Tim Bennett explains why this new method of fundraising has proved so popular and points out the key risks.

Crowdfunding has rapidly become something of a household term within the financial world thanks to some recent high-profile successes, such as beer-makers Brewdog, and some equally high-profile failures. Here is a brief summary of how it works – please speak to an Investment Manager to find out more.

What is it?

Investopedia.com sum it up neatly as “the use of small amounts of capital from large numbers of individuals to finance a new business venture”. In effect, crowdfunding offers both entrepreneurs and potential backers a mechanism by which they can sidestep traditional banks and venture capital and raise money direct from individuals via the internet.

Who are the fund raisers?

They range from start-up entrepreneurs, who may be seeking seed capital for the first time, to much more established businesses that can call on crowd-finance as a way to pay for a specific project and like the potential to raise money more cheaply and flexibly than they can via other sources. It can also be a way to raise a brand’s profile with the retail public.

Who are the backers?

Anyone who commits money to a crowdfunded start-up must be comfortable with relatively high levels of investment risk – you are as likely to lose everything you invest as you are to make any money. Generally investors therefore tend to be individuals risking relatively small amounts although there is nothing to stop someone investing large sums and across multiple projects.

How does it work?

There are several different models, which include donation-based fundraising and peer-to-peer lending. However the highest risk, highest profile version is pure equity-based fund raising. Here backers invest in a project, typically via a website, having seen an entrepreneur’s promotional material and been convinced by the business case. Each entrepreneur will set a target amount they want to raise and a target date by which they hope to raise it – it is then up to investors to decide how much they want to pledge. They, in turn, become equity stakeholders in the fledgling venture and hope to earn a return further down the line if and when a growing firm they have supported is bought out by say a Private Equity House.

What are the risks?

Whilst some high-profile names, such as Brewdog, have made a success of the crowdfunding model, the truth is this is high-risk investing. According to insurer RCA 50% of start-ups fail and if they do there is no FCA compensation scheme set up to repay investors. In short, you should be prepared to lose all of your money, and fast, when naïve or inexperienced entrepreneurs are involved, which is often the case.

What’s more, even if you invest successfully, you could be locked in for years until a buyer is found. As David Gallagher of crowdfunding site Kickstarter puts it; “we therefore encourage backers to do some research on the creator and their project before backing it and to evaluate their ability to complete it”. The problem is that many retail investors may not be equipped to undertake the detailed assessment of a business case that is needed or even have enough information to do so.  So, whilst this is a relatively new, exciting and fast-growing area of investing, this is very much an arena where the “buyer beware” rule applies. Think carefully before committing and only invest money that you can afford to lose.