Crowdfunding takes Dragons' Den into the mainstream

Crowdfunding has captured a disproportionate share of the media’s coverage of the alternative finance space. Virtually every day you’ll probably run into a sexy new  campaign looking to raise funds for an innovation, business or initiative – my own favourite was back in the summer where one ‘entrepreneur’ tried to raise money to fund their own potato salad. Yet these fun campaigns obscure the sheer volume of genuinely exciting new businesses and inventions being funded every week online.

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My colleagues at AltFi Data reckon that here in the UK crowdfunding platforms have helped cumulatively raise over £50m in equity towards new businesses through to October 2014 – with £1.3m funded in the last month alone. And these numbers only incorporate equity fund raising platforms such as Crowdcube,Seedrs and Syndicate Room , excluding the potentially bigger reward and donation based platforms like Kickstarter and IndieGoGo.

Obviously we need to put that headline £50m into some perspective. In the space of just a few years crowd funders have put in a huge slug of money into early stage companies but it’s still small change when compared to traditional venture capitalists (who don’t really like early stage businesses in the UK and probably invest about £350m pa) and more experienced angel investors (running at £850m pa). £50m is also a relatively tiny number when compared to the money flooding into P2P loans , which according to AltFi Data has topped £2.1 billion to date – with £118m per month going into these P2P platforms, a significant percentage of which is finding its way to funding small businesses through loans.

What’s especially interesting is that with the odd exception or two, the vast bulk of the money going into crowdfunding is provided by private investors – institutional money has been flooding into P2P loans but I can think of no decent sized institution putting money to work to work in the crowdfunding space. A few small corporate advisory outfits such as Braveheart and Worth Capital are beginning to engage with the sector and Faber Ventures recently put £180,000 to work in an email based tech start up called Maily but that’s about it as far as institutional involvement extends.

Institutions have been put off by one other self-evident truth – as an investment based asset class (a subset of venture capital, surely), there’s an almost complete absence of returns based data. This reflects the fact the sector is still just a few years old and the vast majority of the businesses funded to date are still in the start up and early growth stage of their evolution. All the major platforms can point to businesses funded by their investors that have gone on to subsequent additional rounds of funding involving venture capitalists but there is – to my knowledge – only one public IPO based exit of a crowdfunded business to date. A few weeks back an Israeli based crowdfunder announced that ReWalk Robotics – a developer of wearable, robotic exoskeletons for those that have suffered spinal cord injury – had listed on NASDAQ. According to www.altfi.com “ ReWalk has raised a sizeable $3.3m over the past year in two separate funding rounds via the Israeli equity crowdfunding giant OurCrowd. Now the company has issued 3.45 million shares on the NASDAQ in order to raise net proceeds of around $36.3m”.

OurCrowd itself is an interesting case study about what seems to work in the exciting world of crowdfunding. This  Jerusalem-based has quietly built up a portfolio of only 46 companies –  compared to the hundreds who have gone through platforms like our own immensely successful Crowdcube. Those 46 businesses have received over $60m in funding  with 20 of OurCrowd’s successful campaigns raising more than $1 million each, and 4 have raising over $3 million i.e big sums of money for a smaller sub set of businesses Those big numbers suggest another reason for lack of engagement by institutions – most of the capital sums being sought out by the big UK platforms is just too small for professional investors to consider.  

Which brings us nicely back to the potato salad story from the beginning – although donation and reward based crowdfunding has grabbed the headlines, the real future lies in equity based participation i.e buying actual shares in live businesses that aim to return your money (and more) with some form of exit as the upside. That bias towards donation and rewards based funding is in part a result of a US bias – under existing SEC rules (the US regulator) , platforms cannot solicit equity investments from mainstream retail investors via online exchanges. Those rules are about to change and we should expect a boom in equity crowdfunding in the US which will inevitably provide rocket fuel for the growth of the big UK platforms.

A brand new book by established City investment manager Gervais Williams (of Miton) called The Future is Small, also hints at another catalyst for explosive growth in crowd based equity fund raising – our broken financial system. Gervais argues that since the global financial crisis our addiction to debt has not lessened and that large corporates are in fact even more addicted to leverage. Yet banks and institutions have pulled back from lending and investing to small businesses because they can so easily lend to large corporates through liquid bond markets. Williams argues that this will all change over the next decade as low growth rates and deflationary impulses (powered by deleveraging) kick in. The future lies in funding really small businesses – ant sized businesses he calls them – and Gervais predicts a boom for private investors as they start to snap up micro and small cap shares, with beneficial results for the UK labour market.

But I’d argue that Williams preferred ‘market place’ for this activity  – AIM – is deeply flawed. AIM is a failure I’m afraid and although Gervais valiantly talks up the decent contingent of well-run smaller businesses listed on the market, I’m afraid the market overall has bene flooded with investment grade ‘crap’ i.e event driven tech, mining and energy start ups designed as vehicles for investors to lose most of their money.

Online crowd funded market places are the real future for small business funding. At the moment outfits like Crowdcube have an understandable very early stage bias but as they and their funded businesses mature we’ll start to see a proliferation of private secondary markets. These will host more robust businesses looking to trade shares and raise capital away from AIM – and at a lower cost. We’ve already seen platforms like Asset Match and Britdaq emerge to provide a secondary market for established businesses and I can imagine that the likes of Crowdcube and Seedrs will soon run their own secondary markets for investors looking to sell on shares in established, profitable businesses .i.e giving private investors an exit route and a valuation metric for their crowd based shares.

So, my guess is that within the next ten years crowdfunding will be a perfectly respectable asset class. It will probably form a large share of a broader venture capital/private equity/micro small cap allocation worth anything between 0 and 15% of private investor’s portfolios – helped along by the very generous tax incentives that are attached to the Seed EIS and original EIS scheme (worth as much as 50% of any upfront investment).

Given this potential, how should you as an investor – looking to make capital gains - approach the crowdfunding sector. I’ll keep returning to this challenge in later articles but the first and most basic principle is to be data driven, listen to the hard facts and don’t be emotional. This is a tough ask for a sector that is entirely driven by smart marketing and emotional appeals but the hard stats tell us that investing in early stage businesses – and even more mature growth businesses – is a tough old game. There’s a very good reason why the UK has deployed so little institutional venture capital to date and that’s because most investment advisors think the sector is just too damned risky.

But I’d maintain that if you are data driven and hard nosed there is good money to be made – and I’d point to data from recent reports from the UK Business Angels Association as evidence. A report from a few years back (using research from government funded charity Nesta) looked at what I suppose one could call the ‘special forces’ of early stage investing, angels. These wealthy, largely male (!), older, experienced investors (many with a business or professional background) have been in effect crowdfunding for many years and their experience suggests there’s money to be made. Very experienced ‘super angels’ may be investing in as many as 8 to 10 deals a year but even your common-a-garden angel is investing in 3 to 5 deals pa – with an average investment per angel per deal of around £40k. 56% of these accumulated deals had been a loss with the vast majority of those duds a complete wipe out. But 44% of their deals made a gain, 35% of those with a solid gain (between 1 and 5 times the original investment) and 9% producing ten bagger gains. This backs up US research which suggests that 10% of all exits produced 90% of the total gains. On average investments over a 3 to 5 year period produced a 2.2 times multiple in total returns.

Looking at what the angels invested in is also revealing – 23% went into seed funding, 14% into start ups and 53% went into slightly more established early stage businesses. Internet, technology, and media businesses accounted for the lion’s share of all  the money invested.

These numbers won’t necessarily apply to crowdfunding investments – most angels are a good deal more cautious and can deploy very large sums of money compared to the hundreds of pounds wagered by most online investors. But they do give us three important lessons. The first is that you should absolutely expect failure but that done sensibly you don’t need to write off 90% of your investments – there’s no reason to think that sensibly managed the failure rate shouldn’t be more than two thirds. Assume one in ten will provide a ten fold return, factor back in the 30 to 50% tax relief and you should be able to make a decent profit.

The next key lesson flows from these hard numbers ? You need to diversify like crazy! I recently talked to one hugely experienced angel investor who now uses crowdfunding platforms – he told me that to succeed “ investors need dozens, if not a hundred or more stakes in a long line of businesses”. You might only put a few hundred pounds in each but you need the huge diversified pool of assets to make the numbers work to your favour – hopefully somewhere in that big portfolio will be one or two ten baggers. One alternative to  a bulging portfolio is to go down the fund route – Crowdcube for instance has its own fund managed by Strathtay Ventures (a unit of the bigger VC firm Braveheart) that invests alongside individual investors to build a diversified portfolio. Syndicate Room has its own alternative take on the same challenge in that it only puts individual money to work alongside existing angel investors, who’ve done the due diligence on the business.

My last key lesson – told to me time and time again by angels – is to focus like a hawk on the management of a business. Anyone can construct an amazing powerpoint, come up with a spiffing idea, even bodge together a great spreadsheet based projection, but what will make or break a business is the quality of its managers and founders. Do they have business experience ? Have they managed their way to an exit before ? Have they made other investors real hard cash ? Its management, stupid!

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