Crowdfunding takes Dragons’ Den into the mainstream

And you're the Dragon. You'll have to be hard-nosed toearn good returns

When covering crowdfunding, the media tends to focus on racy, innovative, or fun campaigns: my own favourite story was when one entrepreneur' tried to raise money to fund the making of their own potato salad. Yet this type of story obscures the volume of exciting new businesses and inventions being funded every week.

My colleagues at AltFi Data reckon that crowdfunding platforms such as Crowdcube, Seedrs and SyndicateRoom have helped raise over £50m in equity for new businesses in the UK, as of October 2014.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

In fairness, that's still small change compared to traditional venture capitalists (who probably invest about £350m a year in early-stage businesses) and more experienced angel investors (running at £850m a year).

It's also tiny compared to the money flooding into peer-to-peer (P2P) loans, which, according to AltFi Data, has topped £2.1bn to date.

But there's good reason to think that crowdfunding will see explosive growth in the years ahead, for reasons explored in a new book called The Future is Small, from investment manager Gervais Williams of Miton.

The key catalyst is our broken financial system. Williams argues that since the global financial crisis we have not cracked our addiction to debt. Yet banks and institutions have pulled back from lending to and investing in small firms because they can so easily lend to large corporations through liquid bond markets.

Williams says this will change over the next decade as low growth rates and deflation (due to deleveraging) kick in. So the future lies in providing equity funding to tiny firms ant-sized businesses, as Williams calls them.

Williams' preferred market place' for this activity is Aim. On this point, I think he's wrong: Aim is a failure.

While Gervais valiantly talks up the decent contingent of well-run smaller businesses listed on the market, the market overall is flooded with poor-quality stocks: technology, mining and energy start-ups designed as vehicles for investors to lose most of their money. Instead, I reckon that crowdfunded online market places represent the real future for small business funding.

For now, the likes of Crowdcube are focused on very early stage companies. But as they and their funded businesses mature, we'll start to see growth in private markets for buying and selling existing shares in these companies. These markets will also host more robust businesses looking to trade shares and raise capital away from Aim, and at a lower cost.

Already, platforms such as Asset Match and BritDAQ have emerged to provide a secondary market for established businesses. I imagine that Crowdcube and Seedrs will probably soon run their own secondary markets for investors looking to sell on shares in established, profitable businesses.

This will give private investors an exit route for their investment, and also provide important valuation metrics for their crowd-based shares.

Within the next ten years, crowdfunding should be a perfectly respectable asset class. It will probably form a large share of an allocation to venture capital, private equity and micro small caps that might be worth anything from 0% to 15% of private investor's portfolios. The generous tax incentives that are available, which can be worth as much as 50% of an investment, can only help with this.

Given this potential, how should investors approach the crowdfunding sector? The key basic principle is to be data-driven, listen to the hard facts, and don't be emotional. The statistics tell us that investing in early-stage businesses is very tough and often leads to losses. But I'd maintain that if you are hard-nosed, there is good money to be made.

A UK Business Angels Association report from a few years back looked at what you could call the special forces' of early-stage investing angels. These wealthy, largely male, older, experienced investors have, in effect, been crowdfunding for many years.

Among this group, very experienced super angels' may be investing in as many as eight to ten deals a year, but even less-experienced angels are investing in three to five deals, with an average investment per angel per deal of around £40,000.

Of these accumulated deals, 56% had been a loss, with the vast majority a complete wipe out. But 44% of deals made a gain, 35% of those a gain of between one and five times the original investment, and 9% producing ten-bagger' gains (meaning they are worth ten times their original price).

This backs up US research that suggests that 10% of all exits produced 90% of the total gains. On average, investments over a three- to five-year period produced a total return of 2.2 times the initial capital.

Looking at what the angels invested in is revealing: 23% went into seed funding, 14% into start-ups and 53% went into slightly more established early-stage businesses. Internet, technology, and media businesses accounted for the lion's share of the money invested.

These numbers won't necessarily apply to crowdfunding most angels are more cautious and can deploy very large sums, compared to the hundreds of pounds wagered by most online investors. But they do give us three important lessons.

The first is that you should expect failure, but that you needn't necessarily write off 90% of your investments. Sensibly managed, the failure rate shouldn't be more than two-thirds. Assume one in ten will provide a ten-fold return, factor in the tax relief,

and you should be able to make a decent profit.

The next lesson is to diversify like crazy. One experienced angel investor who now uses crowdfunding platforms told me that to succeed, "investors need dozens, if not a hundred or more stakes, in a long line of businesses".

You might only put a few hundred pounds in each, but you need this hugely diversified pool of assets to make the numbers work in your favour. Hopefully somewhere in that big portfolio will be one or two ten baggers. One alternative to a bulging portfolio is to go down the fund route.

For example, Crowdcube has its own fund managed by Strathtay Ventures, which invests alongside individual investors to build a diversified portfolio. Syndicate Room has its own alternative take on the same challenge, in that it only puts individual money to work alongside existing angel investors, who've done the due diligence on the business.

My last point told to me time and time again by angels is to focus like a hawk on management. Anyone can come up with a spiffing idea, construct an amazing PowerPoint presentation, or even bodge together a great spreadsheet of financial projections.

But what will make or break a business is the quality of its managers and founders. Do they have business experience? Have they managed their way to an exit before? Have they made other investors real hard cash?

In short, it's all about the people in charge and whether they are likely to deliver on those easily made promises.