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A Novice Investor’s Guide to Crowdfunding




By Ryan Weeks on 5th June 2015

Rocío Lara, https://goo.gl/Uf4M2r

This is a relatively succinct introduction to the UK equity crowdfunding sector for the inexperienced investor.

 

The concept is simple. A company needs to raise money in order fuel growth. In order the raise that money, the company frees up a portion of its equity. Equity roughly speaking translates to ownership. If a company wanted to raise £100k at a valuation of £1m, the investor that supplied that £100k would receive a 10% equity stake in the business.

 

In the crowdfunding model, such transactions are funded by multiple investors. The equity acquired by each investor is determined by the amount of capital that he or she injects into the business.

 

Almost all of the platforms operate an all-or-nothing model. In other words, the fundraiser from the previous example wouldn’t be able to touch a penny of the £100k unless they were able to successfully raise the full amount. This helps to ensure that backers invest on the financial terms that were advertised to them. Once complete, the fundraising company walks away with the money and the investors walk away with their respective shareholdings.

 

The facilitators themselves – the platforms – make their money by charging a transaction fee, usually to the fundraiser. This fee generally fluctuates between 1% and 5% of the total transaction size.

 

Who?

 

Which people and which types of companies does the equity crowdfunding sector target?

 

In terms of people, investors will fall broadly speaking into one of three categories: retail, accredited or institutional. Let’s put aside the latter for now (there isn’t a great deal of institutional investment within the equity crowdfunding space at present, but there are certainly some venture capital firms sniffing around).

 

The term “retail” typically refers to investors that have little or no prior experience of investing in equity (or indeed, of investing full-stop). The potential for such investors to get involved in equity crowdfunding varies platform to platform. Some sites accept retail investors – but FCA rules dictate that only 10% of such a user’s investible assets may be allocated to the sector.

 

Other sites will only accept accredited investors – and will often run a background check or issue an online test of some kind in order to ensure that such backers are indeed as wealthy/knowledgeable as they claim. The “accredited” umbrella term also encapsulates “Angel” investors. These are individuals that invest in the equity of early-stage companies for a living, and they tend to carry a reputation for having often singled out high-growth startups.

 

That brings us nicely to the other side of the equation: the fundraisers themselves. The bread and butter of the equity crowdfunding sector is the startup. The term “startup” refers to a recently launched company that tends to be in need of an initial injection of capital in order to get off the ground. Investing in such companies can be prove highly profitable – as such deals carry tremendous “upside”. But on the hand they are also highly risky, as it’s extremely difficult to accurately forecast if and how a startup will succeed.

 

But the equity crowdfunding sector is beginning to attract more established companies as well. Some of the platforms have helped publicly listed companies to raise money via the issuance of shares. Such deals represent a very different investment proposition. The ceiling in terms of potential reward will be lower. The risks are arguably lower too, as the shares held by investors may be liquidated on a stock exchange if required. More on liquidity later.

 

Platform structures

 

Not all crowdfunders are born equal.

 

Structure and process varies platform to platform, and without naming any names, it’s important to assess the following features:

 

  • Shareholder structure: For some platforms, investors in a round will receive their purchased shares directly. For others, shares will be held by a “nominee” – which is in most cases the platform itself – which will act on behalf of the shareholders.
  • Fee structures: All platforms charge a success fee of some kind, but exactly when that fee is extracted varies. Some platforms take the entirety of their fee upon the successful funding of a campaign. Others take a portion of their fee upon campaign completion, and another portion if and when the fundraising company stages an exit of some kind. This may be referred to as having “skin-in-the-game”, because the platform, like the investors, is then reliant on its fundraisers succeeding in order to generate revenues.
  • Angel-led”: Angel-led platforms will only host fundraising campaigns that have been carefully curated and invested in by a professional investor. The idea is that private investors can then invest with an increased level of assurance, following in the footsteps of a seasoned professional.

 

Liquidity and exits

 

Prior to investing, it’s important that you understand that you’re entering into a high-risk waiting game. There’s no guarantee that you’re money will come back to you, let alone that a return will be realised. Equity crowdfunding investments are also extremely illiquid at present. That means that once you’ve invested it’s very difficult if not impossible to withdraw your funds from the investment ahead of schedule.

 

In order to withdraw your money from an equity crowdfunding deal, you’d need to sell your shareholdings on a secondary market. This would ordinarily involve offering the purchaser some form of mark-up or discount to face value. Secondary market activity is sparse within the equity crowdfunding world at present, but we may begin to see a more active marketplace for private company shareholdings develop as the industry evolves.

 

Another key requirement before investing is to understand how and in what form you might receive a return. In the equity crowdfunding space, a return would generally come in one of two forms: a trade sale or a public listing. Though there have been very few examples of either to date, these are the most commonly cited target exit methods amongst fundraising companies.

 

A trade sale involves another company choosing to take ownership of the original fundraiser via share purchase. If the price tag on the purchased company is higher than at the time of its equity crowdfunding round, the investors from that round stand to make a return on their cash.

 

A public listing typically occurs when a business has scaled significantly and wants to take things to the next level in terms of profile and volume. The company will float on a public exchange, meaning that its shares are then available to be traded on that exchange at will. This presents existing shareholders with the option of selling out of a company.

 

Shareholder rights and investor protections

 

It’s vitally important that you understand how to ensure that you’re protected against the fundamental risks that come with the territory of investing in early stage equity. Prior to investing, you’ll be looking at key metrics like whether or not the valuation is fair, projected revenues, target market share, and so on. But it’s vital that you also take account of exactly what types of shares you’re purchasing, should you choose to invest. Failing to do so could result in a situation where you lose your money, or miss out on returns, even if you’ve proven shrewd enough to have invested in a highly successful company.

 

The primary areas of concern are dilution risks and issues relating to your rights as compared to other shareholders. “Dilution” is defined as a decline in share value due to the issuance of further equity. In other words, the value of your investment in an early stage company takes a tumble because that same company has taken on further equity investment, meaning that the profits of the company will now be shared between more investors. How do you guard yourself against this? It usually boils down to the class of share that you’ve invested in. Indeed, share class will also tend to dictate what rights you have as a shareholder.

 

Some equity crowdfunders will only facilitate the sale of “A Shares”. But others will also deal in “B Shares”. Holding a B Share rather than an A Share exposes you to a number of risks as an investor. It could affect your voting rights – in other words your right to influence the direction of the company that you now own a part of. It could also influence your right to claim dividends. There’s yet to be an example of a crowdfunded business paying dividends to shareholders – but it’s a worthwhile consideration nonetheless. But most important to my mind is that you, as a B Share holder, are at far greater risk of dilution.

 

Let’s take a theoretical situation. A company has issued 100,000 A Shares and a 100,000 B Shares – each nominally equal to a 50% ownership stake. The A Shares will be dilution risk-free. What this generally means is that they have the exclusive right-to-refusal on any newly issued A Shares. So imagine a situation in which another 100,000 A Shares were issued a year down the line, and that these are all snapped up by the existing A Share holders. Their stake in the company is suddenly worth a little over 66%, shrinking the B Shares holders’ stake from 50% to a third!

 

But to distil this into its most simplistic terms- the easiest way to protect yourself is to ensure that your interests are aligned with management or any major shareholders. And the best way to do this is to ensure that you all own the same class of shares.

 

Conclusion

 

Equity crowdfunding is a dynamic and exciting space to invest in, but the risks are plain. AltFi Investor will be offering detailed coverage of individual investment opportunities and instruments within the sector – providing investors with the requisite tools for making informed investment decisions. 

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