Why crowdfunding is trending: Investing in the Facebook era

You could buy into the next big thing, but you could just as easily lose the lot

It's a little like being one of the dragons on the BBC's hit series Dragons' Den. Businesses present you with their pitch and you decide whether or not to invest. Such is the basic crowdfunding concept, which has spread from the US to the UK at breakneck speed.

We already have the likes of PleaseFundUs, PeopleFund.it, Buzzbnk and Spacehive, which all focus on creative and public projects. And these are being joined by launches banktothefuture.com and Kickstarter, which hails from the US.

Whereas social lending sites such as Fundingcircle.com use debt as the focus for their collective power, these crowdfunding sites are offering equity – asking a group of investors to put up relatively small sums of money to help start-ups get on their feet. Instead of earning interest on a loan, the investors put up cash in exchange for a stake in the business.

The likes of Crowdcube and the newly launched Seedrs provide an online platform for people to pitch their business idea or a project, in the hope that they will bring in as much money as possible.

Typically there is a specified target to reach within a specified time, and money is returned to the investors if this is not met, much as a group buying site such as Groupon works. If the target is met, investors receive shares in the business or project they have helped, although in some cases contributors can receive rewards instead.

"The pull for investors is the ability to have a stake in 'the next big thing' – the next Twitter or Facebook – or to play at Dragons' Den and uncover the next Levi Roots that everyone else has missed," says Andrew Whiteley at the independent financial adviser Provisio.

From an investment perspective, you get to invest what can be fairly modest sums of money (from as little as £10) with the potential for impressive returns if you back the right horse.

Tax-wise, returns from equity-based investments are subject to the usual rules, but many of the equity models offer investors Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) relief on their contributions, which could mean up to 50 per cent income tax relief and exemption from capital gains tax.

However, it's not all plain sailing with crowdfunding. The Financial Services Authority (FSA) warned recently of the risks that investors could lose the whole of their stake and said it should be the preserve of sophisticated investors. To date, Seedrs is the only crowdfunding site that is authorised and regulated by the FSA.

Most start-ups fail, and even if they don't, they are unlikely to turn a profit quickly so you may not see a return on your investment for a number of years.

There is also no access to the Financial Services Compensation Scheme (FSCS) if things go wrong, and the FSA has also warned that investors' shares will produce few dividends and will potentially prove to be very difficult or even impossible to sell.

Even if you do manage to back a young business that goes on to do very well, you may have to hand a slice of your investment back to the platform – Seedrs, for example, charges investors 7.5 per cent of any profits they make if the business is sold, floats or pays a dividend. Additionally, when the company needs to raise more money and issues further shares, existing shareholdings may be diluted.

Kusal Ariyawansa at Appleton Gerrard Wealth Management says: "It is about time we had the regulator standing up and forecasting problems – problems which on many occasions have been created by bad advice based around greed, both for the adviser and the client.

"This way, the client really will need to be well off before an adviser can sign such investments off as suitable."

That does not mean crowdfunding can't play a role in a diversified portfolio, but only if you are willing and able to take a punt. Investing for growth and income is important to keep any portfolio balanced, but the message here is to only play around with cash that you can bear to lose.

Harry Katz, a financial adviser at Norwest Consultants is unequivocal. "As far as investors are concerned, this should be looked at as a substitute for wasting money at William Hill, the lottery or the football pools," he says. "It is less of an investment and more of a flutter."