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Do investors really understand the risks of crowdfunding?

by Louise Hill

Crowdfunding has emerged as a finance option for more than just floating a ‘Baby Trump’ blimp into the sky above the Houses of Parliament.

The first online crowdfunder – a way of raising money by pooling small amounts from a large number of people – is thought to have taken place in 1997 when rock fans raised $60,000 dollars to help pay for the band Marillion to tour the US. Since then the phenomenon has grown from people being offered ‘rewards’ for contributions, to being offered an equity stake or the chance to join the booming peer-to-peer lending space.

It is widely used as a fresh route to finance business, particularly niche, early stage businesses which may struggle to find favour with traditional lenders.

Interest has surged, helped in no small part by social media which can spark a frenzy of activity given the right product or cause. The creators of ‘Baby Trump’ (pictured above) managed to raise £18,000 to make their dream of floating an orange, nappy-wearing President in the heart of London a reality. More serious business ventures now aim to secure even greater backing for their own projects.

In the fintech world crowdfunding has been used as a prime way to secure capital. Monzo, a digital-only banking service, raised an impressive £20m in less than three hours at the end of 2018. In the past few weeks one of its fellow fintech firms, Nutmeg, has announced its own crowdfunding plan to raise £10m.

With a wave of platforms available, from Crowdcube to Seedrs, it is easier than ever for the person in the street to invest in brands even younger than the fintech names. New products such as ‘mini-bonds’, P2P lending and Innovative Finance Isas have also offered people a way to invest in higher-risk ventures.

But do investors know what they are getting themselves into?

Customers invested £110,000 a minute in Monzo during its latest crowdfunding round, yet some have questioned just how much those customers knew about the fundamental business. It seems likely that the technical aspects of the underlying business were ignored, if anyone was aware of them in the first place.

When it comes to start-up companies the hype and excitement of crowdfunding often covers up a lack of due diligence and technical knowledge on the part of investors, something that businesses could take advantage of.

With this naivety on the part of some there comes the danger that more people are sucked into the vortex of crowdfunding and expecting – but perhaps never receiving – gold-plated returns when their chosen project hits ‘the big time’.

Research from AltFi found one in five investment prospects opting to crowdfund have failed. The cash invested in most cases is not protected by the Financial Services Compensation Scheme, and the Financial Conduct Authority has hinted at greater regulation of the sector. With no back up and regulation currently scarce many investors are at risk of major losses.

Nevertheless, the dream of catching a ‘unicorn’ (a business that goes on to be highly valued) is growing. People want to be able to say they were there at the beginning of the next Facebook or Amazon. Yet many will never be valued anywhere near the $1bn mark or enjoy the global success of the megacap names.

However, as we saw with the surge in cryptocurrencies, only one ‘breakout’ success story is needed to lure people into believing they will be next to reap the rewards, if only they can find the right business to back.

It doesn’t help that the world of traditional investing, of fund managers and stock markets, seems particularly out of touch for younger generations. For many their first taste of the financial world at large was watching the globe plunge into economic crises in 2008. People want to be part of something new and more exciting. The number of 18 to 24-year-olds investing through Crowdcube has nearly quadrupled since 2016, according to the FT. Hardly a statistic you would expect to see when it came to youngsters adopting a Lifetime Isa.

The likelihood of more naïve investors being swept up in the crowdfunding frenzy means more should be done to alert them to the inherent risks they take on when they hand over their hard-earned money and protect them when things turn sour. The risk of losing everything they invested, or of being caught out by ruthless fraudsters, is very real. Until regulators step in, investors should do their homework to prepare for the worst while hoping for the best.