Investing Basics: What is Equity Crowdfunding?

Equity crowdfunding allows a large number of people to provide money to a start up or early stage business in return for shares in the company – says Tabitha James

It has been around for a number of years but tended to be the preserve of high-net-worth business angel investors, able to invest more than £25,000 in a range of ventures.

The model has changed and there are now a huge range of peer-to-peer lending, reward and equity crowdfunding opportunities available to the DIY investor with minimum investments as low as £100 and a large number of platforms to choose from.

Unlike buying shares that are listed on a stock exchange via a broker a whole new industry has been created by platforms and aggregators looking to deliver access to private equity investment.

‘individuals pooling their money to become shareholders when the opportunities, and risks, are at their greatest’

Buying shares in a start-up company is very similar to buying shares in any private company in that you become a shareholder in that company, may receive dividends, have the opportunity to make additional investments (pre-emption rights) and can vote on company strategy and governance.

Such investments may come with tax advantages it, as a result of your circumstances and the company’s eligibility you qualify for Seed Enterprise Investment Scheme (SEIS) or Enterprise Investment Scheme (EIS) tax relief.

Investing in start-ups could be considered as part of a DIY Investor’s diversified portfolio; by investing relatively small amounts in multiple businesses rather than a lot in one or two businesses you can spread your risk, and it is sensible to invest only a small proportion of your capital in start-ups as an asset class, with the majority of your investable capital invested in safer, more liquid assets.

Rewards based crowdfunding and peer-to-peer lending have experienced extraordinary growth in recent years but it is equity crowdfunding that is now receiving a high degree of attention – individuals pooling their money to become shareholders when the opportunities, and risks, are at their greatest.

Experts believe that equity crowdfunding will transform capital markets, companies’ ability to achieve funding and attract ongoing finance, by democratising investment into the growth engine of the economy — start-ups.

An entirely new class of investor can now enrich themselves in the way that that only venture capitalists and angel investors had previously.

Equity crowdfunding does have the potential to deliver huge returns and online technology opens up a world full of ‘local’ investment opportunities at the click of a mouse.

‘Equity crowdfunding does have the potential to deliver huge returns and online technology opens up a world full of ‘local’ investment’

The payback from equity crowdfunding can be enormous Facebook or Dropbox’s return on investment of 62,000% and 39,000% respectively may have been exceptional but a long-term investment in the right startup could produce higher returns than any other asset.

Technology takes what were local angel investing opportunities and rolls them into a global equity crowdfunding market. Online platforms deliver access to investment opportunities in private securities and deliver transparency, information, research and processes to protect investors and evaluate the cases around the world.

As long as you take some simple steps to mitigate the risks involved, early stage investing can extremely rewarding and can immerse the investor in an exciting new businesses in which they are financially and emotionally invested.

A report published by the British Business Angels Association (BBAA) analysed 1,080 business angel investments and found that over the period studied angel investors received an average annual rate of return of 22%; compare that to the average deposit account or index tracker fund.

‘a stark fact is that most start-ups fail’

However, a stark fact is that most start-ups fail so an investor’s success depends upon the winners they pick more than making up for the failures the report found that returns from angel investing were not neatly distributed – 9% of the deals returned more than 10 times the original investment and provided 80% of the total cash returned.

As well as the financial returns, those investing in early stage companies are helping to fund the next generation of entrepreneurs – creating jobs and some fascinating companies to boot.
 

Risks of Equity Crowdfunding

There are five principle risks to think about when considering making investments in early stage companies:

Loss of Capital

The majority of start-ups and early stage businesses fail – over 90% of tech start-ups – and in any individual company, it is significantly more likely that you will lose all of your invested capital than that you will see a return of capital or a profit.

Those considering equity crowdfunding should not invest more money than they can afford to lose without terminally damaging their investment portfolio.

Lack of Liquidity

Investments are likely to be highly illiquid which means that you are unlikely to be able to sell your shares until or unless the company floats on an exchange or is bought by another company; even for a successful business, flotation or purchase is unlikely to occur for a number a years from the time of your investment.

Lack of Dividends

Start-ups and early stage businesses are rarely able to pay dividends which means that even if the company you select is successful you are unlikely to see any return of capital or profit until you are able to sell your shares, which may take several years.

Businesses have no obligation to pay shareholders dividends and in this type of business profits are typically re-invested to fuel growth and build shareholder value.

Dilution

Any investment you make may be diluted if the business raises additional capital at a later date and issues shares to the new investors; the percentage of the company owned by early investors is thereby reduced.

The new shares may also have certain preferential rights to dividends, sale proceeds and other matters, and the exercise of these rights may work to your disadvantage; dilution may also result from the grant of options, or rights to acquire shares, to employees of the company or to service providers and other parties closely connected with it.

However, despite the risks, an increasing number of investors are deciding that the physical and spiritual enrichment that can be achieved with equity crowdfunding makes it worth a shot, even if it forms only a small part of their investment portfolio.