THE BLOG

Crowdfunding: A Lifeline to Small Businesses or an Expensive Way to Gamble?

15/08/2014 14:12 BST | Updated 14/10/2014 10:12 BST

There has been much discussion and significant misunderstanding around the term 'crowdfunding'. It has been presented as a panacea for businesses struggling for financial investment - but it can just as easily be thought of as a money pit for the unwary investor.

There are several different types of crowdfunding: debt; reward; equity.

Debt crowdfunding refers both to secured lending, which tends to be business oriented, and to the unsecured lending to individuals and businesses. Secured debt lending, or peer-to-peer lending, is great for small businesses as it is subject to light-touch regulation and carries less risk for the funders. This type of funding fills a gap in the commercial lending market where banks find it hard to make money servicing the sector. Unsecured lending to business resembles a straight gamble and is not for the faint-hearted.

Reward crowdfunding tends to be for the more artistic type of fund-seekers. Investors are rewarded not by cash dividends, but with something creative - an autograph or a piece of art, for example.

Equity has the highest profile and is arguably the most controversial form of crowdfunding. It allows typically riskier businesses to get funding where they might otherwise struggle. It is, in theory, a great way for the general public to connect with start-up businesses. There is no obligation, however, for the business that receives equity funding to pay the money back. Investors buy a stake in the business in the hope that they will profit from its success. There is of course huge risk involved here and no guarantee that the business will succeed. Failure means that both business and funders will be left with nothing. This form of crowdfunding is based less on science than on hope. Investors should accept that they are most unlikely ever to see a return on their money; the reality is that most small businesses fail.

The general investor rarely appreciates how high risk equity crowdfunding is. But at least equity investment is regulated - an investor can't put more than 10 per cent of their available capital into this type of crowdfunding - because of the real danger of failure.

So why do funders choose to invest in this way? Because they like the product or idea that is pitched to them and want to support a business they believe in? Perhaps too because they think money can be made out of it. But potential equity investors should remember that funding of this type is essentially a lottery. It is best to assume that money will be lost on equity crowdfunding; if there is a healthy return then frankly that is a bonus. The Government deserves credit for recognising this issue and providing tax relief to investors who make such equity investments. These tax reliefs mean that at least 50 per cent of the investment is subsidised by tax refunds; indeed, depending on the circumstances, tax relief can subsidise up to 86.5 per cent of the investment.

For the business being funded, this form of investment is widely welcomed because entrepreneurs can trial their ideas with other people's money.

Despite the pitfalls and warnings though, equity crowdfunding is increasing in popularity. More fun than the Grand National but with less certain rewards perhaps.