Backing the next Uber through crowdfunding

Crowdfunding raising money from large numbers of people, usually online covers several different types of business.

There's debt-based crowdfunding, or peer-to-peer (P2P) lending as it's usually known. These P2P platforms, such as Zopa or RateSetter, enable you to lend money directly to individuals or businesses. Rewards-based crowdfunding involves backing projects on sites such as Kickstarter, Indiegogo or Patreon (see below).

If the project goes ahead, you get a reward, such as a discount on the full purchase price, a special edition of the product, or early access to it. And equity crowdfunding involves buying shares in new companies while they are in their start-up phase. Platforms such as Seedrs, Crowdcube and SyndicateRoom let you invest in the latest hip craft brewery, "disruptive" app-based finance firm, or "the Uber of" pretty much anything.

Start your trial of MoneyWeek today

Get unparalleled financial insight, analysis and expert opinion you can profit from.

Start your trial

Sign up for MoneyWeek’s free twice-daily newsletter.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Sign up

In the first two examples, the return on your investment is clear. P2P lending gives you a fixed level of interest on the money you lent (assuming the borrower does not default on the loan). Rewards-based funding gives you a product or service and the satisfaction to fund somebody's brilliant idea (assuming the product you back is ever completed).

Equity crowdfunding is a little different. You're buying a stake in the business with the hope of earning dividends or capital gains as that business is sold. The theory goes that if you get in early on a successful business, you stand the chance of reaping huge rewards.

In addition, equity crowdfunding comes with attractive tax breaks in the form of the Seed Enterprise Investment Scheme (SEIS), which offers tax relief of 50%if you invest in very early stage start-ups, and the Enterprise investment Scheme (EIS), which offers 30% relief for investing in later-stage companies. (However, not all crowdfunded businesses qualify for these tax breaks).

But how often do investors turn a solid profit? While the equity crowdfunding sector is still young, the results so far aren't encouraging (see below). That's why the Financial Conduct Authority warns that these kind of investments are "a high-risk activity", in which "it is very likely that you will lose all your money".

Even if the business does not fail, it is "unlikely" that you will ever receive any dividend income. And if you want to sell your stake on, you're likely to be disappointed as "most platforms do not have a way you can cash in your investment (a secondary market)". In short, tread carefully.

Crowdfunding: the first five years

Solid returns from UK equity crowdfunding investments over the last five years have been in short supply, according to a study from AltFi, an alternative finance consultancy. In a recent report called "Where are they now?", AltFi's analysts looked at the status of 955 funding rounds involving 751 companies on six crowdfunding websites: Crowdcube, Seedrs, SyndicateRoom, Venture Founders, Code Investing (previously known as CrowdBnk) and Angels Den. Of those 751, just five have produced an exit "where investors have had a chance to realise their investments".

Three of the exits had been funded on Crowdcube. E-Car Club, an electric car-sharing service, was sold to Europcar, at a return said to be around 2.5 times the original investment. Camden Town Brewery was bought by Anheuser-Busch InBev for a 67% premium. Wool and the Gang, an online knitting retailer, was sold for a "small premium".

Two exits were also made on the Angels Den site, but "a sale price could not be confirmed in either case", according to AltFi Data. Kiki Loizou, writing in The Times, reported that Angel's Den became "prickly" when asked for full details and "said it would be best to avoid saying its network had produced any exits".

Of the remaining firms in the study, just 24% are categorised as a "success", which AltFi Data defines as having delivered a return for investors, having raised more capital at a higher valuation, or is "showing no sign of distress".

Overall, AltFi Data calculates that the internal rate of return across all fundraising events is 8.55%. Factoring in the effect of the EIS and SEIS tax relief brings the return up to 19.14%, which sounds okay. But it may be too optimistic to assume that because a firm has raised money at an higher valuation that it's worth that valuation or that firms that are not evidently in distress are worth what was originally invested.

Most importantly, bear in mind that just five of these firms have give their investors a way to cash out. If you have no way to exit your investment, your return remains entirely theoretical. Meanwhile, some losses have been very real. Claims management firm Rebus raised more than £800,000 from 109 investors on Crowdcube. Ten months later, it collapsed, becoming the biggest crowdfunded failure so far. "If crowdfunding is to survive," says Loizou, "it must be a success for its investors." The data so far doesn't show that it is.

Patreon: funding artists over the internet

Patreon is a clever variation on the reward crowdfunding concept. The site lets artists get paid for making their art by anonymous "patrons". It was founded in 2013 and originally became popular with YouTube bloggers and the creators of online comics, but now covers all forms of artistic expression, including theatre, photography, writing, and music.

Artists set goals for the amount of money that they want to raise. These goals can be one-time ones, but more often they are recurring. Backers pledge a certain amount a month until they decide to stop. In return, they may (or may not) be given a reward by the creator, though artists are under no obligation to do this. Rewards can be regular updates on the artist's progress or exclusive online "hangouts" with backers. Some are doing remarkably well.

The website "Wait But Why", for example, is currently pulling in almost $20,000 a month from Patreon. Singer Amanda Palmer has almost 9,000 patrons, who've pledged over $35,000 in the year since she set up her page on the site.