Alternative finance has taken off in the UK, and there are many different investment opportunities for investors including consumer lending, property loans, business finance, and equity investment. With new ways to invest there are also new risks to consider. In this blog we review equity crowdfunding vs peer-to-peer lending, and consider how the risks could impact you, balanced against the returns you could stand to receive.
Equity crowdfunding is a way for individuals to invest in a company, typically a startup or early stage business, in exchange for shares in that company. Traditionally limited to venture capitalists and angel investors, this form of alternative finance has opened up equity investing to a much wider range of individuals. Finance is raised by a group of people (‘the crowd’) in order to reach the company’s funding goal. It is generally restricted to sophisticated investors and high net worth individuals, but some platforms offer exceptions to this requirement. Investors may receive returns on their equity crowdfunding investments from dividends, the sale of the company, or through the sale of shares if the company is listed on a stock exchange.
Equity crowdfunding is regulated by the Financial Conduct Authority (FCA) in the UK, and some investors may be eligible for compensation under the Financial Services Compensation Scheme (FSCS) if they experiences losses due to bad advice from an Independent Financial Advisor. There are a number of risks to consider with equity crowdfunding, particularly as start-up companies are at a greater risk of failure than established businesses with a reliable trading history. Equity crowdfunders risk dilution, illiquidity, lack of dividends, and loss of investment if the company goes out of business.
If the company you invest in issues new shares and you decide not to purchase any, your investment will become diluted due your reduced percentage of ownership. The value of your investment and any dividends you may receive will likely be reduced. Your voting rights can also be affected. Some companies may issue pre-emption rights, which give current shareholders ‘first dibs’ over the chance to purchase additional shares, but some don’t. Be sure to investigate this when selecting companies for investment.
It can be very difficult to sell your shares once you have purchased private equity in a company. If the company you invest in doesn’t offer pre-emption rights, you will likely find it even more challenging to sell your shares. There is no guarantee that a company will list its shares on a stock market, which can also impact your ability to sell your stake in the company.
Lack of dividends
Companies are under no obligation to pay dividends to their investors. Start-up companies are likely to reinvest profits into the company instead of paying them out to shareholders, and it may be some time before the company becomes profitable enough to pay dividends. Equity crowdfunding can be a long-term investment and it may be years before you receive a return on your investment.
Loss of investment
Businesses can and do fail, and start-ups face a number of challenges to their success. As many as 80% of businesses fail within 18 months, and given the high rate of start-up failure, you could lose part or all of your initial investment. You must be willing to lose your total investment if you invest through equity crowdfunding, as you may not be able to claim compensation for any losses you receive.
If you’d prefer to lend money to a company rather than buy equity in it, you could consider peer-to-peer (P2P) lending. In exchange for funding part of a company’s finance requirement, you can earn monthly interest in addition to your capital repayments. As with equity crowdfunding, companies receive funding through a crowd of investors. P2P investors usually see returns within the first repayment cycle, unlike equity crowdfunding which can take months, if not years.
P2P lending is regulated by the FCA, which is currently in the process of regulating the industry and approving platform applications for authorisation. The FSCS may cover some P2P investments, but only if investors have received advice from a regulated advisory platform after 6 April 2016.
P2P lending’s risks are different to those of equity crowdfunding, but they should be taken seriously.
When you invest in a loan, you are investing a sum at a particular interest rate for the duration of that loan. Some platforms allow you to sell your investments before the loan is fully repaid, but your ability to sell your loan part depends on another investor’s interest in that loan and your particular investment in it. You may find it difficult to sell your loan part if the company is experiencing any kind of strain, such as negative news reports or a repeated late payment history. Some platforms, such as LendingCrowd, may suspend the sale of loan parts if they are aware of such a situation, to protect new buyers from investing a loan when there is a known issue.
Borrowers agree to repay investor funds at regular intervals, typically monthly, but there is no guarantee that they will be able to repay on time every month. Some borrowers may fall behind in their repayments, impacting the amount of interest you expect to receive each month, particularly if you rely solely on the interest you earn from P2P investments. There is an opportunity cost as well: late repayment affects your ability to reinvest your interest the moment it’s paid back, and while you may eventually receive the interest you are owed, you’ve lost potential interest every day the repayment was late.
Loss of investment
While some borrowers may make late repayments, some may fail to repay at all. Some, though not all, platforms have funds set aside to cover bad debts, but the amount varies between platforms. As with equity crowdfunding, you should only invest if you are prepared to lose your entire investment.
Reducing your risk
Whether you invest in equity crowdfunding or peer-to-peer lending, diversification is crucial for mitigating your risk. You might reduce your risk by investing in several kinds of businesses, by using a number of alternative finance platforms, and by investing in a few different ways (click here for ways to invest and here for how returns differ). It is a good idea to invest in sectors you have experience in or have researched extensively. We have a number of tips for diversifying with LendingCrowd.
Before you decide on how you want to invest, we recommend speaking with your financial advisor and performing your own analysis of the risks related to the form of alternative finance you use, the platform you invest with, and any individuals or companies you choose to invest in.
Note: This blog is intended merely as an overview and not a comprehensive list; consult your financial advisor for a full risk assessment. Please note that the information in this blog is subject to change at any time, and that LendingCrowd takes no responsibility for any financial risks you incur after reading this information.
At LendingCrowd, we’re here to help! If you’d like more information on investing with LendingCrowd, contact us at 0131 564 1600 or send an email to email@example.com.