Follow the crowd

Except it's not quite like that. The reality is that you're sat in front of a computer screen in your living room, about to hand over some cash to a bunch of complete strangers with no track record. Only about one in 10 of these businesses makes investors any profit whatsoever, and there are no official figures because angel and crowdfunding groups say they don't keep a record of their businesses' success. This lack of information is not an accident, and in itself proves a point. The odds are never in your favour, especially if you treat it as a bit of fun and don't do your homework on your investments.

It is possible to make money, though. Professional angel investors report making bumper returns - earning 30 times your initial investment is not uncommon - although even they admit that most of their investments go to pot. And they spend days and weeks on end, poking their noses into company accounts and interrogating the directors to sort the wheat from the chaff. They also spread their risk by having portfolios of at least 10 companies - rather than taking a punt on just one or two.

Being able to diversify like this is one of the nifty things about crowdfunding - and you can build yourself a diverse portfolio of companies for as little as around £100. Most crowdfunding groups allow very small investments - sometimes as little as £5 or £10, which makes spreading risk possible even for investors with very small amounts to play with.

And they don't charge you a fee for joining or investing, either. Instead they take a cut of the money they raise for each company (usually around 5 per cent), and the companies don't mind this because it works out cheaper than a bank loan. In fact, the lack of bank lending since the financial crisis is a major reason why small businesses are so hungry for small investors' money - and why crowdfunding websites are now popping up everywhere.

How to choose a crowdfunding platform?

That, however, means there is a sea of different crowdfunding platforms for you to choose from, and wading through them can take time - and that's before you've even started browsing the companies. All crowdfunding platforms claim to have a strict vetting process - but the reality is that some are more selective and are more scrupulous than others.

If you're going to have a proper stab at crowdfunding, we reckon you should use more than one site, but here's our pick of websites and groups that are most suited to different types of investors - bearing in mind that not everyone is looking for the same experience.

BEST SELECTION OF POTENTIAL INVESTMENTS

Our pick: The Syndicate Room (www.syndicateroom.com)

Unlike other crowdfunding platforms, The Syndicate Room only lists companies that have already been promised at least 25 per cent of the funding they need from professional angel investors. This means before you even get to see these businesses, they have been scrutinised by investors whose interests are aligned to yours - as they're hoping to make money in exactly the same way as you. The valuations you see on the site are also calculated by these professional investors - which are likely to be more realistic as companies are prone to producing "flattering" valuations if left to their own devices, according to co-founder Gonçalo de Vasconcelos. The Syndicate Room has only been live for around six months so it lacks the track record and scale of some of the bigger sites, but its methodology sets it apart from the crowd.

Notable transactions: e-Go, the first aircraft to be designed and built in Britain in decades, has just completed a £650,000 funding round via SyndicateRoom.

How many companies get full funding: 83 per cent.

Minimum investment: £500.

BEST SHAREHOLDER RIGHTS PROTECTION

Why does it matter? If you've invested money in a business that does turn out to be profitable then that's great. But things can still go wrong. If there are a thousand investors all scraping around for profits things can get nasty, and you could find your shareholder rights being diminished overnight. It's complex stuff, which is why it's important to have legal protection against this kind of cut-throat activity.

Our pick: Seedrs (www.seedrs.com)

Seedrs is one of the only equity crowdfunding platform with formal approval from the Financial Conduct Authority. This means investors have to complete a questionnaire to certify they are sophisticated investors. A stand-out feature of Seedrs is the nominee protection it offers - which protects the shareholder rights of investors with money invested in successful businesses. It has a number of complex legal structures in place to ensure this, but once investors start making a profit they have to give 7.5 per cent of it back to Seedrs for the privilege. Since 2012, Seedrs has had 65 start-up businesses successfully funded, with around £6.1m invested.

Minimum investment: £10.

Average investment per business: £703.

How many listed businesses get full funding: 20 per cent.

Tax breaks: Around 87 per cent of fundraising has been eligible for SEIS breaks, and 10 per cent has been eligible for EIS.

LOWER RISK AND INCOME GENERATING

Why does it matter? For some investors the risk of investing in new inventions or brands is just too risky, and its also difficult to get income from (S)EIS investments, which might not be suitable you if you're a pensioner.

Our pick: Abundance Generation (www.abundancegeneration.com)

Founded by the co-creator of peer-to-peer lender Zopa, Abundance Generation is a regulated platform introducing investors to small renewable energy projects. Typically wind farms and solar panels, the technology behind the investments is well established - which is where it differs from traditional crowdfunding projects where your money is being used to back brand new inventions. Demand is high and 100 per cent of the projects on the platform get full funding - usually within several weeks of being listed. High levels of demand also mean you can choose to sell your shares to another buyer for a fair price if you decide you want your money back. Managing director Bruce David says solar panel investments currently yield around 7 per cent and wind farm investments yield around 8.5 per cent. He says you should expect to hold the investment for at least 10 years before getting your money back.

Minimum investment: £5.

Average investment: £1,500.

Tax breaks: None (but can be put in a Rowanmoor or Jardine Lloyd Thompson Sipp).

BEST FOR THE 'FUN FACTOR'

Why does it matter? Crowdfunding is one of the most entertaining ways to invest your money - and many investors see it as a hobby rather than a way to get rich. So if you're willing to risk your money, you may as well have the best time possible doing it. If you're investing in small companies for the fun factor, there is no contest between looking at a company profile through a computer screen and actually turning up in person to a Dragons' Den-style meeting.

Our pick: The Ideas Factory (www.theideasfactory.com)

The Ideas Factory (TIF) holds regular investor meetings in central London, hosted by its eccentric founder, Jonathan Willis, who is an experienced angel investor himself. The pitches are impressive, there's plenty of time to ask questions and no pressure to invest, and the sessions are very well attended by professional angel investors. It's an extremely good opportunity to get tips and bounce ideas off them (and there's a bar which encourages a sociable atmosphere). And as well as being a fun experience, TIF also has an impressively robust vetting procedure in which around 95 per cent of the companies applying to pitch their idea to private investors are rejected - a much higher rate of refusal than most of the popular crowdfunding websites.

Minimum investment: Depends on project, but normally upwards of £1,000.

BIGGEST INVESTOR POOL

Why does it matter? More investors equals a higher demand, which means listed companies are more likely to get funding. This lessens the chance of you wasting time eyeing up companies that fail to raise enough money to meet their target. And if you believe in the power of the crowd, then a bigger pool of investors could indicate a better model for success.

Our pick: Crowdcube (www.crowdcube.com)

Crowdcube is the monster of all crowdfunding sites, with 60,000 registered investors. It's also one of the few to be FCA regulated. Of these, 20,000 have self-certified as a high-net-worth or sophisticated investor and 30 per cent of its investor base earn over £80,000 a year, according to co-founder Luke Lang. In 2013, 54 businesses listed on Crowdcube secured over £12m - more than any other site. Six-figure investments are not uncommon as Crowdcube is also used by a number of full-time angel investors with very large sums to invest. Crowdcube is also a popular choice among female investors, with 25 per cent of its investors being women, compared with just 3 per cent female angels reported by the UK Business Angel Association.

Notable transactions: Kevin McCloud of Grand Designs fame raised a crowdfunding world record £1.9m for his Hab Housing venture via the platform.

Average investment: £3,000.

How many companies get full funding? 20-25 per cent of those listed.

SAVE TAX WITH SEED FUNDING

While the risks associated with investing in start-up companies are hair-raising, crowdfunding starts to look a lot fluffier when you consider the tax breaks you can get. They have the potential to allow you to recover the vast majority of your money. Before you invest, check the company is eligible for Seed Investment Enterprise Scheme (SIES) tax relief (not all the ones listed on crowdfunding sites and at investor meetings qualify).

Jude Cook, managing director of crowdfunding platform Sharein, describes SEIS relief as: "The best tax breaks that have ever existed". As an individual you can claim up to £100,000 in relief every year. Currently, you can claim back up to 100.5 per cent of the money you invest in SEIS eligible companies. This means that, in theory, there is no downside risk to your investments at all.

However, it isn't quite this straightforward. Here's how it works. Once the company in which you've invested has spent 70 per cent of the money it raised in that particular fundraising round, you can claim 50 per cent of the value of your initial investment amount back on your tax return, by deducting it from your income tax bill. But the drawback is it is impossible to know when this will be, and there is no guarantee the company will ever declare it has spent 70 per cent of its funds (and there isn't any data on this, either).

There are other tax breaks. If you hold the investment for three years or more its entire value is free from inheritance tax and capital gains tax. If you make a loss on your investment - or it becomes totally worthless - you can offset some of that cost by claiming it back in income tax. How much you can claim back depends on your income tax rate. And if you've got a capital gains tax bill for the year then you can currently offset some of it by claiming back 28 per cent of the value of your SIES investments. However, in April this year the amount of capital gains tax you can claim back for SIES investments is being halved from 28 to 14 per cent. That will reduce the maximum SEIS relief you can claim from 100.5 per cent to 86 per cent.

Nevertheless, the tax breaks you get for investing in small businesses still work extraordinarily well at limiting the downside risk of investing - but to get them you have to be organised enough to include them on your tax return.

And just because the pain of downside risk is limited, it doesn't necessarily make crowdfunding a good investment. Thousands of people investing purely for a tax break creates false confidence in the market, so don't fall into this trap. If you're going to invest your money in a company, then you need to believe it has real potential to succeed.

THINKING OF CROWDFUNDING? BE AWARE OF CHANGES HAPPENING IN APRIL

With crowd funding websites popping up all over the place and swarms of investors piling in, it hasn't taken the Financial Conduct Authority (FCA) long to pay attention. It is proposing some new rule changes which will be announced in April this year – which are designed around protecting investors. The exact details aren't yet known, but here’s what the industry is anticipating.

Investing restrictions: Because most investments in start-up businesses result in a 100 per cent loss of investment, firms won’t be allowed to promote these platforms to you unless you’re a sophisticated investor, a high net worth investor, or you receive investment advice or investment management services from a regulated adviser. Alternatively, you can invest if you certify that you will not invest more than 10 per cent of your portfolio (excluding their primary residence, pensions and life cover) in unlisted shares or unlisted debt securities. There’s also talk of a limit being placed on investors who don’t have a financial adviser – possibly around £1000 a year, however this is not confirmed.

Marketing restrictions: The FCA is expected to make the way crowd funding platforms promote companies stricter. The industry is worried this could stifle the amount of money being invested and lead to fewer companies getting full funding – and exactly how it will enforce restrictions isn't yet known. Promotional tools such as a star rating or ‘investment of the week’ awards could amount to advice, which would mean the website would need to apply to the FCA for permission to advise on investments. Limits the FCA has placed on the marketing of unregulated collective investment schemes, or UCIS, will also apply to platforms that offer these investments.

INTERVIEW: How to invest successfully in small companies

Around five out of 10 small companies become worthless and only about one in 10 makes money for its investors. Investors in those that do make money can sometimes find themselves being pushed out as shareholders. So if you've invested money in a company that has taken off, you need to maximise your returns as there's a lot that can go wrong. Peter Cowley, an experienced angel investor, explains below how to give yourself a chance of finding successful companies and make the most out of owning their shares.

"I see investing in small companies online as a total lottery. Many people believe anything they see, and that's a shame for them. The thing you need to realise is that the interests of crowdfunding platforms are misaligned to yours. They're making money by displaying companies on their site and getting you to invest. You, the investor, want the company to succeed so you can make profits. But they don't necessarily care about that - because as long as the companies are getting funding, they're making money.

"But if you are serious about making money from crowdfunding, you need to get face-to-face with the companies you're investing in. You need to look at the company directors as human beings. Are they capable of taking a company to the next level? Do you trust them? Investing as a group is also highly advantageous - which is why crowdfunding can work well. You all have different skills and expertise which you can use to pick apart companies to see if they really stand up - and you spread the risk between you.

"After you've invested, the best way to make money is to make a good exit from the shares - especially if the Enterprise Investment Scheme (EIS) criteria are met, when there is zero per cent capital gains tax.

"The most important EIS criterion is the length of investment - you must have owned the shares for more than three years. But, in my experience, exits before three years are usually complete failures - so you should be aiming to hold them for longer than that anyway.

"In some cases there may be a possibility for you to receive dividends, but angel investors don't normally expect them. This is mainly for two reasons: a) because the dividend money could and should be reinvested to grow the business, because this will ultimately result in a better return for you when you finally sell your shares; and b) because dividends are taxed at your marginal rate - which is usually 40 to 45 per cent if you're a higher-rate taxpayer - which is much bigger than EIS's tax rate which is 0 per cent. If you can avoid the higher rate of tax, you should, which is why dividends don't always make sense.

"I generally prefer to invest in businesses that have a low enough equity capital requirement so that angel investors and crowdfunders can provide all the funding.

"That's because if the company requires more money than angels can provide, a venture capitalist may get involved. And this isn't good news. Venture capitalists naturally have to protect their investors, and they have no EIS tax advantages so they will try to introduce preferential terms for their investment. This is absolutely fine - until something goes wrong. This is when the other investors can get diluted very heavily.

"To protect yourself, something to look out for is experienced angel investors sitting as non-executives on the board. They will be taking a lot of time making sure everything suits their interests - and their interests will be more or less aligned with yours. I will never invest in a company unless there is a trusted investor director on the board.

"Another thing to look out for is that EIS shares must be ordinary and have no preferential rights (there are rare exceptions to this). This is so future incoming investors get the same terms as those already investing. It means your rights can only be diluted, only if you don't continue to invest. Always check the shares are ordinary before you invest, and if they aren't, ask why not."

Profile

Name: Peter Cowley

Enterprises: Founder of Camdata Ltd (specialist electronics business), has speculatively built five houses, project managed the new Cambridge CAB, sophisticated angel investor.

Best angel investment: He sold Ept Computing to Red gate software and made 15 times his initial investment in less than three years.