Crowdfunding: cash cow or too good to be true?
10:05 09 March 2016
Crowdfunding has enabled anyone to become an investor, just by choosing a business online. But how risky is it? SABAH MEDDINGS reports.
Once upon a time, launching a new business depended on personal wealth or a visit to the bank manager, cap in hand, to ask for a loan.
But in a volatile economy, bank funding can be difficult to secure - especially for the thousands of young entrepreneurs without the cheap houses their parents had to use as security.
Today’s digital natives look to the power of the internet to raise vast sums of cash through crowdfunding – either asking for donations, borrowing money or offering shares in their start-ups.
It is an arrangement that gives them easy access to capital, and offers investors the alluring prospect of owning a slice of the next big thing – but is it too good to be true?
Dr Dimitrios Dousios, lecturer in entrepreneurship at the UEA’s business school, said it was no “silver bullet” for achieving a high return on investments and business success, but its growth was easily explained.
“On the one hand, every single aspect associated with bank funding is slow to move,” he said.
“With bank funding, to have access to start-up capital you have to keep up with regular payments.
“It is also down to the power of the new IT platforms which empowers individual entrepreneurs.”
Mark Addley, director at PwC, said crowdfunding was attractive because it can involve a tiny fraction of the equity a venture capitalist or business angel would typically demand. “Managed well, the fundraising exercise doubles as a targeted marketing campaign - every new investor is a potential brand champion, with their loyalty reinforced both by a sense of ownership, and by exclusive discounts and special promotions,” he said.
Equity-based crowdfunding is the most problematic due to the valuation of the business in its initial stages. Investing in an over-valued business can lead to losses, even if it is a success.
And the Financial Conduct Authority has warned investors it is likely they will lose all their money - as most start-up businesses fail.
But crowdfunding continues to grow, often with private investors who have seen little return on saving due to low interest rates.
In 2015 the UK online alternative finance sector grew 84pc, and equity crowdfunding now accounts for 16pc of UK early-stage and venture-stage equity investment.
However, little is known about the success rates of crowdfunded businesses, and it is largely unregulated.
Richard Ross, director of Norwich-based wealth management firm Chadwick’s, said he did not recommend it to his clients. “One of the concerns we have whenever there are returns above market rate is it probably means there are risks people haven’t appreciated,” he said.
And the concern with private equity was exit strategy, he added. “Even if the company is successful, unless it is successful enough to be listed on the stock market it can be difficult to take the money out.”
TSB chief executive Paul Pester told the EDP in an interview last year that peer-to-peer lenders would struggle to survive the next downturn.
“Anybody can lend money when the economy is running smoothly and when the economy is benign,” he said. “I’m really nervous that some of those customers who are putting in their money don’t realise that if one of the customers can’t pay the money back, it’s them that takes the loss.”
A report from AltFi Data and law firm Nabarr studied 367 businesses which raised money on the five biggest crowdfunded websites - Crowdcube, Seedrs, SyndicateRoom, Venture Founders and CrowdBnk.
It found 70 of the firms were either no longer trading or experiencing difficulties likely to result in investors losing all their money, while 80pc were still in business. Just 22pc had realised a return for their investors.
But Cambridge-based SyndicateRoom appears to have had more successes. Out of more than 70 companies it has found investment for, just two have failed.
It works by allowing private investors to invest alongside professional investors, and share the same risks and benefits.
Founder and chief executive Gonçalo de Vasconcelos said: “I think we are barely scratching the surface.”
He said 80pc of funding rounds that went live on the site were successful.
And tax relief initiatives such as the Enterprise Investment Scheme which allows an individual to invest £1m in any tax year and receive 30pc tax relief have added to the momentum.
Away from the high-risk investments of equity and peer-to-peer lending, Norwich-entrepreneur Edwin Bailey has launched a new site, reward-based Blossom Zone.
He hopes the platform will help businesses in Norfolk and Suffolk to finance start-ups, with an emphasis on rural businesses and tourism.
Case study: Droplet
Mobile-payment app Droplet, which launched in Norwich, launched a crowdfunding bid last spring to raise £500,000 in exchange for a 12.5pc stake in the company.
More than 300 people invested between £10 and £200,000, which allowed the company to take on staff and roll out into cities across the UK.
For founder Steffan Aquarone, pictured, who used Crowdcube, it meant larger investors he had already lined up invested on the same terms as shop owners and customers.
The app, which is free from fees, builds a revenue from monthly subscriptions which retailers pay to run their loyalty programme through the app.
When customers pay they press a button and their face and name appears on the merchant’s screen so they can be charged and given their stamps.
It is now making a profit, and Mr Aquarone said he would soon be ready to launch the next stage of funding, to scale the business up further.
“It wasn’t the only way we could have raised money,” he added. “About two thirds of the money was arranged by us. But we felt we wanted to give our customers and merchants a chance to own a slice of the business.”
Mr Aquarone said the money from users showed a great belief in the business. “They wanted a piece of it regardless of who else was in,” he added.
Types of crowdfunding
Donation-based crowdfunding is a way to source money for a project by asking a large number of contributors to donate a small amount to it. These are given as gifts with no expectation of a tangible return. The average amount of money raised this way is £6,000, according to Dr Dimitrios Dousios of the UEA.
Reward-based crowdfunding. In this case, contributors can expect a prize, such as a free service from the company, invitation to a launch night or first use of a facility. This is particularly popular with the creative industry.
Debt-based crowdfunding, also known as peer-to-peer lending. Dr Dousios said this typically takes the form of a loan, and can be many small loans taken from a crowd. The danger here is if a company fails to be a success, investors can lose all of their investment.
Equity-based crowdfunding. Shares are sold to investors in return for cash. Businesses usually undergo extensive due diligence.
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