Tempted by crowdfunding? Nine key rules
It offers access to the firms of the future but it’s very easy to lose your cash. Jane Wallace explains what to consider before you invest
As well-established companies suffer stock market wobbles amid the current uncertainty, some investors may be looking for alternative places to put their money. One (risky) option is to bet on the embryonic firms of the future before they list.
An easy way to invest in these companies is through crowdfunding, where small amounts of money are raised from a large number of public investors. It is often used by entrepreneurs seeking funding for projects in their early stages.
This kind of fundraising has gained a higher profile thanks to some successful campaigns. Revolut, which issues prepaid currency cards, raised £4m last year on Seedrs, a crowdfunding website, while beer maker BrewDog clinched £10m through a mini-bond sold on Crowdcube, a similar site.
Robin Vaudrey, who works for the European Investment Fund, a venture capital firm, has invested via crowdfunding since 2014. His holdings include Oppo, which makes ice cream with 60pc less sugar than regular brands. Not all of his holdings have been successful. For example, the founder of one, Giftgaming, fell ill and the firm collapsed.
Mr Vaudrey’s advice to beginners is to ask questions of the website, other investors and especially the entrepreneurs, to invest only what you can afford to lose, to diversify, and to be patient about returns.
There are dozens of platforms that host thousands of hopeful companies. The reality is that lucky winners will be vastly outnumbered by losers, such as restaurant group Square Pie, which collapsed this year after rising rents and falling trade killed its business.
It won’t be the last. Only 6pc of the companies funded via Crowdcube have generated any return.
Alex Davies, founder of Wealth Club, an investment broker, said: “These companies aren’t really vetted, so you’re taking a lot of risk. You need to think of it as a punt, not an investment.” The City watchdog, the Financial Conduct Authority (FCA), said in April that it was looking at how to better regulate crowdfunding.
The odds aren’t good, but there are companies that do well. How can you pick out the good from the bad? There is no secret formula, but the following nine points could help you avoid basic mistakes.
A company will ultimately succeed only if the product or service it is selling is worthwhile. Testing (or tasting) the goods yourself is useful research. If you rate the company’s proposition, others probably will too.
Quality of management
The calibre of the people in charge and their experience are crucial. “Lots of people can have ideas, but far fewer can execute them,” said Mr Davies. “You’ll want to know if they’ve done this or similar before. You don’t really want people experimenting with your money.” Check the information given about the directors and their background.
Ben Yearsley of advice firm Shore Financial Planning said he wanted to see managers’ own money on the line. He gave an example where the founders had contributed nothing yet allotted themselves a 75pc stake in the firm. “That, to me, is a big ‘no’,” he said. “I’m always looking for management to be on the hook for a serious amount. It might be working for nothing for two years, or committing £100,000.”
A start-up must be able to stand out from the crowd. If many others offer the same thing, the firm will struggle. Exclusive deals with retailers or distributors can help.
Mr Davies said high-margin businesses, such as a veterinary hospital, usually had better chances of success because the specialist knowledge and larger commitments of capital required were harder to match.
Identifying the real worth of a start-up is complicated because there is no “one rule fits all”. Those familiar with price-to-earnings ratios or profitability measures like “Ebitda” could use them to make comparisons with similar businesses; bear in mind that technology firms tend to have higher valuations.
Common sense is key. There may be data on past revenue, profits and projected earnings. Mr Yearsley said: “You need to look at the history of the business. If turnover has gone from £100,000 to £250,000 to £500,000 in the past three years and management predicts £1m this year, maybe a high valuation is justified. But if turnover is falling you should question a high multiple.”
Companies seek capital to help them grow. It is up to the investor to decide whether the stated targets are realistic. Check how quickly the firm’s profits are growing and consider whether it’s operating in a growth market. “For a small company with an interesting product, 10pc growth a year is easily achievable, but 100pc is more of a stretch,” said Mr Yearsley.
With failures so common, it makes sense to spread the risk between lots of companies.
Kirsty Grant, investment director at Seedrs, said: “This is why we have the £10 minimum investment. Even if you have only £100 to invest, it still means you can divide it between 10 companies, not just one or two.”
Mr Yearsley’s advice is to decide the total amount you want to invest in crowdfunding and then spread it among at least 20 to 30 companies.
Getting your money back can be problematic: dividends are rare and although there are nascent “secondary” markets, selling your shares can still be difficult. A float or a takeover, if it does happen, could take five or 10 years to emerge. Whether the company will be attractive to future buyers should be a central pillar of your selection process.
Popular deals can sell out quickly. Monzo, a “challenger” bank, raised its first target amount in just 96 seconds, leaving many disappointed. Luke Lang, co-founder of Crowdcube, said: “Most companies don’t fund at that rate and you do get a chance to ponder the documents in advance.” His advice for staying ahead of the pack is to sign up to the websites’ email newsletters.
Charges and taxes
Most crowdfunded companies are structured via the Enterprise Investment Scheme (EIS) or Seed Enterprise Investment Scheme (SEIS), both of which carry healthy tax perks. An investor in the EIS can knock 30pc of the value of their investment off their income tax bill. For the SEIS it’s 50pc.
There are still fees to pay. Seedrs charges investors 7.5pc on any return and takes 6pc of the amount each firm raises. Crowdcube takes 7.5pc of funds but there is no charge to investors.
Both websites undertake some due diligence, but they do not accept liability for it and there are gaps, especially in verifying ownership of assets and historical finances. The shortcut is to pay a manager such as Wealth Club, which has access to portfolios of vetted EIS schemes for a 3pc-5pc initial fee and 2pc annually. Kuber Ventures has a similar offering.
Justin Modray of Candid Financial Advice said: “Crowdfunding remains a niche investment and I wouldn’t risk more than a small part of an overall portfolio on it.”