The Old World
In the old world the easiest way for an investor to invest in equity was via a publicly listed company. Investors use brokers to buy and sell shares in a business and the value of these shares would rise and fall depending on the company’s performance. The investor was able to make a return if they sold the shares for a higher value than they purchased them or via dividend payment from the company. Investing in start-ups and other private companies was very difficult for investors. Conversely, it was difficult for these businesses to raise equity funding.
Raising capital or funds via equity for private companies was traditionally led by venture capitalists, angel investors or other financial institutions and funds. A business would often pitch multiple times to different investors in order to receive the equity funding they required.
The New World
Equity crowdfunding allows businesses to offer an equity stake in their company to investors in exchange for funding. Businesses are still able to do this via the traditional routes of angel investors and venture capitalist. However, they can now also do this via an intermediary crowdfunding platform such as Crowdcube or SyndicateRoom. The crowdfunding platforms in the UK operate different funding models that the businesses and the investors need to be aware of as they will impact the types of shares that will be offered and the future rights of the investor. All equity crowdfunding platforms in the UK are regulated by the FCA.
Businesses work with the platforms to determine the valuation of their business and they agree the % stake of the business that will be made available to the public. This will determine the target amount that the business will look to raise on the crowdfunding platform. The crowdfunding platform will host a suite of documentation about the business, its team, their financial performance and what they intend to use the funds for. A campaign video will often be created to allow the founders to present their business and why they are raising money. Investors can then choose to invest as little as £10 in businesses and investment is only taken if the business meets their pre-agreed funding target.
Once the investment is taken by the business via the crowdfunding platform a share certificate is issued to the investor as they now hold an equity stake in that business. The form of this share certificate may vary depending on the model that the crowdfunding platform operates. Investments made via equity crowdfunding platforms can also often be eligible for SEIS and EIS tax relief. The business has a legal responsibility to keep their investors informed of their financial performance. This can often be done via a portal provided by the business or in some cases the crowdfunding platform.
Equity crowdfunding is a high risk investment largely because of the fact that investors will not receive a dividend payment and investments are highly illiquid. This means that it is virtually impossible to buy or sell shares held in a private company. Furthermore, a number of these businesses will fail which can result in an investor losing their investment in full. Investors need to be fully aware of these risks before investing and they should also undertake independent and detailed due diligence of any company that they wish to invest in.
There are only a couple of ways that an investor can make a profit via an equity crowdfunding investment. The two main methods are as follows:
Purchase – A larger business can purchase the business that has raised funds. This process may involve the compulsory purchase of shares held by private investors. This includes those that had been bought via a crowdfunding campaign. If the valuation of that business is higher than at the point of the equity crowdfunding round, shareholders will receive more money for the shares versus what they initially invested.
Listing – The other possible option to exit from the investment will occur if the company chooses to become a publicly traded company via an IPO on an exchange. This would mean that any privately held shares in that company could be traded openly on a stock market allowing investors to sell their shares at a potentially higher price than they were purchased.
The Future of Equity Crowdfunding
It is hard to know exactly what the future of the industry holds but a number of commentators believe that the following areas are the most likely trends:
Regulations – The current regulatory landscape in the UK is favourable for equity crowdfunding. As a result of recent industry criticism, there is a possibility that the FCA may tighten regulation. These regulations may include the requirement for increased due diligence on businesses raising funds, or a more standardised approach to documenting financial performance. It will be a difficult balancing act for the UK’s regulator. Not only because too much regulation could choke off a thriving industry, but too little can expose investors to unacceptable levels of risk.
Increased Due Diligence Tools – Investors need better tools for performing due diligence on possible investment opportunities. There is a risk that investors are too quick to invest in a business without performing the necessary due diligence on their investment. Companies like OFF3R are already empowering investors to do this due diligence on their own. There are also 3rd party providers surfacing to help investors with this work such as CrowdRating. The focus on due diligence should greatly increase over the coming months.
Larger Rounds – Equity crowdfunding was initially intended for start-up businesses looking for seed funding to get off the ground. However, going forwards there will be greater focus on supporting larger businesses that want to scale. In 2016 we saw goHenry become the first crowdfunding campaign to hit the EU upper limit of just under £4million. There will be more businesses raising up to this limit. In addition to larger rounds we will see more established businesses turning to the crowd to raise finance. Whilst also taking advantage of the marketing benefits harnessed from a successful campaign.
Secondary Market – One of the largest drawbacks of equity crowdfunding as an investment asset class is the lack of liquidity. It is very difficult for an investor to exit their investment without an external event taking place. Such as another company acquiring the business or the business listing on a publicly traded exchange. One possibility for increasing liquidity would be to create a secondary market. This would allow shareholders to buy and sell their shares in private companies to other investors at an agreed price. The major stumbling block with this model comes down to the setting of the price. This is due to there being no universally accepted mechanism to set value’s of private businesses. Crowdcube have already announced plans to develop a secondary market for companies that have raised on their platform.
Collaborations and Consolidation – The industry has grown at a phenomenal rate. Consequently, this has involved a huge proliferation of platforms hosting crowdfunding opportunities. This number of platforms is not sustainable in the long run. Due to investors demanding a higher quality investment experience. Therefore, there is likely to be a consolidation of crowdfunding platforms over the next couple of years. More traditional financial institutions will also begin to collaborate. Both with the crowdfunding industry, but also with the platforms that serve it. Venture Capital firms like Balderton Capital have already worked closely with crowdfunding platforms and this collaboration will only increase. The two forms of private investment should not be competitive but complimentary.
Please head over to our detailed guide on Equity Crowdfunding to find out more.