Crowdfunding is often seen as the racy relation to peer-to-peer lending. News certain types of crowdfunding are being allowed into the Government’s new Innovative Finance ISA (Individual Savings Account) is raising a few eyebrows. However, only certain types of funding will be allowed. Could the new rules alter the development path of the nascent crowdfunding market? And what do they mean for investors?

In July 2015, the Treasury announced its intention to launch an Innovative Finance ISA from the start of the next tax year (April 2016). This was initially just intended to include peer-to-peer loans, but will be widened to include crowdfunding debt from the Autumn.

Debt vs equity

Crowdfunding debt is distinct from crowdfunding equity, though in practice the two are often packaged together. Crowdfunding equity will perhaps be more familiar - investors provide cash to a business in return for a share of its profits, it dividends and any sale price. In crowdfunded debt, the investor effectively extends a loan that pays interest and the return of the initial investment. Most crowd-funding platforms offer both options, though historically equity crowdfunding has been more common.

To date, equity crowdfunding has also had a monopoly on all the chunky tax breaks. Almost all equity deals qualify for SEIS relief. This grants a seductive 50% income tax relief upfront, plus investors can offset any losses at their highest tax rate. Peter Walsh, founder of venture capital ‘dating’ site Match Capital, says: ‘Investors could be receiving £100,000 for just £25,000 or so of investment. This is very attractive, particularly to higher tax payers.’

Debt crowdfunding has not enjoyed the same perks. With attractive tax breaks on other types of early-stage investment, many investors consider that if they are going to take the risk on small company, they need to be incentivised to do so. While there are no statistics for it, a lack of tax incentives may have deterred some potential investors into debt crowdfunding.

Bruce Davis, founder of renewable energy crowdfunding site Abundance says that the new rules go some way to leveling the playing field. Debt crowdfunding will enjoy all the usual ISA tax breaks - tax-free income and capital gains. While these do not come close to the tax breaks available for most equity crowdfunding deals, it makes debt more appealing.

However, he points out, there are still limitations, notably around mini-bonds. Davis says that, after lengthy consultation, the regulator has decided that all investments held with the new ISA must be ‘transferable’. This would automatically exclude certain mini-bonds, which are non-transferable.

Playing catch up

Davis says that the law has not yet caught up with the regulations. Crowdfunding sits in a legal middle-ground between public and private placement. However, he adds: ‘It is not a big step for debt issuers to make the instruments transferable.’ He can see more companies doing this to take advantage of the new ISA rules and issuing new offers through crowdfunding platforms.

The Innovative Finance ISA will also be subject to the restriction that an investor can only use one ISA provider per year. This may deter those investors who already make regular contributions to an ISA on a mainstream broker platform, for example. Davis adds: ‘Someone may come along and try and aggregate the two, but this is difficult from a regulatory perspective.’

But could it negatively affect the equity crowdfunding market? The market as a whole is growing rapidly. Statistics from industry consultant AltFi show that crowdfunding platforms have now extended around £205.8 million to small businesses and investment is growing at a rate of more than 200% per year. Luke Lang, a co-founder at Crowdcube, says that the platform is now seeing 25-30 new funding opportunities every month.

He is also seeing a change in the type of companies that are coming onto the platform: ‘We are seeing increasingly high calibre enterprises, run by strong executive teams that may have come from established groups such as ASOS, Ebay, Innocent Drinks, with a track record of scaling and growing businesses.’

He also says that crowdfunders are increasingly investing alongside venture capitalists and other professional investors. For him, this represents a profound change for the industry, meaning later-stage, less risky companies are now sourcing funding through crowdfunding platforms.

As such, in the context of the expansion of the crowdfunding industry generally, and the tax reliefs already available on equity investments through the SEIS scheme, it is difficult to see the ISA changes having any meaningful impact on the shape or structure of the crowdfunding industry.

Match Capital’s Walsh also points out that the two types of crowdfunding investment are operating in different parts of the market. He says: ‘It is not as straightforward to issue debt. Many crowdfunded companies simply won’t have the track record to be able to do it, or would be looking at sizeable interest rates. Therefore when looking at crowd-funded debt, investors are often dealing with relatively established businesses.’

Small slice

He points out that even crowdfunding as a whole is still only serving a relatively small part of the market: ‘Only around 2,000-2,500 companies are getting funding, compared to around 600,000 new company registrations. What is happening to everyone else?’

Lang concludes that the inclusion of crowdfunding debt is good news for investors and it will certainly make bonds more attractive to businesses and investors alike; but adds: ‘We don’t feel it will adversely skew or impact the equity market, which we predict will continue to grow at a rapid pace. Bonds are for more established businesses with proven business models, generating multi-million pound revenues and profitability. Equity on the other hand gives businesses of all sizes the opportunity to raise finance from a crowd of investors, and is particularly attractive to earlier stage companies that may not be in a position to service a debt as they invest heavily in their growth.’

How can investors decide both between equity and debt and between individual opportunities? The potential rewards for equity opportunities are huge - four to five times the initial investment or more - but it can take time to exit. It might take a trade buyer, another round of funding or an IPO to realise that investment. And there is a chance you could lose everything. For debt, investors get their money back incrementally, which can be more appealing. If they have already had six months worth of interest payments, it may be less painful if the company ultimately goes bust.

James Codling, co-founder of Venturefounders, says that investors need to keep in mind that these are very early-stage investments and even those with great ideas may fail on poor execution. On their site, they aim to pick a handful of the best opportunities from which investors can select.

He says: ‘For us “past proof of concept” is really important. We don’t want businesses that are just a “man with a plan”. We want to make sure that the management team has a proven track record of delivering.’

Management check

As such, a lot of the group’s analysis is focused on the assessing the quality and experience of the management team, their motivation and goals. He adds: ‘Management is the most important consideration in determining whether a venture will be success or not.’ From there, he will look at the legal and corporate structures of a business, whether there is tangible intellectual property in place. ‘Does the business have a viable future? Is there a market that it is trying to take on?’

Crowdcube’s Lang believes there is a wisdom in crowds and investors must take time to ‘look and listen’ to what is being said about a company. He also emphasises diversification. No-one is trying to claim that these are anything other than high risk businesses and some, inevitably, will not deliver.