Which is the odd one out? (a) An origami boat. (b)Tickets to a film premiere. (c) The satisfaction of helping someone realise their dream. (d) Having a supporting character in a novel named after you. (e) A course in video game design. (f) A stake in a start-up business that offers the chance of a financial return.
As with so many questions, there is no ‘right’ answer*. It really depends on what floats your boat, doesn’t it? But in the context of this article the ‘correct’ answer is (f). Because when the motivation for putting money into a crowdfunded project or start-up is the prospect of cold hard cash (rather than more esoteric or intangible non-financial rewards), things can get complicated - for investors, the ‘investees’ trying to raise funds, and the crowdfunding platforms that bring them together.
During its brief history, most crowdfunding has been raised through online platforms such as Kickstarter and Crowdfunder, where returns on financial ‘donations’ or ‘pledges’ result only in non-financial rewards, and this has been a boon for some businesses.
In the last year, seven Kickstarter projects have raised headline-grabbing investments of more than $1 million each, though the company’s own stats show that funding is not raised for 56 per cent of its projects, and how successful they go on to be may be a moot point to investors who are not looking for financial rewards.
But crowdfunding is evolving and more investors, investees and facilitators are exploring models that do offer investors financial rewards. Indeed, there are a number of variations on this theme. These range from lending marketplaces such as Zopa and Funding Circle where the investment model is based on ‘debt’ (and the investor lends money to a business for a project, startup or expansion), to equity crowdfunding platforms such as Crowdcube and Bank To The Future where the investment model allows the investor to formally become a shareholder in the business.
“We focus on tech start-ups and traditional businesses that would have been funded by venture capital or an ordinary business angel,” says Simon Dixon, CEO and co-founder of Bank ToThe Future, which provides equity crowdfunding and also offers business loans.
“We also do match-funding,” adds Dixon “where business angels step in and contribute funding at the point when the crowdfunding investment reaches a pre-defined limit, so that businesses can combine their online and offline fundraising efforts.”
Staying on the right side of the law
As some crowdfunding schemes are ‘regulated investments’ companies that want to exploit them should tread very carefully.
“The law is very prescriptive about what you can do to raise investment,” says Tony Watts, an expert in financial services legislation at Keystone Law. “Some crowdfunding structures are affected by several overlapping layers of legislation which must all be complied with.”
He adds: “European law, company legislation and financial services rules may all apply and if you don’t know what you are doing it’s easy to risk prosecution through ignorance.”
The financial crisis has helped to make investment banking unpopular and seemingly unfathomable, but even without this it would still look like a black art to many outsiders. If the idea of getting to grips with terminology such as bonds, debentures, convertible notes, financial instruments and securities makes you lose the will to live (let alone try to use them to raise business finance) you may want to look at a wide range of crowdfunding investment models, and dig deep and get yourself some expert advice before you opt for equity crowdfunding.
Weighing up the risks
The risk/reward balance of cloudfunding models demand careful consideration by investees and potential investors. Providers of the online crowdfunding platforms that offer loans and/or equity all back this up with a certain amount of due diligence (such as credit referencing and background checks) on the businesses, entrepreneurs, and startups looking for funding, and often apply risk ratings. Just like traditional bank loans, crowdfunding loans come an obligation to repay the debt (often with interest), and if this is not met the business borrower may face the risk of insolvency.
The debt model is generally a lot less complicated than equity crowdfunding from a legal and regulatory standpoint in the UK, as long as there is no provision of consumer credit – and factors such as this will influence the appeal of crowdfunding loans to investees and investors.
Equity crowdfunding has much in common with the offline version, and as anybody who watched the recent Facebook debacle knows, you may get a return on your investment but you could also lose your shirt. Investors therefore need to carefully select the crowdfunding model that best meets their needs.
Crowdfunding investors also need to be aware of the tax implications of their investment decisions. Some may feel that the relative security of the loan investment model pales by comparison with the opportunity to take advantage of the tax efficient investments offered by the UK government’s Enterprise Investment Scheme (EIS) and the Seed Enterprise Investment Scheme (SEIS), which can enable eligible individuals who invest in new shares issued by a qualifying company to exploit tax benefits including capital gains tax (CGT) deferral relief, CGT exemption, income tax relief, and relief for losses.
But as William Robins, a founding partner at Keystone Law, explains, crowdfunding investors will need to take care that they do not inadvertently act in a way that prevents them from satisfying the eligibility conditions for EIS and SEIS relief.
“This is a complicated area, and although the rules are clear, their application and enforcement is not,” he cautions. For example, accepting some of the weird and often wonderful non-financial rewards that characterise crowdfunding could prevent you from enjoying what could otherwise be significant tax relief.
To fully exploit EIS/SEIS, crowdfunding investors must not to accept anything of significant value from the company they have invested in.
“There are rules under which ‘receipts of insignificant value’ can be ignored,” explains Robbins, but he can envisage a situation where an investor makes a big gain on their investment, claims the relief on their self assessment form (and thus pays no CGT and gets tax relief on the sums invested), only for H M Revenue & Customs to become aware of the value received and not only claw back the relief but also impose CGT and penalties. How much gets taken away will depend on myriad factors, including your tax position, the size of your investment, and the value of the non-financial reward on offer.
Bear in mind that your idea of what constitutes either significant or insignificant value may be rather different to the one taken by HMRC. “I can’t see the Revenue being bothered about a copy of a book or even an origami boat, but they might be less understanding if you are flown to the premiere of a film in Cannes,” says Robbins.
So where financial returns are a motivation for crowdfunding, spending less on perks may be to the advantage of both investors and investees.
POINTS TO REMEMBER
- Know what you are doing: ignorance is costly – whether it puts you on the wrong side of the law or prevents you from making tax efficient investments.
- Educate yourself: the following can help (a little) with the decision making process
New Routes to Funding – Looking beyond the banks
From Smith & Williamson the auditors and business advisors
The Venture Crowd – Crowdfunding Equity Investment into Business
From the UK innovation foundation Nesta
UKIE Crowd Funding Report: A Proposal to Facilitate Crowd
- Get expert advice: whether you are a potential crowdfunding investor, investee or a facilitator, make use of the help and support of experts in tax and law.
*NB: Do not regard anything in this article as legal or professional advice. It is for general information purposes only and should not be used as a substitute for legal advice relating to your particular circumstances.
