Crowdfunding: There's no rush to join the hordes

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Crowdfunding has everyone from Hollywood A-lister James Franco asking fans to help him make his films, charitable projects calling on the community and start-ups looking for investors to get their ideas off the ground. With the banks out of favour, small businesses are jumping at the chance to get their funding from ordinary people – the crowd – but with little to no regulation, is there a mis-selling scandal lying in wait?

Crowdfunding falls into three categories – donation, debt and equity. With the former, people invest in something they believe in, either socially, or personally, but for no tangible gain.

As an example, London-based music festival LeeFest this year asked fans to raise £50,000 via Kickstarter.com so it could stay independent without selling out to big sponsors.

As a reward, backers were given a free party, merchandise, free tickets to the festival and if they pledged over £300, dinner with the founder and a chance to join the board of creative directors.

Debt crowdfunding, or peer-to-peer (p2p) lending is probably more familiar in the UK. Here, investors can use online platforms such as Zopa.com, the pioneer in the UK which arranges more than £8m new loans every month, to lend out their money to individuals, enabling savers and borrowers to remove the traditional banks from the equation. Projected returns for Zopa lenders after fees are 4.7 per cent over five years and to spread risk all loans are split into small portions to many borrowers.

On the equity side, you have the opportunity to invest in the "next big thing" in exchange for a stake in that project. Small businesses use online platforms such as Banktothefuture.com, Seedrs.com and Crowdcube.com to organise and administer the fundraising.

There is usually a specific target to reach within a timeframe and if this is met, investors receive shares in the business they have helped. You can invest as little as £10 and if the start-up doesn't meet its target, you'll get all of your money back. Tax-wise, you could also benefit from Enterprise Investment Scheme and Seed Enterprise Investment Scheme relief on your contributions.

If you "back the right horse" returns could be impressive and crowdfunding may well have a role to play in a diversified portfolio, but be clear that this is high-risk investment.

The Financial Conduct Authority (FCA) has said this should be targeted at sophisticated investors who know how to value a start-up business and understand the risks involved. They have also raised concerns that some crowdfunding firms may be handling money without FCA permission or authorisation, and therefore may not have adequate protection. "From a social enterprise perspective, I'm a massive fan of crowdfunding – it can be tremendously useful because people are motivated to help – but equity crowdfunding has a much higher risk profile," says Mark Hollingworth of Integral Finance, which offers financial management to life science and technology companies.

Only a handful of platforms are regulated by the FCA; Crowdcube, Seedrs and Abundance Generation. There is no protection from the Financial Services Compensation Scheme, although the UK Crowdfunding Association does have its own code of conduct for members with guidelines regarding cooling-off periods for investors and ensuring money is ring-fenced in case the platform goes bust. The bottom line, however, is that no platform can promise you won't lose some, or all of your money.

Moreover, it may be difficult to get enough information about start-ups to make an informed decision. Mr Hollingworth argues that the onus is on the projects asking for money to be absolutely transparent about what they are going to do it with it and about how much money they are going to need before they have a profitable business.

"On crowdfunding platforms you don't really know who you are dealing with. You wouldn't usually invest money in a business if you had never met the owners. You want to get a sense of the personal values of those individuals… are they capable of what they are promising to do, are they credible?" he says.

The simple truth is most start-up businesses fail and even those that don't can take many years to generate a profit. You aren't likely to benefit from dividends and crowdfunds are illiquid, so it may be difficult or even impossible to convert your investment back into cash. If the company issues further shares later on to raise more money, your existing shareholdings may be diluted.

You may also have to give the platform a share of the return. At Seedrs, for example, you pay 7.5 per cent of any profits you make from your investment, although Crowdcube is fee-free for investors as it takes 5 per cent of the total funds raised plus £1,750 in legal and admin fees off the businesses instead.

There are a few precautions you can take, starting with understanding the business in which you're investing. It makes sense to choose something you have an interest in, Abundance Generation only invests in renewable energy projects and since it launched last summer it has raised £2.3m to fund a community-scale wind turbine in the Forest of Dean, a large-scale domestic solar energy project in the South Downs and an existing solar energy farm in Kent.

"We call it democratic finance, enabling small investors, investing from as little as £5, to produce a regular return from the generation and sale of 100 per cent green electricity from wind, solar, hydro and other renewable energy sources," says Bruce Davis, co-founder of Abundance Generation.

If you want to know more about any particular business, ask for it. You should also find out how your money is protected if the business, project or even the crowdfunding platform collapses. This won't be any kind of guarantee, but appropriate cash reserves or even insurance could offer some relief. Don't invest money you aren't prepared to lose and if you don't understand these risks, don't invest.

"Our advice is do your homework," says Julie Wilson of independent financial adviser PenLife Associates. "If you're willing to take a little bit more risk, the return on savings can be more than double the rate you'd receive from traditional banks. And you might end up feeling virtuous lending your money to small companies that need it to grow rather than the big banks that use your money to pay themselves big bonuses."