17 March 2016
Stand out from the crowd(fund)?
by Frank O’Nomics
Crowdfunding is growing. In a recent report from the University of Cambridge Centre for Alternative Finance and Nesta, UK alternative finance was shown to have grown by 84% to £3.2 billion last year. This figure was below £100 million as recently as 2011. The number of websites that offer opportunities for investors in this sphere has exploded, but a key shift seems to have been a growing institutionalization of the sector (presumably on the, “if you can’t beat them join them” view). In terms of the UK economic outlook the exciting element would seem to be the number of small and medium sized enterprises that have benefited from crowdfunding, which totaled over 20,000 in 2015, raising around £2.2 billion. It is then reasonable to ask the question – Is this just another investment bubble, or is it the future for finance and investment? The answer would appear to be a qualified yes on both counts, but it is first worth considering just what is covered by this rather broad and generic area.
MarillionCrowdfunding has been around since at least 1997, when rock band Marillion (remember them?) asked their fans to back a forthcoming US tour, although you could argue that the Statue of Liberty was a forerunner, being funded by donations in the 1880’s. Over the last few years growth has been exponential, with “investment” falling into three broad types. The first has been donations, where people have committed money to a cause or project that they believe in, generally for little return other than a social or personal motivation, with perhaps an acknowledgement, gift or ticket the only reward. A much greater area for crowdfunding more recently has been in the area of debt, so called P2P or marketplace lending, which bypasses traditional banks (and notably some of the regulators!); here investors lend money to other individuals or SMEs with the expectation of being repaid, together with a rate of interest which is generally better than the banks offer to both parties. Lending might be for property (note that in 2015 debt and equity raising for real estate accounted for £700 million of the aforementioned £3.2 billion of alternative finance) or it might be in the more laudable area of microfinance, where people lend small sums to the very poor in the developing world with no expectation of interest payments. The third area is the rapidly growing one of equity crowdfunding. This was up 295% in 2015 to £332 million. These investments are in shares in a business project or venture, which potentially generate returns if the business performs well, in terms of a higher share price and potential dividend payments. The funding initiatives take two main forms. In the first those raising money set a target but take whatever is offered to them and proceed, even if the target is not met. The second is “all-or-nothing” so that, if the targets are not hit, the firms get nothing. Clearly most investors will be more comfortable with the latter model given that a fully funded project is more likely to succeed.
By way of illustration of some of the potential investment areas, I have chosen some that were fully funded and, in the case of Oppo Ice-cream, already closed. One good example, because of successive fundraisings, is Brewdog. This is a craft beer company formed in 2007, which has come to the market several times (via the website Crowdcube), raising both equity and bond finance. Investments have been made for as little as £95, and in addition to either an equity stake or a 6.5% coupon, both equity and bond holders receive a discount on beer purchased either online or in their pubs. The company now has 32,000 (mostly) very small shareholders, who are largely invested because they like the product. This is fortunate on both counts as it is unlikely that there will be any active secondary market in the shares. Over their 8 years in existence the number of employees at Brewdog has gone from 2 (plus a dog) to 540 (plus a dog), a good example of crowdfunding generating a real economic benefit (although not it seems for dogs). A second good example is Oppo ice cream, who came to the crowdfunding website Seedrs for a second time recently. This company also appeared on Dragon’s Den, which gives you an indication that these are early stage and, to a large extent, unproven business entities. Their product received a lot of press coverage on the basis that they use natural products to produce a low calorie ice-cream, and as a result their funding raising closed very quickly, with them hitting three times their £100,000 target (as a result they sold 23.1% of their equity).
Institutional investors committed 32% of the consumer lending and 26% of the business lending in the alternative finance sector in 2015. They are undoubtedly in a better position than the rest of us to do the appropriate due diligence, but if they are now so keen should we be? The answer, as ever, is that we need to be aware of the risks, and they are numerous. Firstly, those looking at P2P lending should be aware that, while regulated by the FCA since April 2014, there is no protection under the Financial Services Compensation Scheme (currently £75,000 when you lend to your bank). Secondly, the default rates on the loans are on most platforms showing at quite low levels (below 1% in some cases). We should be very wary of such stats as this process is still very new – there are unlikely to be many defaults as the loans are young and this system has not operated for a full business cycle. Lord Turner has already suggested that “losses on peer-to-peer lending which will emerge in the next five to ten years will make the worst bankers look like absolute lending geniuses”. As with our investment portfolios overall, it is important to diversify as much as possible, and so making lots of small loans would make more sense than just one larger one. For the equity crowd funding process it is important to do as much due diligence as you can. Check out the biographies of all the directors, and utilize the platforms to make sure that you get answers to all key questions, with particular reference to the assumptions behind their revenue projections and how much they have personally invested in the projects . Do not assume that you are likely to be able to get your money back for quite some time, and do not invest more than you are prepared to lose – these are risky investments. The final worry must be for the investment platforms themselves – what happens if these go bust? They are your window into these businesses and you do not want that window to close.
Overall it seems that crowd funding can either be fun (supporting that arts project that you really care about) or can potentially generate some above average, but very risky returns, with a few add-ons like cheap beer. For those looking to raise capital it is a cheap alternative (typically the platforms charge around 4% to the borrower and nothing to the lender) to bank finance that they might struggle to get anyway. Remember, this is a sector with little to no regulation and there is a danger that you are left like those little old ladies in “The Producers” – owning 150% of a sure fire failure.
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