How you could invest in the next Facebook before it goes public

Sensible investing is about getting rich slowly. You save every month, you diversify, and you invest for the long run, using cheap tracker funds where possible.

But we all dream of investing in one of those life-changing stocks a company that multiplies your money many times over, turning even a tiny speculative punt into a small fortune.

If you want to make those sorts of big returns, you have to take big risks. And the riskiest businesses of all are those at the earliest stages the start-ups.

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Facebook is a good example. One venture capital firm invested $90m in the social media giant back in 2009. That stake is now worth around $3.5bn.

I'm not suggesting that all start-up investments will perform as well as Facebook. Far from it. In fact, most will fail. That's why you should only ever speculate with money you can afford to lose.

But if you like the idea of using a small part of your investment portfolio as your very own venture capital fund, then I might just have the answer for you.

It's called equity crowdfunding...

How equity crowdfunding works

Equity crowdfunding is new and risky let's be clear about that. But the potential returns are big.

Here's how it works. Young companies effectively advertise for investors on one of the crowdfunding platforms. The best known UK platforms are Seedrs and Crowdcube.

If you've ever used a peer-to-peer lending site such as Zopa, it's a similar idea. But rather than a loan, these companies are looking to raise equity.

The young companies say how much money they're looking to raise, and how big a stake in the company the new investors will receive in return.

For example, right now a company called AngloBuddy is looking for investors on the Seedrs platform. AngloBuddy wants to create new video content for people who are learning English around the world. It is seeking a total investment of £25,000. In return, the new investors as a group will get a 10% stake in the company.

A company needs to raise its target investment within 90 days of appearing on the Seedrs site. If the target is missed, no investments are made, and investors keep their cash.

Investors don't have to pay any upfront charge when they invest. Instead, the entrepreneurs have to pay a 7.5% charge once their cash target has been hit.

If any shares in the investments are sold at a later date, Seedrs will take a 7.5% cut from the investor's profits.

Crowdcube operates in a similar way. The great thing about both sites is that you can invest as little as £10 in any one company. Looking at the sites right now, I'm drawn to several potential investments.

On Crowdcube, I especially like Habhousing, which has been founded by Kevin McCloud of Grand Designs fame.

Then on Seedrs, I particularly like goCarShare which makes it easier for drivers to share their car with other users and cut their travel costs.

What are the risks?

The small minimum investment level means that you can easily spread your money around ten or even 20 investments without betting the house. That means there's a decent chance that at least one of your investments will prosper and you could potentially make an overall profit.

That said, there's also a decent chance that all of your investments will fail. And even if you invest in a company that succeeds and becomes profitable, you could still lose out.

That's because other investors may come in at a later stage and dilute your shares down to a ridiculously small percentage of the total share capital.

The Financial Conduct Authority (FCA) is certainly aware of these risks, but the regulatory picture is a little confused at the moment. As things stand, most crowdfunding sites insist that you're a sophisticated investor before they'll let you part with any money.

And in response to regulatory pressure, Seedrs encourages investors to invest at least £1,000 in total across a range of companies by the end of their first year. It may start reviewing client portfolios in the future to check that investors are hitting that target.

However, the FCA will report the results of a consultation later this year. I think there's a good chance we'll then see simpler rules across the whole industry.

Which sites are best?

It's worth looking at two other crowdfunding sites: Syndicate Room and Crowdbnk.

Syndicate Room differs from the rest because its minimum investment size is much larger at £500. That makes it harder to reduce risk, but the attraction is that all investments on this platform have an experienced business angel as a lead investor' on the project.

So if you invest via Syndicate Room, you know that at least one experienced angel is positive about the investment.

Crowdbnk is interesting because it doesn't just offer equity crowdfunding. There are some potential investments on the site where you'll receive a reward' rather than shares in return for your cash. So if, for example, you invested in an art gallery, you might get discounts on any art that you bought from the gallery.

There are also crowdfunding sites where investors are lend money to businesses rather than buying shares. Two well-known sites in this sector are FundingCircle and Abundance Generation.

But my personal preference is for equity crowdfunding because that's where the biggest potential profits lie. Indeed, one report suggests that if you had invested across 1,080 early stage UK businesses between 1998 and 2008, you could have achieved a 22% annual return.

I also like the Seedrs platform because I like the simple nominee structure for investors. In short, you as an investor won't get voting rights in any company where you invest. Seedrs does all the work for you.

You might see that as a bad thing. But at this level, I think that being represented by the platform itself, rather than scattered among many small individual holdings, means that private investors are less likely to be treated badly by other stakeholders in the business. That at least offers some sort of defence against the risk of dilution.

We'll be looking at crowdfunding in more detail in a future issue of MoneyWeek magazine. If you're not already a subscriber, subscribe to MoneyWeek magazine.

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