7 big differences between crowdfunding and investing in the stock market

Updated: 
A lot of £20 notes

According to an article in the 14th May issue of The Sunday Times, cycling clothing brand Vulpine Performance raised £1 million in a week on the Crowdcube website in 2015, valuing the start-up at £5m.

But having burned through all its cash - and with a recent attempt to raise more money at, bizarrely, a higher £7.5m valuation, having failed - Vulpine reportedly called in the administrators. Around 600 shareholders are set to lose money.
 
Now, I suspect this made the front of The Sunday Times' business section because Vulpine has collaborated in the past with the Olympian Sir Chris Hoy. That gives the unfortunate collapse some star appeal, and a famous photo to go with it.
 
But might we also be seeing the start of a crowdfunding backlash? The combination of small investors losing millions in failed ventures does tick a few boxes from a journalistic standpoint.

Crowdfunding versus investing in shares

For the uninitiated, crowdfunding involves putting money into unlisted companies, Dragon's Den style, in the hope of a huge return down the line. Investors can often invest as little as £10 to become part of the 'crowd'. Most coverage celebrates this democratisation, without which angel investing is the domain of the wealthy and well connected.
 
A backlash could argue several different angles: that many investors don't understand the risks of investing in start-ups and crowdfunding, that many funded companies are valued too highly, that specific companies have not been candid about their financial situation, or perhaps that the entrepreneurs running these businesses don't have the skills to scale, and might have done better working with traditional VCs who could lend more than money.
 
There's probably some truth in all of that. For instance, I've met people who put money into unlisted companies via crowdfunding websites but who tell me the stock market is too risky (or rigged by the City, or similar nonsense). That's silly.

Personally, I welcomed the arrival of crowdfunding, and I believe it adds value to the investing landscape. The important thing is to understand what you're getting into - and to realise that for most people, crowdfunding should only be done with money you genuinely can afford to lose.  Not with money that should be invested in a pension for your retirement!
 
I haven't the space to do an exhaustive guide to crowdfunding - and it's not really our beat - but to get you up-to-speed, here are some big differences between it and stock market investing.

1. It's very risky

Investing in start-up companies is super-risky. We think of small companies on the stock market as being risky, but they are a tiny proportion of the hundreds of thousands of companies that never get so far.

I've seen data suggesting as many as two thirds of investments by US venture capital funds lose money - and those are the big boys and girls who know what they're doing. It's safest to assume most crowdfunded firms will either go bust or at best limp along or be acquired for a song.

2. It's illiquid

When you buy shares in an unlisted company, you're basically stuck owning them until the company is either acquired (which has happened a mere handful of times in the life of the sector) or until it lists on the stock market, enabling you to trade your shares (this has not happened yet with a crowdfunded company in the UK to my knowledge).

The crowdfunding sites talk about creating secondary markets (and one, Seedrs, has just launched its first) but that's really for the future. It's best to assume your investment is locked away indefinitely. In contrast, while small shares on AIM can be very illiquid, you can usually find a buyer for any normal amount of shares at a price, especially if you're willing to take a hit.

3. It's for the long-term

We often say investing is for the long-term, but that's triply true of investing in unlisted start-ups. Firstly, you're almost always investing in a company at the start of its life. Secondly, as I say it may be years before you can sell out anyway. I think a ten-year time horizon is an appropriate way to think about any unlisted investments.

4. The tax breaks are different

There can be big upfront tax breaks for investing in unlimited companies via government schemes designed to encourage investment - so-called SEIS and EIS schemes. These can offer very generous income and capital gains tax relief. However you can't invest in crowdfunded shares via your ISA. It might be possible through a SIPP, if your provider allows it, but I wouldn't expect it to be easy.

5. Forget about dividends

One reason I feel crowdfunding is attracting investors who aren't sufficiently knowledgeable is that I hear them asking start-ups about dividends. People, these are almost always companies raising money to pay the rent and to try to grow enough to make the next round of funding. They are eating cash, not paying it out. Forget about them if you're after an income.

6. You're basically on your own

When you buy shares listed on a stock market, you're investing alongside a crowd, too - albeit of a very different sort. The price the shares trade at will be determined by the fluctuating opinions of a sea of investors, and the ones with the most money - and thus the biggest impact on the share price - are typically the best-informed.

Fund managers, mostly, in turn guided by expert analysts. They're obviously far from perfectly informed, otherwise we'd never see share prices soar and fall. But compare that to crowdfunding, where you must typically make your own mind up based on little more than a promotional video, a few PDFs of facts and figures, and perhaps the reassurance of a couple of seemingly sophisticated investors. There's no 'wisdom of the crowd' here.

7. You could make truly monstrous returns

Finally, the upside! Let's face it - this is why people are drawn to investing in start-up companies. It's one thing to invest in the next Apple or Microsoft when it lists on the stock market.

But imagine if you'd invested in such a company when it was starting out in a garage and scrabbling around for seed money. This is how you could log enough noughts after the first digit of your investment return to make up for all the times you will make absolutely zero - and maybe much more. However, we're talking lottery-type odds here. Millions of companies are founded every year. There's only one Apple.

Conclusion

I've had to be brief here, and there are obviously exceptions and caveats. The important thing to remember is that crowdfunding is overwhelmingly risky, illiquid and opaque - and that's true even if you spoke to the management team over some free beers at a jolly 'Meet The Team' event.
 
You might think I'm saying nobody should invest in unlisted companies. That is not the case. I have myself allocated some money to my own mini-portfolio of unlisted start-ups. I like putting money directly into companies who capture my imagination. And yes, I do like meeting the managers.
 
However, I'm keenly aware of the risks and have invested only a tiny proportion of my total long-term funds.
 
One of the investors in the Sunday Times story who had put money into Vulpine is quoted by the paper as saying: "To me, crowdfunding looks like a ticking timebomb."
 
Perhaps that's true from a regulatory standpoint. The sector is new, and I'm sure it has some growing pains ahead.
 
But we should not be reaching such a conclusion on the basis of one company failing - nor on the first successes, such as the recent high valuation put on Brewdog, the craft beer company initially backed by private investors.

I hope a company I've backed achieves great things, but realistically I know most will meet an unprofitable demise.
 
And that's only a timebomb if I didn't realise the clock was ticking when I invested.

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