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The Risks of Crowdfunding – Part 2 (Founder Beware)




By Richard Goold on 27th January 2016


After my previous article (Founder Beware - 3rd November 2015), I had lots of feedback from founders, investors and crowdfunding platforms themselves.  The feedback from founders was interesting, as the article seemed to chime with what some of them had felt during their fundraising processes (i.e. there has been a lot of talk about the upsides of crowdfunding but not much discussion of the risks).  From the investors and platforms, the overwhelming sense was that I have a fairly negative view about crowdfunding in general… To put the record straight, that is absolutely not the case!

 

I have long held the view that crowdfunding represents the largest change in the world of corporate finance that I am likely to see during my career.  That is not to say though that I think the structures, risks, and long term issues surrounding this new form of finance have been fully thought through by the market.  Quite the opposite.  I am sure that there will be some fairly major public outcrys at one stage or another when crowdfunding investors lose out, founders lose out or a company's growth is stifled because mistakes were made in the early stages of funding the company. 

 

My last article looked at the risks of crowdfunding from a founder's perspective.  In this article, I want to focus on the structures that are used because, in many ways, these are more likely to give rise to problems for companies themselves than the risks to founders described in the last article.  I think it's indicative of the market's maturity (or immaturity) that the issues that I will talk about in this article have not previously been aired. 

 

As I dip into the world of legal structures, rights and obligations I can already hear the yawns and visualise eyeballs glazing over.  However, as someone that manages multiple rounds of financing for companies on a high growth trajectory I know all too well that companies that get their seed financing or series A financing back to front can close the door on series B financing and beyond. 

 

There are two main structures available in the market currently:

 

1               The nominee structure; and

2               The broker model

 

The nominee structure

 

Seedrs was early to market with a nominee model.  It works as follows:

 

Rich Limited (a fintech business) [probably could do with better branding] wants to raise £1 million in seed finance to get it's business off the ground.  Rich Limited markets itself to the public through the crowdfunding platform that runs the nominee model.  After a successful crowdfunding campaign £1 million is raised from 100 people.  The million pounds is invested via a nominee that is legally held in the name of the crowdfunding platform's group but the beneficial interest (i.e. the real value!) is owned by those 100 investors in proportion to the amount they are investing.

 

The impact on Rich Limited is that it has one shareholder on it's books, one shareholder that it has to send shareholder resolutions to and one shareholder that it has to manage.  The beneficial owners might seek information rights and should have some form of voting rights but in the Seedrs model, these rights will be governed by a tightly drafted shareholders agreement.  The shareholders agreement will manage other key rights such as investor consents, pre-emption rights (the ability for investors to invest into further rounds of investment in the company) and such like. 

 

This model can increase the cost of raising the money (as the crowfunding platform has to stay involved to manage the growing portfolio) but if I were running Rich Limited, then I would think the additional costs are acceptable.

 

The broker model

 

The broker model operates in a similar structure to the above except that (surprise surprise) there is no nominee.  This means that each of the 100 shareholders will be a direct shareholder in the share capital table of Rich Limited.  There may or may not be a shareholders agreement.  The investors may or may not receive special rights and protections and the rights around their shares generally are sometimes left to be negotiated between the lead investor and the company (i.e. in ten different crowdfunding rounds we can end up with ten different sets of rights and obligations for the investors and the company).

 

The problem with the broker route is that companies are left with a lot of shareholders on their share register.  With a lot of stakeholders to manage, processes for managing corporate activities become complex and unwieldy. In the worst case scenario, where rights and obligations have not been carefully considered for future growth, the onward growth of a business can be restricted because potential investors can look at a share capital table and say that they are not prepared to invest unless there's a complete reorganisation of the capital table. 

 

Perhaps the market is beginning to turn though: Crowdcube, Syndicate Room and other crowdfunding platforms that have not historically had a nominee structure are beginning to offer this service due to demand from the companies seeking funding.  Those platforms are still offering the original broker route but, for the companies that think hard about their capital structure and want a nominee, more options are now coming to market. Companies really do need to do their own due diligence on the various platforms' approaches though – they should understand the detail of the shareholder arrangements (and agreements) and, ideally, speak to other execs that have had to stress test those arrangements in both good times and bad!

Comments

Gordon Rae

29 Jan 2016 01:08pm

Thanks Richard, for a clear explanation of quite a subtle point. Founders need to think about how they manage shareholder relations, and many of them don't have the skills to do it. I suppose it's a matter of taste whether an entrepreneur would rather deal with a few angels or a crowd with small stakes.

Mark Sanders

27 Jan 2016 01:17pm

Great thoughts. At best it helps to provide the big picture of Crowdfunding. www.croundfundingmat.com

Robert Murray Brown

27 Jan 2016 12:52pm

Yes you have identified the two strands but the broker model isnt as you decsribe it in reality. The vast majority of for example Crowdcube pitches offer only B shares with no rights whatsoever unless you invest over what would be a large sum for real member of the Crowd. Crowdcube and I suspect others, also have various written in clauses that limit both A and B shareholdfers rights. As in the case of the sale of E-Car Club where the drag along (simple majority) was activated automatically, potentially denying investors a far greater return 3 years out. Also if you speak with shareholders as we have, you'll find that most Crowdcube funded businesses ignore them completely. To date Crowdcube have 2 nominee structure deals completed versus 354 broker deals - so hardly a market turn.


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