The principle risks investing in equity crowdfunding projects

The rise of equity crowdfunding has presented prospective investors with a new world of opportunities to diversify their portfolios, find exciting ventures to support and earn unprecedented returns on their capital.

Investing in brand new start-up businesses can provide backers with unusual investment options and can allow them to invest smaller amounts across a larger number of projects, spreading the risk of failure and loss over the entire portfolio.

Still, experts warn that up to 90% of start-ups will fail, making equity crowdfunding a seriously risky business.

Despite stark warnings from the UKs financial watchdog, The Financial Conduct Authority, a year ago, that investors will most likely lose any money they invest through this channel, this emerging market has continued its unprecedented growth (410% between 2012 and 2014) which is showing no signs whatsoever of slowing up.

So what are the risks? And how can they be managed?

The principle risk is investing more money than you can afford to lose in one project. By choosing to invest in more companies with a smaller amount, this risk can be mitigated and increases the chances that among the portfolio there will be one or more projects which deliver a decent return. For example, if you had £20,000 to invest, it would be wise to invest £200 across 100 companies.

Since the industry is so new, it has only recently become subject to proper oversight by the FCA – giving rise to further risk. Regulation is improving, and crowdfunding platforms must adhere to certain rules, but the primary onus is on the investor to carry out the appropriate due diligence and research the market

viability and appetite for each potential investment opportunity as part of the financial assessment process.

Even when investing in a subsequently successful start-up venture, it could take a number of years before investors can release their capital by selling their shares – making illiquidity a further risk to be considered.

Furthermore, companies in these early stages are rarely able to justify paying dividends to their shareholders and tend to plough any profit into financing more growth. This means that investors may not see a penny until they are able to sell off their shareholding.

Before making any investment decisions, investors would be wise to investigate whether the entrepreneur has considered their options for future dilution of shares. When the company sells more shares and attracts more investment in the future, existing shareholdings (including overall value, any applicable dividends and voting rights) could be decreased – or diluted – which exposes the backer to the risk of financial loss. Some company owners decide to offer initial investors protection from dilution by inviting them to increase their shareholding before pitching for further investment, thus protecting the value of their investment.

While the risks are substantial, it is undeniable that equity crowdfunding offers an enticing and viable alternative to traditional funding platforms and enables investors to access a wider variety of potential investment opportunities than ever before.

By making carefully considered decisions based on realistic assessments of a project’s likely viability, investors could find themselves earning a very decent return on their portfolio.

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