Is investing in crowdfunding a safe investment?
Crowdfund investing offers a unique way to generate wealth, but do the potential rewards on offer outweigh any risks?
For startups and entrepreneurs looking for capital to get a business idea off the ground, crowdfunding offers a legitimate way to connect with investors. For investors, crowdfunding presents an opportunity to invest in exciting projects. But is crowdfunding a safe investment opportunity?
As crowdfunding gains popularity, legislation is being developed in Australia and around the world to offer protection for investors in crowd-sourced funding. But what is the aim of this legislation and how will it benefit both investors and the companies seeking financial support?
What is crowdfunding?
Crowdfunding refers to individuals collectively pooling their resources, in most cases via the Internet, to fund the efforts of other people and organisations. The basic premise of a crowdfunding campaign is to raise funds by obtaining small amounts of money from a large number of people.
Crowdfunding campaigns are typically run online via social media or crowdfunding platforms like Kickstarter and Indiegogo. By harnessing the collective efforts of a large group of people, crowdfunding allows companies to enjoy far greater reach and a higher level of exposure to potential investors.
For example, if you have a business idea for a new sports drink but you are unable to receive the necessary funding from banks or private investors, crowdfunding might help. By establishing a crowdfunding campaign through an online platform, you can source funding from individuals all over the world to raise the money you need via donations, loans or even investments.
Some of the best-known examples of successful crowdfunding campaigns include the Pebble Time smartwatch, which raised more than USD$20 million, and the ongoing Star Citizen video game campaign, which, at the time of writing, has generated more than USD$117 million worth of financial support.
What are the types of crowdfunding?
There are three main types of crowdfunding: donations-based crowdfunding, rewards-based crowdfunding and equity crowdfunding.
- Donations-based crowdfunding. These are crowdfunding campaigns where the investors or contributors do not receive any financial return. Donations-based crowdfunding campaigns are often run by charities seeking support for a worthy cause.
- Rewards-based crowdfunding. Under this type of campaign, individuals can make a financial contribution to your business in exchange for a reward. For example, they may receive guaranteed early access to the new product you are developing.
- Equity-based crowdfunding. Equity-based crowdfunding allows the individuals that provide capital to become part-owners of a company. As they own equity in the company, the investors receive a financial return on the funds they contribute. In other words, they receive a share of the company’s profits through a dividend or distribution.
Here, we discuss equity-based crowdfunding and look at the benefits and risks in Australia. .
Equity crowdfunding campaigns in Australia
Although equity crowdfunding is still a relatively new way to raise business capital in Australia, there have been several success stories. In 2016, student support platform Zookal raised more than $643,000 through crowdfunding platform VentureCrowd, significantly more than its goal of $500,000.
The record for the most money raised via equity crowdfunding in Australia belongs to taxi booking and payment software company Ingogo. $4.2 million of the $12 million they raised was funded through equity crowdfunding.
These success stories show the potential of equity crowdfunding to provide a simple and efficient way for startups to raise funds. However, as this unique type of funding grows in popularity, the Australian government has moved to introduce regulations to govern equity crowdfunding and to protect investors from the risks of business failure.
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Australian crowdfunding legislation and what it means for you
Currently, there is no specific legislation governing equity crowdfunding in Australia. In February 2016, the Federal Government introduced a bill on crowd-sourced equity funding (CSEF).
Anthony Lieu from LegalVision, a market disruptor in the commercial legal services industry, says the bill has been the biggest move in support of establishing a primary market for CSEF securities.
If the bill passes, it will make it easier for investors to invest in return for equity in businesses,” he says.
The bill aimed to achieve a number of goals, including:
- Enable retail investors to invest in small businesses and startups
- Protect investors from the risks associated with business failure and fraud
- Reduce the securities and financial regulatory barriers to invest
But with the dissolution of the Senate on 9 May 2016, the bill lapsed. It now falls to the new Coalition Government to carry the bill forward.
Reaction to the bill
The proposed legislation has been met with criticism from some stakeholders, but it does contain a range of measures that will have a significant impact on crowdfunding in Australia.
The bill only allows public unlisted companies with share capital to rely on equity crowdfunding,” says Lieu. “This prevents an overwhelming majority of small and medium enterprises from gaining access to the platform. Proprietary companies that wish to make a CSEF offer must become public companies. To further restrict access, the bill only permits companies with total assets of less than five million and an annual revenue of less than five million (the assets and turnover test).”
Meanwhile, Lieu says that investors want to minimise the risks involved in participating in crowdfunding regimes. “They want CSEF intermediaries to hold an Australian Financial Services Licence. They also want ASIC to conduct due diligence checks on the issuer (CSEF intermediary), provide risk warnings to investors and provide a means of communication between the issuer and potential investors.”
The bill states that investing in CSEF platforms is open to “sophisticated investors” with more than $2.5 million in assets and a $250,000 annual income. So-called “mum and dad” investors will be limited to investing up to $10,000 per offer in a 12-month period. Eligible companies will be able to raise up to $5 million through CSEF in a 12-month period.
Many startups and businesses will be deterred to participate due to the total assets and revenue tests combined with the governance costs of running a public company,” Lieu says.
“The goal is to balance stakeholder interests (businesses and investors), while ensuring regulations are strictly enforced. We want to increase investment opportunities for small-scale retail investors and provide a new way to access funds for small and medium enterprises.”
The future of equity crowdfunding
Legislation surrounding equity crowdfunding is already in place in several countries around the world, including the UK and the US. But Lieu says Australia can first look to a regulatory framework based on the New Zealand model, which also mandates the licensing and gatekeeper obligations for intermediaries.
Moreover, the NZ model follows the same asset-testing requirements for various exemptions and reduced disclosure requirements. However, unlike the New Zealand model, the bill imposes a $10,000 limit on investments by individuals over a 12-month period,” Lieu says.
What are the pros and cons of equity crowdfunding
If you’re looking to diversify your investments portfolio by investing in a project, here are some pros and cons to be aware of.
- Great ideas get funded. If an entrepreneur has an innovative idea, their project can get the funding it needs, regardless of whether or not they meet the traditional lending requirements of a bank.
- Put your money where your mouth is. Equity crowdfunding allows Australians to access unique investment opportunities and support great business ideas.
- Small initial investment. Unlike some other investments, equity crowdfunding typically does not require you to put up a large amount of money to gain an investment stake.
- No legislation in place. Australian legislation surrounding crowd-sourced equity funding is still being developed. Until legislation is finalised, there is little protection in place for investors.
- High risk. As a general rule, investing in startups is much riskier than investing in established companies.
It remains to be seen what will happen to the bill in coming months, but until any legislation is passed it’s worth remembering that there is little protection in place for investors if something goes wrong.
If companies don’t keep their promises to investors, there’s a real risk of losing the funds you invest. As always, the best advice is to thoroughly research any investment opportunity before handing over your money.