It’s not uncommon for these two, very different types of investment to get bundled together by the catch-all term Alternative Finance. Certainly upon explanation of Peer-to-Peer (P2P) lending to those not ‘in the know’, a common reaction is that P2P is “just like crowdfunding.”
In truth, they do share some similarities. Both systems of investment rely on many different investors for each borrower, usually through an intermediary website. They can also both be used for businesses looking for a cash injection, start-ups looking for capital and for investors looking for better returns than through a traditional bank.
But this is where the similarities end. Each type of investment is very different in terms of specifics and there are, of course, varying levels of risk with each type of investment.
The first thing to point out is that, though it seems like a modern phenomenon, crowdfunding is nothing new at all. One of the earliest identifiable forms can be traced back to the 18th Century where a financial strategy called Praenumeration was employed by European book publishers. Books that had been planned or were in the early stages of development would be offered to subscribers upfront in order to acquire some start-up capital. Sound familiar? This would cover the costs of the author, the printing and other publishing costs and in return the subscribers, or investors, would get a discounted rate on the price of the book.
Crowdfunding in the 21st century doesn’t differ much from this, aside the fact that the process is completely online, more or less instantaneous and open to a worldwide audience.
In a crowdfunded venture, the borrower will choose a platform such as Kickstarter, Crowdfunder or Property Partner and set up a proposal for potential investors. As an investor, you’ll get to choose who you lend to and how much. In return, depending on the platform, you could acquire shares in a company, a financial return, a reward based on the product or sometimes nothing at all (like a charitable donation).
As with all things in the financial sector, there are many different types of crowdfunding but they can roughly be broken down into two subsections: Reward Crowdfunding, Equity Crowdfunding and Debt Crowdfunding.
Reward Crowdfunding is more like a form of sponsorship or donation. With Reward Crowdfunding you pledge your money in a person, business or product for either nothing at all (charity) or a non-financial reward. For example: a musician might ask their fans to help raise funds for a new album in return for a credit on the album sleeve or a ticket to a show. 80’s throwback Marillion were the first band to do this when they asked fans to help fund a US tour in 1997 way before Kickstarter was even dreamt about.
Examples of Reward Crowdfunding include Kickstarter, Go Fund Me and JustGiving.
Equity Crowdfunding however is similar to a traditional investment. You’ll invest your money in a company in its early stages (one not floating on the stock market) in exchange for shares in that company – much like BBC’s Dragon’s Den. As a shareholder you’ll be entitled to a share in the profits and dividends if the company scales but you could also lose the value of your entire investment if the company performs badly and fails to grow.
One of the benefits of Equity Crowdfunding when compared to a traditional investment is that you the investor can decide where your money goes and how much of it you want to invest rather than the bank or building society doing this for you. The risks however can be considerable as your capital is at risk when investing in equity despite being only a shareholder. That said, the returns for picking the right company that scales can be considerable.
Naturally as the businesses are in their early stages and you’re investing directly with them you’ll need to be comfortable with the potential risks that come with businesses in their infancy and properly plan for every eventuality.
Debt Crowdfunding is the third type of crowdfunding which includes different types of lending such as mini-bonds, invoice financing and P2P lending, which we’ll go on to in a minute. Mini-bonds are, as the name suggests, a short-term (at least in finance) way for individuals to lend to business whereas invoice financing involves third parties paying out on invoices which business are yet to receive. The final part of Debt Crowdfunding is P2P which we’ve explained below.
Debt Crowdfunding or Peer-to-Peer lending
Strangely enough, P2P once went by a different name - Debt Crowdfunding. In a P2P investment you pledge an amount of money with a platform and invest it into debt, rather than an equity stake.
A good way to think about it is to imagine that you’re lending to someone for a mortgage and being paid interest on that loan rather than acquiring a share in the house itself.
Much like Equity Crowdfunding, you are directly affected by P2P lending if the business or person you invested in doesn’t pay back the investment. However, as your investment is in debt and your initial capital is being repaid with interest you can realise returns much sooner than with shares. That said, the nature of the investment is very different and your realisable return is often fixed - unlike a share where the real profit is made when the business floats or is sold. In the meantime, your only source of income from your investment will be dividends payed out on the shares.
As you won’t have any shares in the business and you’ll (usually) have a set rate of return for the period agreed, much like a standard loan, your involvement with that business will be over once the term of the loan is over. You can also, in some cases, get out of an investment early subject to the terms of the P2P platform.
So, how does it work?
Let’s say you invest £10,000 in a P2P platform. This can be spread out in small increments across the borrowers that you choose (if the platform allows such a choice) so if one investment doesn’t work out, you’ll be covered (in theory) by the returns on your other investments or by one of the platform’s security measures such as a provision fund or insurance plan. Be aware that not all platforms provide these so make sure you read all the fine print before you part with your money and be aware that, like all investments, your capital is at risk.
However, P2P is by no means risk free. As it’s an investment and not a savings account you won’t be covered by the Financial Services Compensation Scheme if the platform itself goes bust in financial crisis. To learn more about tax-free P2P, read our IFISA blog here.
Are there any tax benefits?
One of the many benefits of P2P over crowdfunding also comes by way of the new Innovative Finance ISA (IFISA) which was released on April 6 this year. With the IFISA you’ll be able to use a P2P platform as part or all of your tax-free allowance in an ISA. This means that you can invest up to £15,240 and any return on that amount will be completely tax free. Crowdfunding however isn’t covered by the IFISA yet but there are plans to include it in the future.
That doesn’t mean that Equity Crowdfunding doesn’t benefit from tax relief as the Seed Enterprise Investment Scheme and the Enterprise Investment Scheme do provide benefits for investors.
Where should I put my money?
That entirely depends on your personal and financial circumstances. When deciding where to put your money always play Devil’s Advocate and ask yourself relevant questions. Do you want to tie your money in to a lower risk (and lower yield) investment with a fixed rate of return for a set period of time? Then P2P could be for you. But if you’re looking to hold shares and get involved in a business from the ground up, then Equity Crowdfunding could be more up your street.
Whatever you choose, be that P2P or crowdfunding be sure to do all your homework and read every fine detail before you hand over any money. Your capital is at risk if you lend to business.
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