What’s the difference between peer-to-peer lending and crowdfunding?

By Luke O'Mahony

We’re often asked how crowdfunding differs from peer-to-peer lending, as the two are often mentioned together. Crowdfunding, like peer-to-peer lending, is at the cutting edge of innovation in finance, but the two are fundamentally different in terms of risk and rewards.

 

What is crowdfunding?

With peer-to-peer lending, investors lend to people or business, who will repay the cash, plus interest, over the term of the loan.

Crowdfunding is less straightforward, partly because there are two types of crowdfunding: reward-based and equity-based.

Let’s start with reward-based crowdfunding: say you’re a budding director and you want to make a film. You turn to crowdfunding to raise £10,000 for your first feature, but rather than offering to repay your backers using cash, you offer them another kind of reward. You might offer them a ticket to the first showing, or maybe even write them into the plot of the film.

You’ll notice that reward-based crowdfunding isn’t really an investment – it’s closer to a form of sponsorship, as it’s not something you’d go into with the expectation of earning a financial return.

Equity-based crowdfunding works more like a conventional investment in shares. Entrepreneurs or early stage companies offer shares in their business in exchange for upfront investment loan. From the point of view of the business, if they’re successful, they’ll have given up a small part of their company, in the form of shares. If they’re unsuccessful however, the shares are simply worth nothing, and they have nothing to repay. Obviously this would be a bad outcome for the investors, whose shares in the company would become worthless.

Equity-based crowdfunding is attracting substantial levels of investment, and some trailblazing UK crowdfunding platforms are growing the sector rapidly and funding some fantastic small businesses.

Crowdfunding risks

Investing for equity in small businesses and start-ups can be very risky. One of the leading platforms states, “it is significantly more likely that you will lose all of your invested capital than that you will see a return of capital or a profit”. There are other considerations too: these investments are illiquid, meaning that it can be extremely difficult to sell on your investments and get your money back, not to mention the fact that most early-stage businesses fail.

How is peer-to-peer lending different?

Peer-to-peer lending has a track record of being much lower risk for investors. Although on some P2P platforms, investors have made losses, many platforms only lend to creditworthy borrowers. In the five years that RateSetter has been operating, not one individual investor has ever lost a penny.

Investors don’t own shares; instead, the reward is the interest that is paid on the loan. So far, RateSetter investors have earned more than £20m in interest.

Access to money is also easier – so long as another investor available to take your place, you can sell out, although the rate you earn will be reduced to reflect the amount of time you actually invested for.

The tax treatment is different too – you’ll be able to invest in peer-to-peer lending tax free from April 2016, while the tax benefits around equity based crowdfunding are powerful but also more complex.

 

So should I rule out equity-based crowdfunding?

Equity-based crowdfunding isn’t for everyone. It’s widely agreed that, as a form of investment, it’s suitable only for sophisticated investors – in other words, those with a very high level of knowledge about finance in general, and about early-stage business investing specifically, before investing.

However, even sophisticated investors who are fully aware of the risks should only invest what they can afford to lose.

How risky is peer-to-peer lending?

RateSetter’s products are investments, rather than savings, so they don’t benefit from FSCS cover. However, we have a £15m provision fund to help protect our investors. Capital is at risk, but with that risk comes substantially better returns - to see what return you could earn, take a look at our live rates.