Investing in crowdfunding schemes: Is it a good idea?
What are the benefits and risks associated with investing in crowdfunding?
In recent years, “crowdfunding” has become a big buzzword: giving cash-starved startups an opportunity to connect with interested consumers directly. Not only can this help entrepreneurs maintain greater control over their businesses, but it can enhance customer loyalty and result in meaningful contributions that enhance an end product.
At the same time, many hopeful investors have seen their money disappear down the drain, as startup firms raised money via glowing prospectuses that promised fortunes but delivered only dust and dry leaves.
A myriad of crowdfunding platforms have popped up in recent years, driven by a motivation to democratise investing and support young companies that have struggled to attract financing through more conventional means. However, although opening up opportunities beyond sophisticated investors and high net worth individuals sounds like a good thing, some regulators have been keen to stress that these restrictions are in place for a reason.
Back in July, the UK’s Financial Conduct Authority (FCA) wrote a letter to the CEOs of crowdfunding investment sites, warning that, despite a range of marketing restrictions, “too many consumers are still investing in inappropriate high-risk investments which do not meet their needs”. Some firms have been accused of failing to verify a would-be investor’s knowledge and experience too, meaning they can “click through” without fully understanding the risks.
Warning the CEOs that they will be held accountable if expectations are not met, the FCA said platforms must be clearer about the due diligence that has been taken into the projects they promote. This is in the hope that investors are alerted to situations when further research may be required. CEOs were also told to take “reasonable steps” to reduce the risk that consumers hold more than 10% of their portfolio in these “high-risk, speculative investments”.
In the US, the Securities and Exchange Commission (SEC) has also been taking action. In September, the regulatory body launched legal proceedings against three people who were accused of raising $2m through two fraudulent crowdfunding schemes. This is believed to be the first case of its kind to be brought in the US. In separate developments, the SEC dramatically increased the maximum amount a company can raise, from $1.07m to $5, and relaxed the rules surrounding how much non-accredited investors can spend. This could fuel greater interest in crowdfunding, both from US businesses and consumers.
But should you invest in crowdfunding projects, what are the risks, and are there any data surrounding the success of the fledgling businesses that raise money this way?
Investing in crowdfunding: The statistics
According to the Crowdfunding Centre, just 23.4% of projects end up being fully funded – and for those that do reach their targets, an average of $107,334 (£77,758) is raised. The typical project receives financial support from 333 investors, with each making an average pledge of $322 (£233).
Data from Kickstarter gives insight into which sectors tend to enjoy the most success during a crowdfunding investment campaign. Projects related to music, film and video, games, and art make up the lion’s share of those that hit their target, and those related to games were the most likely to raise more than $1m. Of those that did not end up getting fully funded, most were in the sectors of film and video, technology, publishing and games.
What is crowdfunding and how does it work?
Before we delve into top tips, and give you some crowdfunding examples, here is a brief recap of how investing in crowdfunding works.
Those who participate in a raise may receive securities in return, such as stock or shares in the future, and will gradually be paid back when the company is profitable. Alternatively, they may be rewarded with products and other merchandise if the project is successful. Some existing companies also issue bonds that pay interest annually or semi-annually until maturity, occasionally offering additional perks.
On some crowdfunding sites, projects can only proceed if they fully reach their funding target. Failing to raise the amount required on time typically means that funds will be returned to investors.
When learning how to invest in crowdfunding, it is worth making sure you go through a reliable platform with a record of bringing projects to fruition. You should also double check to see if any additional documents have been provided by a startup, such as business plans, projections or feasibility studies. This will help you make an informed decision on whether an idea is viable. Most of all, it is vital to remember that you could lose your entire investment if the company goes bust.
There have been a number of success stories through crowdfunding… and a fair number of horror stories. Some of the projects that have managed to raise the most capital include blockchain platforms such as Ethereum, EOS and Filecoin, all of which embarked on initial coin offerings. Meanwhile, the Kickstarter campaign for the Oculus Rift headset ended up raising $2.4m, almost ten times more than the target of $250,000, the company behind it was later bought by Facebook for a cool $2bn.
On the flipside, some of those who bought “burrito bonds” offered by the Mexican restaurant chain Chilango were left with a difficult decision to make. After entering into a company voluntary arrangement, the company told investors they could either hold onto their bonds in the hope they would receive an 8% dividend in future, or cash out and receive 10p for every £1 in their investment.
Meanwhile, The People’s Energy Company raised about £490,000 in July 2017, promising to offer transparent tariffs and return 75% of profits to customers. Those who pledged more than £10,000 were told they would receive free energy for 15 years but in September 2021, the company became one of the first of many suppliers to go bust as energy prices soared.
The exact number of crowdfunding platforms is difficult to quantify. However, some of the better-known brands include Kickstarter, Indiegogo and Patreon.
Aside from the fact that businesses can fail, there are other risks you should take into account before you invest in crowdfunding. Even when a company proves successful, there’s a chance you may not receive dividends for years in the event that profits need to be reinvested to help the firm grow. These investments can also be rather illiquid and difficult to sell. Also bear in mind that the crowdfunding campaign may be the first of multiple funding rounds, and as a result, your stake in a company could end up being diluted over time.
It can be, but such investment decisions should not be taken lightly. Make sure you do your research into the company and the sector it operates in, seek financial advice and treat crowdfunding opportunities as a modest part of a wider, diversified portfolio.