The wisdom of crowds?
One of the main innovations in both finance and technology over the past few years has been the advent of crowdfunding. Why has it been so popular, what are the risks involved and is it more than just a fad?
THREE MAIN WAYS OF CROWDFUNDING
- Equity crowdfunding involves a company raising finance by selling a pre-determined amount of equity in a business to investors for a certain sum of money.
- Debt crowdfunding is when a company raises money by way of loan to investors who do not receive any equity in the business but do receive a pre-agreed rate of return on the money invested.
- Charitable crowdfunding involves no equity or debt investment; charities raise money for projects from large groups of investors to support their causes.
When a company has needed to raise money in the past, the most popular method for doing so has been to raise a large amount of money from a small group of investors. Crowdfunding, however, is where a company seeks to raise funds by attracting small amounts of money from a large group of investors via ‘campaigns’ run on websites supported by advertising.
Since the financial crisis, it has become very difficult for smaller businesses in particular to raise the money required to expand and grow. As high street banks have withdrawn from corporate lending, a ‘funding gap’ has emerged that has in part, been filled by the meteoric rise of crowdfunding. Additionally, with interest rates at rock bottom for the past six years, investors have been seeking unique returns and are more prepared than ever before to invest money into new types of investments in the hope of achieving a return higher than that offered by their bank account.
The government’s promotion of enterprise in the UK has also meant that over 95% of all equity crowdfunding campaigns attract valuable tax benefits (such as Enterprise Investment Schemes (EIS) or Seed Enterprise Investment Scheme (SEIS) relief which allow for any losses to be claimed back on a tax return) which has further enhanced their appeal. It is against this backdrop that crowdfunding has flourished.
To date, equity and debt crowdfunding has raised a total of £5.8 billion in the UK and the amount of money being raised is growing year on year by over 100%.
There is little doubt that the rise of crowdfunding has played an important role in providing finance since the sharp reduction of lending to businesses began in the aftermath of the financial crisis. The benefits are obvious for the company raising money but can the same be said for the investors? Are the risks considered closely enough and is it all too good to be true?
A 2014 report by Nesta, a charity that works to increase levels of innovation in the UK, highlighted that 62% of all crowdfunding investors categorised themselves as being “retail investors with no previous investment experience”. Attracted to the slick branding of the campaign and efficient technology on the main crowdfunding platforms, investors have been quick to pour money into the companies raising money. However, many investors have not realised that crowdfunding is still a very high risk venture and, as with all forms of
investment, comes with no guarantee of success or even return of capital.
Amongst the main reasons to exercise caution is the price the investor pays for the equity. When a large business seeks to raise money, the numbers used to calculate the value of the business will have been audited and verified by an independent valuer. However, small businesses that seek to raise money will not have the same access to these services and so will therefore need to do a lot of the valuation work themselves, inherently creating a conflict of interest with investors. Ambitious assumptions on growth and limited transparency can affect the value that an investor pays for an equity stake in the business. Coupling this with a very enthusiastic ‘crowd’ means that many companies have been able to raise money at levels that give the company a very full and optimistic value.
Another key risk that investors need to consider is one of dilution. Many of the companies raising money on the equity crowdfunding platforms are high growth businesses in which they expect to go up in value significantly over a very short period of time. To fund this expansion, it is somewhat inevitable that these companies will need to continually raise further funds to maintain their level of growth. The majority of the equity raised on the most popular crowdfunding sites forgo any preemption rights or the ability to prevent your stake in a business being diluted by the company issuing more shares. If a successful company continues to raise round-after-round of new finance, the value of your original shareholding can fall dramatically. There is a small but growing trend of platforms protecting investors from dilution, however the industry as a whole has a poor record of protecting this valuable right for shareholders.
Whilst not all crowdfunding campaigns are run by startups (the average age of a company raising money on crowdfunding platforms is 3.32 years) it is important to remember that the vast majority of startups will fail. Ignoring the protection afforded by the tax benefits, it is very important to consider that there is a real risk of no return of your initial capital on your equity or debt investment and it should be considered as a small part of a well diversified portfolio. The euphoria around crowdfunding has brought a lot of investors to a market that has more ideas than can possibly generate returns on money invested. It should also be noted that over 50% of campaigns never actually achieve their target raise.
Very recently, equity crowdfunding has enjoyed its first ‘exit’ whereby investors have realised a multiple return on their investment in a property business called Mill Residential and just before Christmas, Camden Town Brewery was bought by the giant ABInBev for £85 million giving its investors a healthy payout. Is this a trend though and is the rise of crowdfunding set to continue?
Nick Evans, co-manager of the Polar Technology Fund believes it is:
“We are long-term constructive on alternative lending/finance. Companies in this area are providing funding to new and under-served areas of the economy and are doing so with a radically different cost structure… market penetration is low and we believe online intermediation of small business finance will continue to rise”.
Most equity crowdfunding campaigns have only been completed in the past two years and there is simply not enough data to form a meaningful view on how successful investors have been at backing the right companies and how good the platforms have been at filtering out the best ideas. However, data compiled by AltFi, a research house that monitors trends in the crowdfunding area, believes that the annualised return from the companies that have raised money so far to be 2.17%. Importantly, if you then add in the tax benefits of investing through an EIS or SEIS qualifying campaign, the average annualised return rises very impressively but it should be noted that this is calculated from a very small amount of data. Past performance is not a guide to future performance.
Crowdfunding is undoubtedly a welcome addition to the options available for companies looking to raise money and the effect that this has on the level of enterprise in the UK is a very positive development. For investors, however, it is clear that great levels of caution should be taken when making any form of crowdfunding investment and a reliance on the tax benefits will not be enough to offset the real risk of capital loss.
Please note: This article is for information purposes only. Readers should seek specialist advice for their own circumstances.
Issued in the Channel Islands by Cazenove Capital which is part of the Schroders Group and is a trading name of Schroders (C.I.) Limited, licensed and regulated by the Guernsey Financial Services Commission for banking and investment business; and regulated by the Jersey Financial Services Commission. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.