With returns on retail deposits, stocks and other investments still negligible, small investors who just have a bit of spare cash are finding it difficult to find a decent place to park their money.
However, a new investment alternative is slowly catching on. Using the power of crowds, individuals don’t need to be multi-millionaires to earn a stake in a company, instead they can now invest a small amount and become a part owner of a new startup or a promising young organisation.
Welcome to the world of equity crowdfunding. The concept originally refers to a collective effort to support a cause, project or charity. The public, for example, would raise funds for flood victims or a climber who seeks to conquer Mount Everest. In return, the contributors would see some photos, videos or a book, while others would be just happy to know their money has been put to good use.
As the internet became more prevalent, networking got stronger and bigger, and the idea of collectively funding a business idea then came about. “It’s suggested that an equity share in a company can be offered in return for money used to fund it,” notes Steve Gregory, managing partner at Holborn Assets.
As of last April, there were 452 crowdfunding platforms worldwide and they raised almost $1.5 billion for over a million campaigns in 2011 according to Crowdsourcing.org. However, there have been questions whether the strategy is for everyone, especially retail investors looking to achieve financial returns.
“I would generally class any form of startup or venture capital as high risk, for obvious reasons, the business is an unknown, and so could fail before you see any returns on your investment,” advises James Thomas, regional director at Acuma Independent Financial Advice.
“Conversely, it could fly and you will see a handsome profit. Any investment like this is potentially worthwhile, but you need to be aware of what it is you are investing in.”
Thomas says that since this form of financing is normally “very illiquid”, investors need to be able to commit their funds for a reasonable length of time and accept that they may not be able to get it back at a set time. “You need to consider how much you are investing - can you afford to lose this money? [But] there can be some amazing opportunities to be had, and so should be considered on their merits,” Thomas says.
Gregory says there is merit in the idea of crowdfunding, with some forecasting that in future years, all those wishing to start a business will come to the internet to seek funding. “Funding in such a way could really make small business survive and prosper.”
However, he categorically says he would not recommend private equity investments to any but the wealthiest clients. “I remember a rental company offering to rent out cars in the UAE for $1 per day. People were asked to pay deposits and send their credentials before being allocated a car. It was too good to be true. The company collected all the deposits and left the country, leaving thousands of people with their money gone,” he recalls.
One of the challenges, Gregory points out, is that while crowdfunding platforms promise company shares “it is not likely that a contract can be drawn up” to protect the investor. And, if investors would only contribute a small amount, say $100 in a private equity arrangement, they are highly likely to see their money lost because the majority of small companies fail to get off the ground.
“Any company looking for legal help to draw up individual contracts for its investors is going to face huge costs, and such contracts would favour the company rather than the investor I imagine,” says Gregory.
It could be that the crowdfunding strategy is suitable only to those in pursuit of goodwill, who are willing to give away a small amount for a business idea they believe in without expecting anything in return. “Perhaps some business ideas are such good causes – a company supplying doctors to third-world countries might be a worthy cause, for example – that a decision to be part with some money may be okay if you don’t expect anything back from a small investment,” adds Gregory.
But if you do feel like taking the risk, there are many questions you should ask before parting with your cash. It is important that you pay special attention to the people involved in the business. “Doing due diligence for $100 is probably too time consuming to even contemplate. You would not want to invest with someone with a track record of failed businesses or criminal offences, for example,” Gregory advises.
Following the rising popularity of crowdfunding, the North American Securities Administrators Association, an international voluntary organisation devoted to investor protection, issued the following guidelines for investors last May:
• All investments have risk, but small business investments have even greater risk than normal. About 50 per cent of all small businesses fail within the first five years.
• Issuers using funding portals to raise money may be inexperienced. Their track records maybe unproven, unsubstantiated or outright fraudulent.
• The information about the investment is limited to what is provided through the funding portal. Investors may need to rely on their own research to determine the issuer’s track record.
• Investors may have limited legal ability to take action against the issuer should the investment not perform as represented. Due to limited regulatory oversight over these offerings, investors may be left on their own to pursue costly private lawsuits when things go wrong.
• Crowdfunding investments are mostly illiquid and investors must be prepared to hold their investments indefinitely. It also may be difficult or impossible to resell these securities due to the lack of a secondary market.
• The bottom line: It pays to be sceptical of investment opportunities you learn about through the Internet. When you see an offering on the Internet – whether it is on a funding portal, in an online newsletter, on a message board or in a chat room – you should be cautious until you have done your homework and proven that it isn’t a scam.
