Types of investment
Equity crowdfunding explained
By Michael Trudeau
Article 2 of 4
Equity crowdfunding explained
Find out how equity crowdfunding works - and weigh up the risks involved.
Buying shares in companies to get a return on your money isn't new, but doing so via crowdfunding is becoming increasingly popular.
When you buy shares through a crowdfunding platform, you buy a small slice of that company. And if it becomes successful, your shares could rocket in value or you could receive dividends - a share of the profits the company makes.
This guide shows you how equity crowdfunding works, and explores the potential risks.
How does equity crowdfunding work?
Two websites in the UK that allow you to invest in small companies through crowdfunding are Seedrs and Crowdcube. The range of companies listed on their websites are vast - past businesses have aimed to produce everything from new photographic products to rocket-powered aeroplanes for low-cost space tourism.
Each startup decides how much money it wants to raise in exchange for a percentage of its company. The amount you own is proportionate to your level of investment. It works like this:
- A startup is seeking to raise £50,000
- It's happy to give away 20% of the company
- You invest £500, which is equal to 1% of £50,000.
- You'll receive 0.2% of the company as your share, which is equal to 1% of 20%
If a company doesn't reach its intended target by the end of its deadline, the project doesn't go ahead and your money is returned to you.
Go further: Investing in stocks and shares - read our guide to the basics
The high risks of equity crowdfunding
Even if a project is successful in raising the funds, remember that most startups fail, so investing may involve significant risk to your capital. In other words you could lose some, or all, of your investment. And even if a crowdfunded business beats the odds and not only survives but thrives, it could be years before it makes a decent profit.
Here's the lowdown on the main risks of equity crowdfunding.
Risk 1: Your stake will be worth something only when the business floats on the stock market or buys your shares back.
Risk 2: You're also unlikely to receive dividends - a distribution of the company's profits - because the companies involved often don't make enough profit to pay out to shareholders.
Risk 3: It's not easy to sell your shares. There's no secondary market for you to find buyers if you do want your money back
Risk 4: Whenever you invest in a startup company, you need to watch our for something called 'dilution risk'. This happens when a company issues more shares to raise more money, and the value of your investment reduces.
Other types of crowdfunding
There is another type of crowdfunding, commonly called 'debt crowdfunding'. Instead of buying shares in a company you give it a loan, which it repays with interest over time.
One example of such a crowdfunding website in the UK is Abundance Generation. It mainly gives you the chance to fund green and environmental projects.
Debt crowdfunding works like this:
- You invest in a 'debentures' - these are certificates that are like a loan to the company.
- They pay a cash return twice a year, which comprises an income payment - between 6% and 9% of your investment - and a return of your capital across the life of a project.
- Your investment is repaid in equal annual instalments, but this takes place over 20 to 25 years.
But the big risk is that the green project you've invested in doesn't work out. Your returns could be affected if energy output is lower than expected, or there's a collapse in energy prices.
Debentures are regulated by the Financial Conduct Authority (FCA) and, while they can be traded and transferred, there's no guarantee you'll sell them quickly or get your original investment back.
If a project you've invested in is sold to another company, your debenture could be transferred or cancelled.
You can also lend to companies and individuals via peer-to-peer (P2P) lending sites. Read our guide to learn more about P2P as an investment.
Is my investment protected?
The FCA regulates equity crowdfunding sites. This means careful checks on investors must be carried out - only those who understand the risks or have the financial capacity to cope with any losses should be allowed to take part.
As these sites are regulated and authorised by the FCA, you may have access to the Financial Ombudsman Service (FOS) or the Financial Services Compensation Scheme (FSCS), but these protections won't help if you lose money from a risky investment.
Know your rights: Read our consumer rights guide on taking a complaint to the FOS
- Last updated: February 2016
- Updated by: Michael Trudeau