What are the risks of online investing?
You should ask yourself if equity crowdfunding is right for you. Do you fully understand the associated risks? If not, this post will tell you what they are and the steps you can take in order to limit them as much as you possibly can, whilst more importantly, maximising your chances of building a balanced successful investment portfolio.
Also, when do you need the money that you have invested back? If the answer is “soon”, then equity crowdfunding probably isn’t for you.
Investing into start up, early stage, and established businesses via equity crowdfunding is a form of long investment, which means that you shouldn’t expect to see a return on investment (ROI) until the business is in a position to execute an exit strategy for early stage investors and this could be anything from, at best, 3 years but more likely to be 5 years upwards.
Risk #1 Loss of capital
Businesses at any stage can fail and if that happens, you will lose all of the investment you made. You should never invest more money than you can afford to lose without having to alter your standard of living.
How to mitigate
Ensure that all investments you make in this asset class are in SEIS (Seed Enterprise Investment Scheme) and EIS (Enterprise Investment Scheme) compliant businesses. SEIS offers 50% tax relief. For example, if you invest £1000, it will only cost you £500, meaning that you’ve mitigated the initial risk by half.
Also, if you have invested in an SEIS qualifying business and it fails, you can claim an extra 14% tax relief on the investment. So the original £1000 investment, would now cost you £350. Which, although still an important amount of money, is significantly less that the full £1000.
Whilst the tax relief available on EIS businesses is lower, at 30%, the fact that the businesses should be more mature than start ups, offer a lower risk profile, and may exit a little earlier.
Risk #2 Liquidity
Unlisted or private companies are also referred to as non-readily realisable investments by the Financial Conduct Authority (FCA).
This asset class presents a risk in that the investment is illiquid when compared to other investments.
It is more difficult to sell or exchange shares without suffering a loss on their original purchase value. Illiquid assets also cannot be sold quickly because of a lack of ready and willing investors or speculators to purchase them.
Currently, there is no secondary market for shares in equity crowdfunding (like there is in the stock market), although this may change as the online equity crowdfunding market evolves.
Similarly, it’s not easy to sell shares at all, unless at a major milestone, such as when the business exits.
Therefore, investing in businesses at this early stage of growth is form of long investment, and once you have invested, you most likely won’t see a return for a number of years.
The majority of the investment opportunities listed on equity crowdfunding platforms are private, unlisted companies and will be of limited liquidity.
Investors in unlisted companies may normally expect to sell or realise their investment when, and if, the company floats on a publicly-listed stock exchange, or is bought by another company, which often takes a number of years from initial investment.
How to mitigate
Another way to mitigate the risk of illiquidity is to look for investments which may offer early exits. Some business investment opportunities may offer exit routes to investors in the form of a share buy-back which could be facilitated by the introduction of further funding rounds, at a later stage.
This means that the business owner may be in a position to buy back the shares that they sold within a couple of years, depending on levels of success and growth.
Risk #3 Rarity of dividends
Unlisted companies, particularly start up and early stage businesses rarely pay dividends. If they do, then their level will depend on the success of the investee company, which may take some years to achieve. If it happens at all.
Companies have no obligation to pay shareholders dividends and generally investee companies will reinvest profits to grow and build shareholder value.
Therefore, if you invest in an unlisted company, even if it is successful, you are unlikely to see any return of capital or profit until you are able to sell your shares in the investee company. Even for a successful company, this is unlikely to occur for a number of years from the time you make your investment.
Most start up and early stage businesses are not in a position to offer dividends, especially in the first few years.
Instead, they offer a ROI, which will most likely come when the business exits, and therefore will not take place until a number of years after the initial investment.
How to mitigate
If you want to invest solely for dividends, then online equity crowdfunding into start up and early stage businesses isn’t for you.
For dividends, your portfolio should include investments in listed stocks and shares. This is a very different asset class where investors invest for growth.
Risk #4 Dilution
If the company raises additional equity funding in the future, it will issue new shares to new investors and the percentage of the business that you own will decline.
Any new shares may also allow for certain preferential rights to dividends, sale proceeds, and other matters. If such rights are exercised by new investors, this may work to your disadvantage.
If the investee company grants options (or provides similar rights to acquire shares) to connect employees, service providers, or certain other parties/individuals, then your investment may be diluted as a result.
Dilution of the value of the shares you have bought will occur if you choose not to take part in follow-on rounds.
How to mitigate
Ensure that when you invest in start up and established businesses, you invest through a platform that protects smaller investors and allows them to participate in follow on rounds.
Here at GrowthFunders, we have received a couple of comments, in which people have voiced their concerns over the possibility that the investors who make up “the crowd” don’t fully understand what it is that they are doing.
GrowthFunders’ counter argument to that is that in order to become an online angel, there are a few steps you have to take which prove that you understand the risks involved with investing in this asset class.
This is an exciting asset class but it is a high risk/high reward investment strategy. We’re delighted that the FCA have ensured that smaller investors can now take advantage of the tax relief associated with investors in start up businesses through the Seed Enterprise Investment Scheme and Enterprise Investment Scheme.
These breaks, as well as the ability to invest in this asset class at all, were previously only available to high net worth individuals.
At GrowthFunders, we are committed to ensuring that our investors understand the risk reward profile associated with investing in start up and early stage businesses.
It’s important that investors only allocate a small portion of their investment portfolio in this asset class.
In order to invest in businesses via the GrowthFunders platform, you’ll need to take an appropriateness test, which will only take couple of minutes, but will show that you have the appropriate levels of understanding necessary.
We have some very exciting investment opportunities, all of which are either SEIS or EIS compliant. But before investing, make sure you have decided how investing in this asset class fits with your overall investment strategy.
If it does, you could be helping to support the next generation of great British businesses.