Crowdfunding: What It Is and How It Works

If you've ever dreamed of being a part of a successful business venture, then crowdfunding may be the answer you've been looking for

Maria Collinge
May 14, 2024
What exactly is crowdfunding and should you invest in a crowdfunded business as a way to diversify your investment portfolio? (Image: Female Invest)
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Have you ever thought about investing in a scale-up business which has built something you feel passionate about? Well crowdfunding might be the avenue that allows you to do that. 

Crowdfunding is revolutionising the way we think about entrepreneurship, as it enables a large pool of investors (the crowd) to pool their money together to give a promising company the boost it needs to grow. With crowdfunding, ideas are not restricted by the barriers of limited capital, but facilitated through a vast network of individuals who can now come together to bring new business ventures to life. It is therefore an empowering alternative investment outside the traditional stocks and shares model and has huge potential for high returns. 

So what exactly is crowdfunding and should you invest in a crowdfunded business as a way to diversify your investment portfolio? Let's dive right into it.

What is crowdfunding?

If you've ever dreamed of being a part of a successful business venture, then crowdfunding may be the answer you've been looking for. This approach to generating capital allows individuals to invest small amounts of money in a company they believe in, ultimately helping them get off the ground. 

Not only does this democratize the funding process, but it also diversifies investment portfolios by allowing individuals to invest in companies whose values they align with and potential they believe in. 

Crowdfunding platforms are democratizing the investment process, allowing anyone to invest in a business they believe in (Photo: Edwin Andrade/Unsplash)

How does crowdfunding work?

Facilitated through crowdfunding platforms, investors can invest in promising projects for as little as $10, and crowdfunding sites can take a percentage of the funds raised to generate revenue. 

This platform enables anyone with a unique and marketable idea to pitch it to investors waiting to back innovative and entrepreneurial ventures.

A great example of crowdfunding's reach was seen when a man requested funding to create a new potato salad recipe. Although he only needed $10, he ended up raising more than $55,000 from 6,911 backers. Crowdfunding has created an opportunity for entrepreneurs to make their dreams a reality by gathering support from all walks of life.

Types of crowdfunding

There are three main types of crowdfunding to be aware of: debt crowdfunding, rewards crowdfunding and equity crowdfunding.

Crowdfunding enables you to align your investments with your values. There's power in that.

1. Debt crowdfunding

This unique investment opportunity allows you to lend your money directly to a business of your choosing, with the promise of a return on your investment in the form of interest payments. Similar to bonds, crowdlending provides a stable and reliable investment option for those looking to grow their wealth over time.

2. Rewards crowdfunding

Unlike traditional investing, rewards crowdfunding offers non-financial returns for investment. From branded merchandise like t-shirts and water bottles to bikes or anything in between, businesses can entice investors with unique rewards. As an investor, you have the opportunity to contribute to the success of a small business and receive a tangible, personalized return on your investment.

3. Equity crowdfunding

Imagine being a part of the birth of an innovative business idea and watching it grow into a thriving company. With equity crowdfunding, you have the power to make that happen. By investing in an unlisted company, you become a part-owner and have a stake in its success. Plus, with a large pool of investors contributing, the risk is spread out, making it more accessible for individuals to invest. The potential for growth is enormous, as the company could eventually list on the stock exchange or be acquired for a substantial sum. 

Whilst crowdfunding has the potential to generate huge sums of wealth, the chances of that happening are very slim so make sure you're aware of the risks (Image: Female Invest)

The pros and cons of crowdfunding

As with any investment opportunity, crowdfunding comes with a whole host of pros and cons that must be carefully considered before taking the plunge. 

Pros of crowdfunding

1. You can invest in a business with little money

Have you put off investing because you don't have a lot of money saved up? Crowdfunding could be a good solution, because you can invest as you like in a company seeking capital through crowdfunding. 

2. You can diversify your investments

When you invest in a crowdfunding campaign, you are investing in a small portion of many different businesses. This diversification can help to mitigate risk and improve returns.

3. You can get involved with exciting projects

Crowdfunding can be a great way to support businesses that you believe in and which you feel good about supporting. Additionally, it can be fun and interesting to follow the progress of a business that you've personally invested in.

4. You can potentially make a lot of money

If the business that you invest in is successful, you could make a significant return on your investment. Additionally, if the business goes public or is acquired, you could see an even bigger return.

When considering investing in a crowdfunding project, it's crucial to be aware of the risks involved. Because there's a lot of them! (Image: Female Invest)

Cons of crowdfunding

1. It can be a high-risk investment

Crowdfunding platforms are unregulated, which means that there is a higher risk of fraud. Additionally, the success of a crowdfunding campaign is not guaranteed, and you could end up losing your entire investment.

2. Crowdfunding investments are not liquid.

Investing in a crowdfunding campaign typically means that you will not be able to sell your shares for at least a year. This can be problematic if you need to access your money sooner than that.

3. You may not have any control over the company

If you invest in a crowdfunding campaign, you will likely have little to no say in how the company is run. This can be problematic if you disagree with the direction the company is taking.

4. Crowdfunding campaigns can take a long time to reach their goal

Crowdfunding campaigns can take months or even years to reach their fundraising goal. This can be frustrating if you are looking for a quick return on your investment.

5. You may not make any money from your investment

Even if the crowdfunding campaign is successful, there is no guarantee that you will make any money from your investment. In fact, it's possible that you could lose money if the company fails to meet its goals

Tax benefits of crowdfunding

This isn't to be overlooked. Investing in a crowdfunding business can come with great benefits, especially when it comes to taxes. Depending on your location, the government may offer tax breaks to those who invest in innovative ideas through crowdfunding. 

In the UK, the size of the company affects how big the tax break can be. Either it’s in an EIS category or a SEIS category, depending on how much profit they turn over, how many years they’ve been in business and how many employees they currently have. To benefit from the tax breaks, you also have to make sure that you hold on to the companies for a certain period of time, usually around 2 years. 

In Spain, Germany, the USA and the Netherlands there are also some tax benefits that might be worth investigating if you live in these countries and are interested in crowdfunding. 

Further afield, check up on your government website or relevant crowdfunding platforms if there are any benefits that you could access from making a crowdfunding investment. 

Before diving into any investment, it's crucial to take a step back and evaluate your financial situation (Image: Female Invest)

Is crowdfunding for me?

Good question. Before diving into any investment, it's crucial to take a step back and evaluate your financial situation. Can you comfortably afford to lose the money you’re putting in? This is especially important in crowdfunding, as businesses involved might still be in their infant stages. 

Investing in crowdfunding also requires patience and a long-term outlook. While the benefits may take longer to materialize, it's important to remember that slow and steady wins the race. With the right mindset and dedication, crowdfunding investments can pay off in the long run. It's about taking a leap of faith and giving your investment time to grow, like planting a seed and watching it blossom into a beautiful plant. 

But it’s also important to note that there are no guarantees, and there’s a wealth of research which shows that a very small fraction of start-up businesses actually succeed. So you need to be fully informed about the potential of the business before taking the plunge. That requires lots of homework and due diligence on your part. 

In a nutshell, if you have a high-risk appetite, then perhaps it’s for you. Otherwise those with a low-risk appetite to investing should probably divert their investment attention elsewhere.

Tips for crowdfunding success

1. Invest long-term

There’s loads of stats out there, but most are pretty unanimous in floating around the harsh figure: 85% of crowdfunded companies fail. That means that only 15% will go on to be successful.  As a result, your goal needs to be a long way in the distance to make sure that you can soak up the losses and still hit your goal in due course. 

Secondly, usually crowdfunding delivers gains at whatever point in the future that the company is bought by another company or launches on the stock exchange. There’s no telling how far in the future this might be, and there are no set time horizons. Normally though, it’s no less than five years and it’s often a great deal longer. No one has a crystal ball!

Your goal needs to be a long way in the distance to make sure that you can soak up the losses and still hit your goal in due course (Image: Female Invest)

2. Consider tax incentives

Tax benefits require you to keep hold of the investment for a set period of time before you’re able to benefit from them.  This means that you need to clearly think through your time horizon, and any other tax implications that might be woven into your overall financial situation.

3. Get to know the company

It’s important to make sure that you’re giving your hard-earned cash to a legitimate company. One of the main ways to avoid falling into a negative situation is by really getting to know the company you’re dealing with inside and out.

If you’re dealing with a new and early company, it can be difficult to gather information as they don't have the same obligation as publicly traded companies to publish their accounts. This means you’ll need to do your own research and investigate their business model, profits, and debts. Dive deep into their online activity and don't hesitate to check out their website, socials or review sites to gain a better understanding of their product or service.

4. Be an active investor

Even though crowdfunding projects can take a while to see returns, it's important to remain engaged and continue spreading the word. You put your money into these companies for a reason - perhaps it was the product or service they offer, or maybe you believe in the people behind the scenes. Take an active role in supporting these businesses. Stay updated on their progress and share news of their success with others. By becoming a champion for these companies, you are not only investing in their future, but also in your own. 

Supporting women-led businesses through crowdfunding

It's frustrating to see such a disparity in funding opportunities for female-founded businesses, with only 2% of venture capital funding going to them in the UK alone. But rather than lamenting the issue, let's celebrate the strength and resilience of these women who turn to crowdfunding as a means of financial support.

And it's not just about making a difference in their personal lives - many of these businesses are dedicated to addressing global issues like climate change, equality, and world peace. Additionally, research shows that female-led companies often generate a better return on investment, proving that diversity and representation are crucial components of success. 

Research shows that female-led companies often generate a better return on investment, proving that diversity and representation are crucial components of success (Photo: Female Invest)

The bottom line

Unlike other investments, you cannot quickly trade your shares at the click of a button. Instead, you may have to wait for the company to list on the stock exchange (by setting up an Initial Public Offering), which could take years, or for the company to be acquired by another investor. This means that you need to be patient and have a long-term investment strategy if you're serious about pumping your money into a crowdfunding project.

By taking the time to research and choose the right opportunities, crowdfunding can offer the potential for significant returns over time. Remember, investing is all about the long game, and with the right approach, crowdfunding can be a fantastic way to build wealth and reach your financial goals.