Crowd funding explained – the fees, the risks and the reasons for investing

13th September 2013

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Unless you’ve been meditating in a cave for the last year, you will have heard of crowdfunding, which is, at its most basic, where a group of individuals get together to fund something they like.

But you might not have given it more than a passing thought, until perhaps this summer, when the concept rose to prominence as high profile fund raises from Nicola Horlick, who convinced backers on Seedrsto part with £150,000 to fund a film company venture, and Grand Design’s Kevin McCloud, who raised £1.5 million for his Hab Housing company last month, aroused interest.

Suddenly, it is not just fans sticking a tenner into their favourite band’s tour kitty and it is pricking the ears of more serious investors. But is it suitable for all of us? Financial journalist Rebecca O’Connor weighs up the options.

Why invest in crowdfunding?

Crowdfunding differs from traditional investing because it is (mostly) accessible to people with small amounts of money – in some cases as little as £5. This accessibility to the masses harks back to a founding ideal of being open to everyone. Whether an investment of £5 is really an investment is up for debate, but the point is it gives people the opportunity to put something aside somewhere other than an e-saver paying 0.5 per cent.

Unlike investors in funds, crowdfunders do not have to pay fees to a fund manager. Instead, the project or business pays the platform a fee. As the focus is increasingly on investment management fees, the low cost to investors might seem increasingly appealing.

Another plus point: it is a direct investment in a business. Your money is not diluted across several different businesses as it would be in a fund. Good if you like control. However, if you wish to diversify to spread risk, this could be a downside.

The feel good factor is worth a mention too. Unlike faceless funds, crowdfunders feel involved in what they are investing in and may well also feel that their money is going somewhere worthwhile.

Equity v debt crowdfunding

Crowdfunding is as diverse as the business universe. You can crowdfund “cat” cafes in East London or renewable energy projects in Kent. One of the biggest differences between types of crowdfunding is that some are debt-based, where investors lend money to a business in exchange for an agreed return over an agreed time period, whereas others are equity stakes, the value of which can rise of fall in line with the profitability of the company and which you may have to hold for an indefinite time period. Generally speaking, debt investments are considered less risky than equity, but that still depends on the stage of the business, which brings us to…

Start-ups versus established

Another key thing to bear in mind is that some crowdfunds are for start-ups with little to no trading history and others are for established, mid-size firms with proven revenue streams. Start-ups are riskier but potentially more rewarding if the business survives and reaches its targets.

Risks

Crowdfunding is a fast-growing sector – lots of new platforms are springing up. The FCA-authorised ones such as Kickstarter and Abundance Generation represent a lower risk than those that are not authorised. Vet the platform as well as the business you want to invest in.

The biggest risk is that you may not get any of your money back. The next biggest is that your returns will not come in as expected. Crowdfunding platforms do perform some due diligence but the amount varies.

Julia Groves, chair of the UK Crowdfunding Association, says: “We ask that platforms are clear about the amount of due diligence that has been undertaken on a listing. If no due diligence has been carried out, they must say so. All platforms must at least check that the information given by the business is accurate. Sometimes, if a business is very early stage, there can be hardly any information available.”

The success of a raise is in a way a mark of the vote of confidence – the majority of attempts to raise money via crowdfunding platforms fail because they haven’t adequately impressed enough investors.

Liquidity can be a problem – if you want to sell your investment at any time, it could be difficult to find a buyer as secondary markets are immature.

The FCA is currently undertaking a consultation on the sector and is likely to make a number of recommendations to protect investors in early October.

Fees

Fees are paid by the project or business raising the money, not by the investors, although the business can use some of the money raised through the crowdfund to pay the fees, this will not affect investor returns. They range between 3 and 7.5 per cent. There can also be trail fees of around 1.5 per cent if the platform provides an ongoing service to the business, such as distributing returns or acting as shareholder nominee.

Opportunities

Crowdfunding represents a potential opportunity for savers who want a better return, as well as for more sophisticated angel investors. The growth of the sector is currently limited by the lack of availability of tax breaks such as ISA or SIPP status, or EIS relief, compared with other investments.

As things stand, while there are opportunities for the risk averse to get involved, it remains better suited to those with some appetite for higher risk. Either way,you don’t have to be wealthy to put money into a crowdfund, but you do have to understand the risks.

Visit the UKCFA [www.ukcfa.org.uk] for more information.

1 thought on “Crowd funding explained – the fees, the risks and the reasons for investing”

  1. Anonymous says:

    Had a read through some of the platforms. Bank to the future are asking the borrower for 5% to arrange crowd lending + the lender return makes for an expensive loan.

    The UK crowd funding sector is insular, and only funds British businesses. The UK isn’t leading Europe’s crowd funding business. isePankur is a EU wide platform whom I’ll try to do business.

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