The wisdom of crowds?

‘It’s an investment,’ a friend once told me about a new car he was about to buy.

Was it?

Sometimes it’s hard to tell – the words ‘it’s an investment’ have been used to justify many an expense. (He really wanted that ride, no matter how much it was about to drop in value.)

Now that equity crowdfunding has arrived in New Zealand, it can be a bit blurry whether putting money into a company that’s raising money on a website is a good or bad investment – or even an investment at all.

This week marked the first company in New Zealand  – a Marlborough brewery – to offer shares on a crowdfunding site, the Snowball Effect. PledgeMe is the other site here that also received its equity crowdfunding licence last month from the Financial Markets Authority.

As of this morning, the brewery was already 87% towards reaching its goal of raising $600,000 so it can expand its business. But before you pony up to keep the kegs flowing at your local, let’s take a closer look.

How crowdfunding works

Crowdfunding began as a simple idea. Using a website, a group of people (the ‘crowd’) contribute to a project or cause that they want to see happen, like an indie musician’s album or buying new tyres for a St John’s ambulance. So it all started as a brilliant way to fundraise for contributions and donations – much like passing a hat around online.

There have even been crowdfunding campaigns to erase someone’s debt.

In exchange for contributions, those fundraising would typically offer some perks, like signed copies of the album when it eventually got made, or postcards from that round-the-world trip that everyone donated for. All good up to here.

Then the ‘equity’ crowdfunding side of things began to develop (it was illegal at first), with small businesses offering shares of their company in exchange for contributions. With that brewery’s offer, this has now begun in New Zealand – allowing small businesses to exchange shares for up to $2 million in funds. It’s a new opportunity for companies to raise money – but how does it look for investors?

Suddenly you’re a venture capitalist

Now, backing new ideas and new companies is something angel investors and venture capitalists do all the time, and crowdfunding aims to open up this sort of thing to us mere mortals as well. Instead of putting up $500,000 to help someone’s business dream take flight, for example, it might take just $500.

But let’s go back to the very basics of investing and ask some key questions before we call something an investment, because it may be just a contribution or a donation in disguise. And although it may give you the true satisfaction of picking a future success and being a part of it, it may not really end up growing your finances at all.

Which is what investing is all about. Essentially, it’s like going shopping, but it’s buying assets that put money back into your pocket – not like the normal things we buy that just burn a hole, which are called liabilities. Assets are the things you buy in order to reach your future goals and stay ahead of inflation.

Shares, or parts of businesses, can be an asset, growing in value either because of the dividend that the company pays or because they become worth more and can be sold for a higher price to other investors down the line.

The asset test

So do shares you get from putting in money with the crowds measure up to this asset test? With equity crowdfunding, are you really buying something that will grow in value?

The answer is: it will be extremely difficult to know. Even more difficult than if you bought shares on the NZX, because although there are rules for equity crowdfunding sites, you will receive less information and know less about the company offering shares and its finances than you would in a regulated share offer. There is no way to know the value of the shares you’ll be buying. So you might be a fan of the brew, but that’s no guarantee it will be a good investment.

Risky business

Getting your money back into your pocket will also be more difficult than it usually is on the sharemarket. Here’s why:

• Many start-up businesses fail. Events happen that are beyond their control, and these blows are hard to take when a business is just getting going.
• Most don’t pay a dividend to investors – they need all the funds they can to keep the business alive.
• They may need even more funding in order to survive and offer more shares to the public, making the shares you bought worth even less (you’ll own a smaller slice of the pie).
• There is no market for reselling the shares you buy, so if you want to cash out, it will be hard to quit.

The FMA has more important information you should know if you’re considering your crowdfunding options.

But I still love crowdfunding

All of this is not to say you shouldn’t back your favourite craft brewery or a worthy cause on a crowdfunding site. Cruising these sites can restore your faith in humanity – they show just how generous people can be.

It’s just that you really may want to reconsider putting in money that you are aiming to grow towards your goals. It should be money that you’re prepared to lose.

By all means contribute to something great. Just don’t call it an investment.