Run, don’t walk, from equity crowdfunding

Equity crowdfunding is a kind of very basic stock market for tiny startups. It looks interesting, but here’s why equity crowdfunding is a total disaster.

It’s fintech week at Risk and Reward!

On Tuesday I explained the ins and outs of peer to peer (P2P) lending. On Wednesday I talked about the explosion of interest in p2p, and the race to get regulated in advance of the first “innovative finance” ISA. And yesterday I explained why some people are worried about it.

Over the week I’ve occasionally dropped the word crowdfunding, because it’s often used interchangeably with peer to peer lending. But they tend to refer to different things.

Peer to peer lending is what it sounds like: when a saver loans money to a borrower. In the case of Funding Circle, which is one of the biggest and best established P2P lending sites, companies do the borrowing. So it’s a sort of high tech, high yield corporate bond market for ordinary investors. Which is pretty cool. It pays good interest and so far investors have gotten what they were promised.

The word crowdfunding usually refers to something different though. It’s about buying equity, or shares, in a business. Equity crowdfunding is a kind of very basic stock market for tiny startups. These companies truly are tiny – usually they’re miles away from floating on the real stock market.

And it does look interesting… a chance to get in at the ground floor with a fledgling business, like an angel investor.

The financial press is full of stories about unicorns, ie mega-valuable private startups, and their angel investors. The top Angel investors do very well for themselves.

A report called “Siding with the Angels” shows that in the UK between 1998 and 2008, 1080 companies were backed by Angel investors. Over 10 years, the investors came away with a whopping 22% per year. The dream of equity crowdfunding is that an ordinary investor could pull off the same trick.

But…

This article is here to disabuse you of the idea! Equity crowdfunding is a total disaster. Here’s why.

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Very briefly, here’s how equity crowdfunding works: a company sets a funding target of say £100k. Ordinary investors can size the business up and if they like it, back it with as little as £10. If the business attracts £100k worth of funding, it keeps the money and the investors get shares in the business. If it doesn’t make its target, the investors get the money back.

So far so good. But the problems come after that. If the startup simply fails, then the investors obviously lose their money. But even if a startup survives, it usually goes back to the market for more funding in exchange for more of its equity. And the crowdfunder’s share gets watered down.

On the biggest exchange, Crowdcube, investors normally get “class B” shares. Class B shares have no voting rights, so they can’t prevent themselves from being diluted. That’s where crowdfunding differs from the big shot angel investors who’re backing Uber, AirBnB and Facebook.

The net result is that on average, Crowdfunding simply doesn’t work. The FCA doesn’t pull any punches:

“It is very likely that you will lose all your money. Most investments are in shares or debt securities in start-up companies and will result in a 100% loss of capital as most start-up businesses fail.”

Pretty emphatic! And how about this – The Sun’s former editor, Kelvin MacKenzie, alleges that Crowdcube encouraged companies to add to their own fundraising bids, in order to trick the public into thinking they were more popular than they really were.

There’s a better way

I absolutely understand why investors get involved with equity crowdfunding. It promises riches. And it’s fun! As Ashley, a reader, wrote in yesterday,

“I am aware that most small business or start ups fail but as part of my portfolio there is no better feeling than seeing something you have invested in start to take off, way before it was picked up by the crowd.

I have my boring blue chip dividend stocks but they offer none of the buzz of crowdfunding a new and exciting idea.”

If you have a big risk appetite, and you’re looking to scratch that itch, I have some alternatives. The first is peer to peer lending on one of the big established platforms. It’s not an equity stake so it’s never going to make you rich. But if you’re up for taking a risk, it’s possible to make a very healthy 8-10% return on the riskier peer to peer loans.

The second alternative is to invest in small companies properly.

Forget about dicey class B shares in a company you know very little about. Buy shares in promising small businesses on the public markets. And take the advice of a full time expert whose only job is to find them.

Thanks for all your email this week, I got more than I could publish. But I’ll make sure to get back to each of you. If you’ve got a comment on today’s article – and particularly if you’ve managed to invest successfully in an equity crowdfunding scheme – I’d love to hear from you! sean@agora.co.uk

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