idea is you get back more than you lent.
This type of crowdfunding is regulated by the Financial Conduct Authority (FCA), but it isn’t protected by the FCA’s compensation scheme.
P2P and P2B lending does carry significant risk. For example, you may not be able to get your cash back quickly, and you may lose some or all of the money you put in.
Investment crowdfunding (also called ‘equity crowdfunding’) typically involves buying part of a company. The part you own is called a ‘share’.
You’ll usually be one of many shareholders, along with other crowdfunders, investment firms and people working at the company.
Companies sell shares as a way of getting money, usually to fund their growth. Equity crowdfunding is typically done by businesses that are small, new and unlisted (i.e. not on the stock market).
Benefits of investment crowdfunding
Making money (possibly). Simply put, if the company does well, the value of your shares should increase. This means you could walk away with more money than you put in – but read the risks below to see why this isn’t always the case.
Supporting a business you believe in. It can be rewarding to fund the growth of a company or project that you want to succeed.
Risks of investment crowdfunding
Whilst investment crowdfunding is regulated by the FCA, it’s a risky business. Here are some of the main dangers:
Losing money. If the company does poorly, the value of your shares may decrease. Bear in mind that most startups fail, so it’s likely you’ll lose your investment completely.
Difficulty turning your investment back into money. Shares bought through crowdfunding can be difficult to sell – this is called a ‘lack of liquidity’. What’s more, small businesses rarely pay out dividends (i.e. a portion of what the company has earned) to shareholders.
Losing out to new shareholders. The business may sell more shares to other people at a later date. This is called ‘dilution’ and it can affect you in several ways, including voting powers, dividends and share value.
At the risk of sounding like a school textbook, the simplest way to understand dilution is to imagine the company as a basket of apples. There are five apples and you buy one, so you own 20% of the basket. Then five more apples are added, making a total of ten apples. You still have one apple, but you now own just 10% of the basket.
In some cases, the business may agree to give you first dibs on new shares. You should check this before investing.
Can I reduce the risk?
You may be able to control the risk of investment crowdfunding by:
Spreading your bets. You could invest small amounts in multiple companies for a better shot at success. In the investment world, this is called ‘diversification’.
Spend only what you can afford to lose. It’s best to assume you won’t get your money back, so invest only as much as you’re prepared to lose.
Do your research. Give any company a thorough background check before you buy shares. Make sure you understand the level of risk and what value you’ll get after any charges, taxes and allowances.
Where to find crowdfunding investments
Here are three popular crowdfunding sites to check out:
Crowdcube – this has been around for a while as crowdfunding sites go. Each investment opportunity has a business plan and a video, explaining why the company’s raising money and what you could get out of an investment.
SyndicateRoom – this site features companies that are already backed by ‘business angels’ (firms that invest in startups). These firms research the investment opportunities themselves, which may give you more confidence.
Seedrs – this site focuses on helping entrepreneurs raise money to launch a business. Seedrs offers support to give these startups the best possible chance.
We hope you’ve found this helpful! Next, you might like to learn about inflation and how it can affect your money.
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