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What is crowdfunding and how does it work?

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Crowdfunding gives businesses and projects a chance to raise money directly from the public, without going to the banks. And, if you’re an investor, it means you can invest directly in small and growing businesses. However, it can be risky and companies that people have put money into have gone bust.

Q. What is crowdfunding?

A. Crowdfunding allows people to invest between £10 and tens of thousands of pounds in start-up companies or more established businesses that want to expand.

Business owners will give up a share of equity (a percentage of the business they own) in return for an investment. It works on the same principle as the TV programme Dragon’s Den, but instead of seeking funding from four or five millionaires, businesses raise money from hundreds or even thousands of ordinary individuals.

SAVVY TIP: In the United States, the early crowdfunding websites tended to offer a reward rather than a share of the business in return for investing in it.

Q. How can I invest through crowdfunding?

A. There are lots of different crowdfunding websites both in the UK and elsewhere. The UK Crowdfunding Association has a list of crowdfunding platforms that have signed up to its code of practice.

SAVVY TIP: Be aware that only members have signed up to its code of practice. Affiliate members are those that are not yet operational or registered in the UK.

Q. How do I get started?

A. You can choose how much you invest. There’s normally a minimum limit, which can be as low as £5. The business will decide how much it wants to raise and how much of the business it will give up as a result. It will produce a pitch document that you will be able to read.

Q. What happens if the business doesn’t raise the money it expects to?

A. Some crowdfunding websites will insist that a business raises all the money it needs before someone’s money is invested. Others will let the business keep the money that’s been pledged even if the total it’s looking for isn’t achieved.

Q. How risky are they?

A. There are two main risks when invested via a crowdfunding website. The first is that the crowdfunding site itself goes bust and that some or all of your money disappears. This could happen if the site went bust once your money had been invested but before it had been paid over to the business. There’s also a risk that, if the company were to go bust, you wouldn’t be able to access information about your investments.

SAVVY TIP: Check that the crowdfunding website you are thinking of using is a member of the UKFA (the UK’s crowdfunding association). If it’s signed up to the UKFA as a full member it should keep client money separate from its own. It’s worth asking what cash reserves the crowdfund website has.

The second risk, and potentially one that’s far more likely to happen, is that a business you invest in doesn’t deliver the returns it expects, takes much longer to deliver the returns than it said it would or — at worst — goes bust.

As I update this (24 May 2016), it’s emerged that the Solar Cloth Company, which raised £1 million through crowdfund platform Crowdcube in January 2015, has called in the administrators. In February this year a claims management company called Rebus called in the administrators after raising £800,000 on Crowdcube in April last year. And in August 2013, Bubble and Balm, a fairtrade soap maker and an early company to raise funding through the crowfunding website Crowdcube, went bust. It had raised £75,000 in 2011, when it had a contract with a major supermarket, but when the contract was not renewed, its orders dried up.

Q. Are crowdfunding websites regulated?

A. Yes, as of April 1st 2014, all crowdfunding websites operating in the UK must be regulated by the Financial Conduct Authority. Some, such as Abundance Generation, which specialises in renewable energy projects, and Crowdbank, were regulated before then. Regulation by the FCA means there are limits on how much you can invest via crowdfunding (no more than 10% of your money), unless you’re very wealthy or a ‘sophisticated’ investor (ie one who’s invested in risky assets before).

SAVVY TIP: From April 1st 2014 all crowdfunding websites in the UK are regulated, however, money you invest will not be protected by the Financial Services Compensation Scheme in the same way that bank and building society savings are.

Q. Can I invest in businesses that are crowdfunding through an ISA?

A. The rules changed on April 6th 2016 with the launch of the Innovative Finance ISA. That lets people invest in peer-to-peer lending through an ISA. This ISA has the same features and rules as cash and stocks and shares ISAs. In the future, the government plans to let companies that are issuing bonds (IOUs for loans) through crowdfunding platforms to do this via an ISA and it is consulting on whether or not to let people do equity crowdfunding (where you invest in return for a percentage of the company) through an ISA, but it’s not possible yet.

Q. How do I weigh up the risks before I invest?

A. The simple — and slightly glib – answer is only to invest money you can afford to lose. Try and do some research into the business and try and keep in mind that the company I’m thinking of investing in may deliver none of the returns it’s promising.

Related articles:

Understanding dividends – how they can boost your return if you invest in shares

Peer-to-peer savings explained; are peer-to-peer savings safe?

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