The great adventure: How to navigate the world of equity crowdfunding as an investor

Debt and equity crowdfunding have the potential to revolutionise small business funding. In 2012, The Breedon Report predicted a funding gap of £59bn for UK companies by 2016, if nothing was done. The government’s response was to make funds available via alternative finance providers and to enhance the benefits to equity investors via the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS). This catalysed the development of equity crowdfunding. In simple terms, this emerging model gives retail investors the opportunity to buy a stake in a startup or small business. Last year, the market grew by a staggering 420 per cent in the UK alone, with volumes totalling €111m (£82m).

 

Debt crowdfunding is a much bigger industry – taking into account peer-to-peer business lending as well, volumes totalled €1bn in 2014. But it and equity crowdfunding serve different functions. A debenture with an investment period of, say, 20 years, is not comparable in terms of what it can offer an investor with a stake in a promising startup.

 

Equity crowdfunding gives businesses an opportunity to secure funding and brand advocates. For would-be investors, it’s the chance to be a part of something through ownership, and to invest in projects usually the preserve of the venture capitalist. Of course, VCs can win big, but many projects fall flat – with equity, the everyday investor is exposed to the same risk premium.

 

And of course, this emphasises the peril of equity: unlike debt, an investor may well not know for years that things have gone wrong – you’re looking forward to a payout, but the investment folds, with no warning.

 

So what does it mean to be a savvy armchair equity crowdfunding investor? How can you minimise the risks before taking the plunge?

 

 

According to the Financial Conduct Authority (FCA), 62 per cent of equity crowdfunding investors describe themselves as retail investors with no previous experience of early stage investment. “Regulation plays a core part in developing confidence and engagement in new ways of doing business and investor protection. And crowdfunders definitely need protection,” says Jonathan Rogers, head of financial services regulatory at Taylor Wessing.

 

Despite improved protections at platform level, the inherent hazards in the underlying assets and lending book mean that crowdfunding is still a high-risk strategy for investors. The majority of those within the industry want proportionate regulation. Too much, and the sector runs the risks of raising barriers to entry and hampering new market entrants. Too little, and platforms always have the onus of proving themselves, with no recourse to a basic standard.

 

Last year, the FCA introduced the first rules for crowdfunding. These limit investors’ stakes to what they can afford to lose, along with placing strictures on platforms themselves. Platforms can only deal with retail investors who have certified that they have not, in the last 12 months, and will not in the following 12 months, invest more than 10 per cent of their net assets in unlisted securities. They also have to assess whether the investor has the necessary experience and knowledge to understand the risks of making an investment. And “being authorised means a platform is subject to a level of scrutiny on its business plan and financial situation, as well as the firm’s website and approach to marketing,” explains Rogers. A platform should present a balanced picture of an investment – both the upsides and downsides.

 

And behind the scenes, authorised firms are subject to core consumer-centric requirements, like client money protections, minimum capital standards, planning for an insolvency event, and last resort protections from the Financial Services Compensation Scheme. “All this is not only intended to reduce the chances of a platform collapsing, but also helps to ensure the investors and lenders don’t lose out if it does,” says Rogers.

 

 

Once on a platform, it’s important to scrutinize the calibre of the companies listed. “A platform has a responsibility to make sure that customers are not going to lose their money. They should be looking for companies that they think will succeed,” says Anthony Eskinazi, founder of sharing economy firm JustPark, which raised £3.7m on platform Crowdcube this year. He suggests taking a look at the standing team and the progress they have made to date. “There’s a lot of competition between the platforms to get quality companies on their books. Research press stories too to see who has raised with them in the past.”

 

Many platform founders argue that adhering to current FCA rules is a bare minimum. Goncalo de Vasconcelos, co-founder of Syndicate Room, points out that obligating platforms to check that companies raising money are legal has “no bearing on the company’s future outlook or past statements”. Some platforms will go further, insisting that claims be independently-verified and even filming entrepreneurs being interviewed, to help would-be investors form a judgement.

 

For Eskinazi, the due diligence that he experienced – which was predominantly factual, rather than financial – could have “gone further… particularly given the inflated valuations we’ve seen recently.” But he’s quick to shout caveat emptor, too – “ultimately, it’s for the investor to do their research. If you don’t have enough information, don’t make the investment. There’s only so much hand-holding a platform can be expected to do”.

 

A growing trend in equity crowdfunding is campaigns that have a lead investor – a venture capitalist or angel, who may be a part of determining the valuation. “If you can find that opportunity, jump on it,” says Eskinazi. Retail investors investing in JustPark did so alongside Index Ventures. “I’d always look for an institution or trusted party to participate at the same valuation and in the same round. First of all, it gives the valuation credibility. Second, it’s a confidence boost that the company has the potential to grow.”

 

 

As a potential investor, you can dig even more deeply before pledging your money. An important – and hotly debated – area is when a platform takes money: does it charge a company up front, take from the money raised, or both? Some argue that certain fee structures could create a conflict of interest, encouraging platforms to be indiscriminate in choosing businesses – provided they can get them fully funded, they can take their fee. But for many, this view smacks of the impractical. James Codling, co-founder of platform Venture Founders, which charges an arrangement and profit share but works closely with funded businesses post the round, says “this is how fund management and private equity work. If the businesses we put forward to our investors do well and we deliver a successful return for them, we take a profit share on exit”.

 

Another contentious subject is overfunding – when a company crowdfunding has hit its target, but continues to offer stakes. Bruce Davis, who cofounded debt platform Abundance and peer-to-peer lender Zopa before that, says that overfunding is rarely positive. “Success should be about bringing in the right amount of money at the right time.”

 

“Overfunding is sometimes done more for marketing purposes than anything else, with the mindset, ‘set a lower target to drive investment, which will prompt a successful campaign that leads to overfunding’ – that’s wrong,” says Codling. Investors should be wary of investing in unfunded businesses plans, and should ensure that there’s a clear plan to the next capital raise. If a company has a capital glut, shareholders may end up diluted as a result.

 

But for many early stage businesses, points out Codling, it is “very difficult to forecast with any degree of accuracy how much capital you’re going to require” – which is why a clear, defined use for what they’re going to do with it is so important. And remember, says de Vasconcelos, that a small amount of overfunding is normal when firms are funding via angel investors: “it reduces risk for investors as companies get more leeway before running out of cash. Firms also almost always need more money and more time than planned, so it puts them on the safe side”.

 

 

It’s vital that a platform offers a robust shareholder structure. For starters, that means receiving a shareholder certificate. These agreements have yet to be put to the test, but they are critical – particularly as you may only own around 0.01 per cent of a company. Many leading platforms operate nominee structures, which means that you won’t own shares directly. They usually, however, enshrine certain shareholder benefits – financial returns, the opportunity to vote and protection against dilution – but also mean that you’ll negotiate collectively, with the platform advocating on your behalf, if your rights are challenged.

 

But there are a couple of technical definitions to be aware of. The first are B-class shares, which several platforms offer. These are nonvoting shares: if you invest under a certain amount, you don’t get as much say in how the business is run. Indeed, a company could move in a completely different direction, and you wouldn’t be able to change that.

 

And it’s the same story with pre-emption rights, which give you the right to buy new shares before they are issued to anyone else. Without pre-emption rights, a company could issue new shares without offering them to existing shareholders, diluting your investment. “New share issues are not necessarily something to be afraid of,” says Codling – it can be “very positive,” indicating that a fastgrowing company needs more funding, which it then gainfully employs, and returns more to investors. But investors need to be protected, and a lack of pre-emption rights have often caught people out. Their effect is portrayed in the film The Social Network, which depicts the sidelining of one of the founders of Facebook. “We do need to do a better job at educating investors. FAQs often go into a lot of detail, but it’s not necessarily technical enough,” says Codling. “Different structures have different pros and cons – it’s important that you understand acutely what those are before going ahead with an investment.”