Is crowdfunding right for you?

What is crowdfunding? The term "crowdfunding" might at first sound like a buzzword or fad to steer clear of, but proponents argue it can offer intriguing opportunities to catch a rising star.

It falls under the heading of alternative finance, which also includes peer-to-peer lending. The "funding" part of the term refers to the money that startup businesses hope to receive to help them reach escape velocity.

The "crowd" is you, along with hundreds or thousands of other investors, each of whom has a relatively small punt on a number of relatively risky investments.

We have all heard dismal statistics about the percentage of new businesses that last, so why would you ever want to throw your money into something that is more likely than not to fail within the first five years, according to recent research by specialist insurer RSA?

Crowdfunding origins

Well, the dream is to peg your capital to the next Facebook or Apple, or perhaps more realistically the next Innocent Drinks, Brew Dog or Dyson.

The idea is that by investing small amounts with many diverse companies, you are more likely find one that takes off, making up for losses you've incurred on the others. Tax breaks and various methods of vetting companies prior to investment can add to the appeal.

Because crowdfunding involves investing in companies early in their lifecycles - although more at the toddler stage than the infant stage - just maturing to an initial public offering (IPO) could yield returns of 10 times your original investment or more.

Crowdfunding first gained popularity with sites such as Kickstarter, where someone can pitch an idea for a project - anything from an innovative computer game to a cardboard bicycle - and people who like it can pledge to fund it if it reaches a certain level of popularity.

Say someone wants to produce a gadget, and they need £10,000 to do so. If 100 people pledged to give them £100, then the project would go ahead. This is known as reward-based crowdfunding because backers will usually receive some token of thanks, in the form of a T-shirt, gift or influence over the product itself.

For those more interested in the potential of real investment returns there is equity crowdfunding, which is slightly different. Equity crowdfunders are investors looking for positive returns by buying shares.

Crowdfunding is now overseen by the Financial Conduct Authority. Previously, those taking the equity crowdfunding route had to self-certify as either sophisticated or high net worth. Now anybody can invest up to 10% of net assets without having to self-certify.

Investing in these ventures is generally fee-free, as the platform's clients are the companies seeking funding, not the investors. Minimum investment varies: Fireflock requires at least £100, while Syndicate Room and The House Crowd take upwards of £1,000.

Tax relief benefits

Investing in unlisted startups is a highly risky business, more suitable for one corner of your portfolio than for the bulk. But there are several ways in which these risks can be mitigated, or at least made more palatable, including the prospect of tasty tax relief.

There are two specific schemes through which you can gain tax relief: The Seed Enterprise Investment Scheme (SEIS) is for companies at the very start of their lives and offers relief equal to 50% of your investment, while the Enterprise Investment Scheme (EIS) is for firms that are rather better established.

In the case of equity crowdfunder Fireflock, all the companies available for investment are approved as SEISs. Syndicate Room takes a slightly more moderate stance, with most of its companies being approved as EISs.

Goncalo de Vasconcelos, founder and chief executive of Syndicate Room, says: "SEIS companies tend to be very risky, and that is why the government gives such good tax relief for brave investors. There is nothing wrong with that as long as the investor appreciates that it is very, very risky. As EIS covers far less risky companies but the tax relief is still incredibly generous, most private investors go for EIS rather than SEIS."

Another way in which some crowdfunding platforms take some of the sting out of the risks involved is by vetting the firms they host, sometimes using "business angels" - experienced, wealthy private investors who are prepared to put upwards of £100,000, and often their own business expertise, into carefully selected startups.

Syndicate Room places more emphasis on this than most, even going so far as to frame itself more as an angel investment platform than a crowdfunder. De Vasconcelos makes no secret of the fact his company is for sophisticated investors. Although the minimum investment is £1,000, he says the average investment works out at about £15,000.

Exit points

One drawback of buying shares in unlisted startups is that they can be nigh-on impossible to sell. There are three typical exit points: when the company is acquired, when it lists on a stock exchange or when it goes bankrupt.

Late last year Syndicate Room had its first success, in the form of Mill Residential Reit (MRR), which floated on the Alternative Investment Market. De Vasconcelos claims this is the first instance of a crowdfunded company reaching listing stage. As of 7 January, shares were trading at a 10.5% premium compared to its share price at the crowdfunding stage.

But he says this is a special case because of the nature of the company - it buys properties and pays dividends from rental income - so the uplift is less than for a tech startup, for example.

According to de Vasconcelos, an IPO "results almost always in a huge return for early investors", up to 10 or even 30 times their original investment. An acquisition would likely be quite profitable as well, but tends to be far more varied and unpredictable.

However, acquisitions also tend to happen more quickly than IPOs. He adds investors should expect to remain invested for between three and five years, the time frame over which a startup typically looks to sell or list.

Callum Campbell of Fireflock is meeting this problem head-on, with plans to launch an eBay-type online exchange, the "Flock Market", for investors to buy and sell unlisted shares on the Fireflock platform.

What else is out there?

Shares in unlisted startups are not the only asset available through crowdfunding. The explosion in the market has brought a wave of innovation, with access to investment in assets from aircraft (Ablrate) to invoice factoring (Market Invoice), to bricks and mortar (The House Crowd).

The House Crowd is a fresh idea that gives people access to the property market without having to buy an entire house. It finds properties for sale that it believes will increase in value or can be fixed up and re-sold, and creates a company specifically to buy each property. Investors buy shares in the company and receive a proportion of the rental income and eventual sales profits.

Like so many crowdfunding platforms, The House Crowd is a fledgling venture in unexplored territory and is still evolving. For example, it had to scrap a previous offer of "fixed" returns - which included an extra 1% per year if you referred a friend - because it was 'creating a rod for its own back'.

It still offers a fixed income-type product promising to pay between 7.5 and 10% per year, but now focuses on an equity set-up whereby investors take three-quarters of net profits.

Although property prices are anything but certain, founder Frazer Fearnhead claims investors "are looking at a typical annualised return of 17 to 18%, of which we take 25%".

The House Crowd has been growing rapidly and claims to have paid out every single dividend on time without issue. Like so many of these new ventures, however, time will show whether Fearnhead's model is genius or madness. The same can be said for the fast-growing crowdfunding industry as a whole.

SEIS and EIS tax breaks

You can invest up to £100,000 in total across any number of SEIS-approved companies within a single tax year. Any given company can raise a maximum of £150,000 through the scheme. Although only a minority of companies will go on to succeed, you would be in line for tax relief equal to 50% of your investment.

So if you put £10,000 into 10 different SEIS-approved companies, you would receive £5,000 of your income tax bill. Companies can only qualify for SEIS if they are based in the UK, have been incorporated for less than two years, employ fewer than 25 people and have assets of no more than £200,000.

The rules surrounding EIS are a bit more lenient. Although EIS investment "only" offers 30% tax relief, each investor can claim up to £1 million in tax relief each tax year, provided they hold the shares for at least three years after issue.

If, when you finally do sell the shares, you make a loss, you can set that amount against income made in the year, less any income tax relief.

For more information visit the UK Crowdfunding Association.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.