If a business needs finance to expand, improve facilities or purchase new equipment, it can either seek to borrow money or ask for capital investment in return for equity, i.e. shares.
But while sources of equity finance used to be restricted to the likes of angel investors and venture capital trusts, today equity crowdfunding operators such as Crowdcube, Seedrs and Angels Den have emerged to enable businesses to raise money online from large numbers of individuals, each making relatively small investments in the hope of scoring a healthy return in the event of an IPO, merger or exit.
As an investor, the process is usually straightforward. Often it’s as simple as signing up to a website, browsing the video and written pitches available, and then choosing what to invest in and how much. Once the legal documentation is completed, you will become a shareholder in that business, be sent a share certificate and appear on the business’s share register at Companies House.
It’s a formula that is proving popular. Today, there are 235 live crowdfunding platforms in the UK, according to data from finance analyst TAB, and investors’ appetite for crowdfunding businesses has grown considerably since 2015, statistics from Businessagent.com reveal. So far in 2017, the average monthly cash injection from all investors across all equity crowdfunding platforms is £13.5 million, compared with £7.4 million in 2015, with a monthly high of 11,202 investors contributing to 93 projects in May this year.
Jon Medved, CEO of crowdfunding platform OurCrowd, says the advent of such organisations has disrupted the way that start-up companies are funded, democratising both sides of the marketplace, meaning investors and entrepreneurs. ‘By opening up opportunities to investors from around the world, the phenomenon is breaking down the geographical barriers that plague many start-ups, particularly those in areas where VC funding is not plentiful,’ Medved says.
For businesses, crowdfunding can represent a welcome source of free publicity in addition to funds. But to what extent does it present an opportunity for investors in 2017?
Medved says, ‘As venture capital and private equity have proven to capture large portions of the overall value creation in the economy, individual investors have increasingly sought exposure to these asset classes. Equity crowdfunding allows the individual investor to tap into investment opportunities once reserved for big players like venture capital firms.’
On equity crowdfunding platforms like his own, Medved says, an investor can find opportunities to buy stakes in promising start-ups, putting their money to work alongside experienced investors, and join the growing trend of getting in on the ground floor rather than waiting for a company to go public.
For all its increased popularity, it is still early days in the crowdfunding market when it comes to hard evidence of investors making returns. It was as recent as July 2015 that the UK’s first equity crowdfunding exit occurred, when E-Car Club, which marries pay-as-you-go car usage with electric vehicles, was sold to car rental giant Europcar.
In 2013, E-Car Club raised £100,000 from 63 investors on Crowdcube, with a valuation of £500,000. Investors put in an average of £1,500, with the largest investment £15,000, and were reported to receive a return on their investment of three to four times.
A significantly larger success story was Camden Town Brewery, which raised £2.75 million in April 2015 thanks to 2,173 Crowdcube investors and was acquired by Anheuser-Busch InBev in December the same year for a rumoured £85 million.
When it comes to successful flotations, FreeAgent, a cloud-based software-as-a-service accounting software company, was believed to be the first UK firm to launch an IPO having previously raised growth capital through equity crowdfunding. In November last year the company’s AIM float raised £10.7 million, valuing the company at £34.1 million, after having originally raised £1.2 million from 700 investors on Seedrs in July 2015.
Emily Mackay, CEO of analyst TAB, notes that, according to Seedrs, the platform-wide non-tax-adjusted internal rate of return (IRR) is 14.4 per cent, and Crowdcube’s portfolio of funded businesses achieved an IRR of 13.3 per cent, compared with the industry average of 8.6 per cent. Anecdotally, Crowdcube observes that most investors in equity crowdfunding commit capital to multiple businesses under the assumption that 60 per cent may not earn a return, 30 per cent may earn them their money
back or a small return, and 10 per cent can earn them a far larger return.
However, the promising stats and tales of successful deals shouldn’t cloud the fact that, as ever, investment in early-stage companies carries a significant degree of risk. Failures include soap company Bubble & Balm, one of the first companies to raise money via crowdfunding in the UK, which raised a total of £75,000 on Crowdcube in exchange for 15 per cent equity but went bust in 2013 as the first high-profile crowdfunding casualty.
More recently, claims management business Rebus folded in 2016 after raising over £800,000, again on Crowdcube. The company was accused of ‘misleading investors’ with its pitch, as investors were reportedly not told that the company had previously hired restructuring experts due to struggles with cash flow.
Pause for reflection
Reports of such unscrupulousness beg the question: does crowdfunding offer enough protection for investors? All equity crowdfunding platforms in the UK are regulated by the Financial Conduct Authority (FCA), and platforms must obtain FCA authorisation before commencing regulated activity. Platforms residing in other countries may be governed by local regulators, and there may also be regulations for non-resident investors.
However, the FCA, which launched a review into the sector last year, said in December 2016 that crowdfunding firms did not always meet their requirements to be ‘clear, fair and not misleading’ with customers, and called for ‘additional rules’ in the market.
Such reflection is certainly food for thought for investors, and the crowdfunding industry does have its detractors. Freddie Achom, venture capital investor and founder and chairman of private equity firm the Rosemont Group, believes that crowdfunding is a technique designed to support entrepreneurs over investors.
‘Crowdfunding is a fad, a dotcom boom,’ he argues. ‘Essentially, the trouble is the danger of having too large a number of investors. By the time hundreds of these smaller investments are made, the end-product and monetary outcome becomes very diluted as people own such a tiny portion.’
For an investment to bear fruit, you must inject more initially and take on that share of the risk, Achom adds.
However, he concedes that if you are committed and an ‘absolute expert’ in your field, there is ‘certainly opportunity in crowdfunding’ if investors are willing to ‘dig deep’.
‘Investing in a “unicorn company” – one that is unique – is worth it regardless of the funding methodology,’ he adds. ‘As the name would suggest, however, these opportunities are incredibly elusive, especially as the crowdfunding initiative has exploded across the internet.’
Investors may also be interested in more specialised operators that have emerged of late. The Resort Crowd, a new crowdfunding platform for luxury resort property in Cape Verde, operates differently from the standard equity model, allowing investors to buy in for as little as £10 and claiming to offer up to 7 per cent fixed annual returns for five years.
Kim Collier, operations director at The Resort Crowd, says, ‘We’ve combined property investment with tourism through the exciting, revolutionary medium of crowdfunding so that sophisticated and beginner investors alike can add a new, exotic twist to their portfolio.’
Other platforms place their focus on particular sectors, such as Capital Cell, which claims to be Europe’s first equity platform specialising in biotech and healthcare. CEO Daniel Oliver says, ‘By specialising, platforms can bring highly focused expertise to screening investment opportunities.
‘Life science is a highly technical area, which has traditionally been open to a very limited pool of investors who have advanced technical expertise and deep pockets. Specialised equity crowdfunding opens up life science investment to everyone by presenting innovative projects in a way that non-specialists can understand.’
Where to begin?
Whether investing using the standard equity model or via innovative, alternative operators, how should those investors interested in putting their money into crowdfunding go about the job?
First and foremost, Medved says that no-one would advise putting a large percentage of savings into early-stage companies. ‘However, an allocation of 5 per cent of the overall portfolio is a general benchmark used by investment professionals, and may increase returns and reduce risk.’
Medved also suggests investing in 12 to 15 companies, which means, to his mind, that investors can hope to generate a 2.6 times return on their investment in three to five years. ‘Statistics of past performance indicate that one or two businesses may soar, two or three may do OK and the rest may well fail,’ he says.
Attractive tax reliefs can mitigate much of the risk of investing in young businesses. One such is the Seed
Enterprise Investment Scheme, established in 2012. It is for businesses that are less than two years old, have fewer than 25 employees, have less than £200,000 of assets and are raising their first £150,000 of investment.
Under the scheme, an investor qualifies for five tax reliefs, says Matthew Cushen, co-founder of Worth Capital. The most significant is 50 per cent income tax relief, so HMRC will give the investor back half of their investment, knocked off their tax bill.
‘There is also capital gains tax reinvestment relief, capital gains disposal relief, inheritance tax exemption and loss relief,’ he adds.
‘The loss relief means that if the investment fails, the net exposure (after reliefs already claimed) can further offset tax paid. Dependent on an investor’s tax rate and tax liabilities, the actual investment risk can be as little as 16 per cent of the investment.’
The different types of share classes available to private investors are also an important factor when approaching crowdfunding. Saul Gindill, senior investment associate at Seedrs, advises that there are three key types of rights attached to shares: ongoing rights to profits (in the form of dividends); rights to a portion of the proceeds on a ‘liquidation event’ (e.g. a sale of a company or its assets, or an IPO); and rights to control the actions of the company by voting. More information on share classes and crowdfunding can be found at Alternative Thinking.
An investor with the time and the interest to choose the companies should keep in mind three basic rules generally espoused by investment professionals, Medved notes. Investments should be diversified in terms of, firstly, the stage of life of the company (based on time and progress); secondly, the industry or sector (advertising, financial, health, cyber security, e-commerce, mobile, etc); and, finally, location (US, Israel, India, etc).
‘A good rule of thumb is that you should invest in ideas you understand and select every investment as though it’s your only one,’ he adds. ‘If you lower the bar then you will only build a bad portfolio.’