Crowdfunding rules could back-fire, says Jeff Salway
IT IS a high-risk gamble and you’re “very likely” to lose all your money, yet the crowdfunding boom continues as one of the sector’s biggest names targets investors in Scotland.
Equity-based crowdfunding platform Crowdcube opened a new office in Edinburgh last week as it aims to increase the number of Scots investing in local start-ups.
However, this month also marks the start of a new regulatory regime that seeks to bolster protection for investors and raise awareness of the risks of crowdfunding investments. The new rules include restrictions that crowdfunding firms fear will deter small investors.
There are two forms of crowdfunding. The best known, and by far the most popular, is peer-to-peer lending, where individuals use services including Zopa, RateSetter and Funding Circle to lend to each other or to businesses in return for interest rates higher than those currently paid by ordinary savings accounts.
The other type is equity- or securities-based crowdfunding. This approach, developed in the US and now growing rapidly in the UK, allows fledgling businesses to make a pitch to potential investors in a bid to win funding.
Investors who contribute can opt for different levels of involvement and reward, typically receiving shares. When the business succeeds the returns can be eyecatching. In the event of failure, however, investors get nothing and risk losing all their capital.
East Fife Football Club recently used the Squareknot crowdfunding service to raise revenue to improve its ground, while Scottish beer maker BrewDog last year broke the UK crowdfunding record when it raised £4.25m through its “Equity for Punks” scheme.
Most equity-based crowdfunding in the UK is conducted through services including Crowdcube, Seedrs and Banktothefuture. Crowdcube recently reported it raised as much investment in the first half of this year as in the whole of last year.
Research conducted ahead of its Edinburgh launch found that while more than a third of Scottish investors had heard of crowdfunding, 70 per cent would use either their bank or a broker if they were to invest in a start-up.
Darren Westlake, Crowdcube chief executive, said: “Scotland has a very strong entrepreneurial and investment culture, but there has been no strong crowdfunding presence until now.
“Scottish companies are no different to any other start-up in looking for ways to finance their business – and like any other business, they have found it increasingly difficult to raise money through traditional routes like banks during recent tough economic times.”
But rules that came into force on 1 October could make life more difficult for both investors and crowdfunding platforms, experts say. Among the safeguards introduced by the Financial Conduct Authority (FCA) are a 10 per cent rule, which stipulates that investors not certified as “sophisticated” or “high net worth” must invest no more than a tenth of their net investable assets.
The regulator had warned the prospect of strong investment returns could blind investors to the risks of crowdfunding. The biggest and most obvious risk lies in the remote chances of a start-up proving a success.
However, investors unable to demonstrate they are sophisticated or high net worth will be deterred entirely, said Barry James, founder of the Crowdfunding Centre.
“The FCA rules are very unclear and make it needlessly difficult for both investors and the equity crowdfunding platforms,” he said. “It should be as friction-free as possible for all concerned, especially small investors.”
Crowdfunding’s appeal lies largely in giving people the chance to invest in something they care about, such as “local businesses you know and trust”, said James. He cited green technology, where investment may be driven as much by a desire to see progress and success as a return.
“Apart from the opportunity to invest small amounts efficiently and spread risk it does mean that you can try your hand without risking much cash and learn a lot in the process,” he added. But the high chance of failure isn’t the only downside. Dividends are rarely paid on shares held in a business or project, diluting the appeal for those who want income, while the value of the investment can be reduced if the start-up issues more shares.
The regulator said those that do invest through crowdfunding should carry out due diligence on the business or the project concerned to ensure they understand the risk being taken, and the value for money offered by the investment, once tax, charges and the allowance for defaults are fully taken into account.