What is crowdfunding?

Crowdfunding is taking off, with record amounts invested last year. But how does it work?

What is it?

Crowdfunding is a way for individuals or businesses to raise cash from investors. In return those investors will either get a physical reward or some form of financial return on their investment.

The different types of crowdfunding

The first distinction to be made in crowdfunding is between individual and corporate ventures. Individual entrepreneurs have used crowdfunding to raise money from large numbers of people to, for example, build a new games console or create new art exhibits.

With individual crowdfunding, the returns are often non-financial. In many cases, your reward for backing a particular venture will be one of the items that the fundraising aims to create. So, instead of getting shares in the underlying venture, you receive, say, one games console when it is finally released.

Corporate crowdfunding tends to come in two forms. The fastest growing form is equity crowdfunding. By handing over your cash, you receive equity (company shares) in the underlying business. Not all shares are the same though - while some will be Class A shares, with voting rights, some other ventures may only offer non-voting Class B shares. 

The second form of corporate crowdfunding is mini-bond fundraising. Here, investors hand over their cash to the business in return for corporate bonds. These company IOUs usually pay a fixed interest payment once or twice a year and, on maturity, return your original investment in full.

What are the risks?

Crowdfunded investments, whether equity- or bond-based, are not covered by the Financial Services Compensation Scheme (FSCS). The FSCS is a Government-backed safety-net that covers up to 100% of the first £85,000 of cash deposits per person per institution.

Without the protection of the FSCS, you could lose up to 100% of your crowdfunded investments, just as you could by investing via traditional stock and bond markets.

However, crowdfunding is regulated by the Financial Conduct Authority (FCA). It warned crowdfunding investors earlier this year that investing in small businesses comes with a great deal of risk. Typically, four out of five (80%) start-up businesses fail in their first two years. The FCA stated: "It is very likely you will lose all your money."

What's more, the risk of failure extends from crowdfunded businesses to encompass the platforms themselves. Should a crowdfunding site go bust (as has already happened several times), investors can be left with little or nothing to show for their outlay.

Make no mistake, crowdfunding is a risky exercise.

Can I sell my investment on?

Crowdfunded shares and bonds are highly illiquid investments. Indeed, they can be very difficult (or even impossible) to sell on second-hand. By buying these securities, you may be locked in for several years, so don't put money into these products that you may need back in a hurry.

Will I pay tax on my investments?

The Government is to hold a consultation on whether to include crowdfunding investments within an ISA, so it looks likely that tax-free crowdfunding is on the way.

Some investments made through crowdfunding sites are already eligible for EIS and SEIS tax breaks, but generally you will have to pay tax on any returns. 

Should I invest?

According to FCA rules, crowdfunding sites are only allowed to deal with certain investors. They are:

• Those who take regulated advice
• Those who qualify as high net worth or sophisticated investors
• Those who confirm they will invest less than 10% of their net assets in this type of investment

You will have to select one of these if you wish to invest, and pass an online test too to prove that you understand the risks involved.

Which is the best crowdfunding site for me?

There are loads of different crowdfunding sites out there, all offering something slightly different.

We've taken a closer look at some of the bigger names in The top crowdfunding sites.