|Alternative Funding Network|
Equity Crowdfunding – It’s pretty ugly right now but could be SO much more.
The wind is certainly blowing fair for the equity crowdfunding industry in the UK at the moment. New platforms are emerging almost every day; the Government is supporting the industry with tax-incentivised schemes for retail investors and gentle regulation; and new retail investors are jumping on board to pump increasing amounts of money into increasing numbers of start-ups who are using the model to raise finance. And I can understand why this enthusiasm exists:
-The Government likes equity crowdfunding because it seems to fill the funding hole left by the Banks.
-SME’s like it because they can gain access to finance through a new model.
-And the public likes it because it can access a new market and possibly, just possibly, pick the new big winner and end up on the Rich List.What’s not to like?
Well lots of things actually when one starts to kick the tyres. Please don’t get me wrong. I like equity – you can’t have an equity risk premium without equity – and I like the sex and violence end of the equity spectrum even more (albeit only as part of a balanced portfolio; I feel I have to say this as a champion of pension funds and financial inclusion). So what bothers me about equity crowdfunding as the model currently stands?
Firstly, unlike debt crowdfunding and other P2P debt mechanisms, it will take a long time for consumers to realise things have gone wrong. You could be sitting around for years wondering how your investment is performing and looking forward to that big pay-out and know NOTHING right up to the point that your investment folds. At least with the debt markets you will know next month, because your borrowers will miss a payment. I would far rather know quickly of failure, and take some form of responsive action, than not know for years and keep holding out hope.
Secondly, the single most important thing you will need if you invest in equity is a robust shareholder agreement. This is the legal document on which you will depend to ensure your rights as a shareholder are upheld. So the agreement had better be good because success in SME terms is for the company, or part of the company, to be bought by Private Equity or, if not Private Equity, then a bigger company. It doesn’t matter really, the point being that success means expensive and extremely talented lawyers supported by a big bankroll stepping in and giving the extant shareholder agreements a proper kicking. The intent? To maximise the utility of the acquiring company by minimising the utility of the minority shareholders…or the consumer investors as they are known.
What’s more, not only does the shareholder agreement need to be extremely robust, crowdfunded investors are, individually, TINY. If a small company has just released £200k of equity in exchange for 20% of the company, and a shareholder owns £1000 of equity, this means that shareholder owns 0.1% of the company. And have these shareholder agreements, created by the legal experts of tiny crowdfunding platforms, crossed swords with the scary legal teams working for the Private Equity world? Not really. And wont, not for another few years at least.
Now, there are equity crowdfunding models that are better than others. There are those that keep you in isolation as a shareholder and leave you to fight your own battles in the event of a challenge to your rights. And there are those who offer you equity via nominee structure and will therefore negotiate collectively in the event of a challenge to your rights. Negotiating with 20% in your back pocket will get you further than if you have 0.1%.
So RULE 1 of Chris Sier’s ‘playing with equity crowdfunding’ rulebook: “Pick platforms that offer you a nominee structure (or similar) for your shares”
There is a tendency for platforms to minimise their workload by making the invested company responsible for documentation. Think about this from the small company perspective. There you are, you’ve got 3 or 4 shareholders who own most of the company, and corporate governance and administration is easy. It’s a chat with your matey co-investors and/or employees every so often, nothing really onerous. You decide to raise money via crowdfunding and suddenly you don’t just have four shareholders, all personal buddies.
Suddenly you have 204 shareholders, 200 of whom will require reports and updates and TAX CERTIFICATES… You could easily spend all of the £200k you raised sending out share certificates, tax certificates and quarterly and annual reports, and never have the money to spend on the important stuff, like growing your business. So here’s...
RULE 2: “Only pick platforms that do the heavy lifting of corporate governance and reporting for the companies on the platform.”
In fact you can tell the motivation of the platform from its business model. If it takes its money from the money raised, then it favours the start up. In other words its interests are NOT aligned with the investor/
shareholders. Conversely, if it takes some or all of its money from the shareholder returns, as and when they arrive, then it is more likely to have its interests aligned with investors. So if you, as a retail investor, want to maximise the chances of your success then
RULE 3. “Pick a platform that takes most of its returns only when investors succeed and get a return. Avoid platforms that take their money upfront”.
Now how about this for a couple of dodgy practices? I have had some robust discussions with various
industry players on these two topics, but I’m going to stick to my guns though and say they are JUST PLAIN WRONG.
-Raising money for yourself across your own platform. And why is this wrong? Well, one of the key roles a platform fulfils is due diligence of a sort on the companies placed on the platform. How big is the moral hazard if you are following a due diligence procedure on yourself to raise money for yourself on your own platform? Who’s to say if you have been a little, er, relaxed in the due diligence of your own documents because, hey, you need the money right?
-Overfunding. Money is requested by SMEs on the platform for projects to help the SME grow. The SME states what it needs and, presumably, this is on the basis of a project plan of sorts. So if the SME gets more money than was requested it probably doesn’t need it for the intended project. What does it do with it, and who decides? Well, excess funding will go on the balance sheet and a combination of company executives, the Board and shareholders will decide what to do with this overfunding. The trouble is…the majority shareholders are likely to be also the Board members (if the company even has a Board) AND they will be the employees. This is moral hazard in extremis and poor corporate governance of almost epic proportions. The majority shareholders, who are the same as the Board and Employees, get to decide how they can spend someone else’s money on themselves?! What is even worse is that SOME
crowdfunding platforms are actually encouraging this practice. Especially those platforms that take money
upfront – of course they want more money to be raised as this is how they get paid.
So, time for RULE 4: “DO NOT pick platforms that have raised money for themselves”. And RULE 5: “Do not pick platforms that encourage
The issues I describe are over and above the more familiar complaints of poor due diligence on investor competence. Being able to repeatedly take the same investor eligibility test until you get it right… OH COME ON! Really?
So I’m pretty down on equity crowdfunding at the moment and will continue to be until all of the above are resolved, by the industry or by the regulator.
Preferably the former, but turkeys rarely vote for Christmas, so it will have to be the regulator I’m afraid.
Strangely though, you may be surprised to hear that I do see a future for Equity Crowdfunding, but the model needs to change. I’ll start with a slightly philosophical thought: Is equity crowdfunding a new asset class, or at least the democratisation of a familiar asset class? Why do I ask this question?
Because it leads me to consider how to blend equity crowdfunding into a portfolio of different asset classes. This is a good thing. It also raises the possibility that institutional money might take an interest in investing via crowdfunding platforms, and that’s a game changer.
In the UK there are approximately £3 trillion assets in life, pension and retail funds. On an asset allocation basis about 5% will be in ‘sex and violence’ – i.e. the racy end of the spectrum where abide PE, VC, Hedge and Angel funds. If only a fraction of this institutional money were invested via equity crowdfunding, say 0.1%, it would pump £3billion into SMEs and start-ups. That really is a game changer. How can we make this happen? By using data. What an institutional investor needs is a way of comparing opportunities across platforms, and then doing some proper due diligence on opportunities in a way that is not
currently possible or enabled by platforms. In other words, if you want to compare opportunities in, say, mobile wallet technology seeking funding via the crowd, then accessing and comparing these
opportunities is key. Fortunately, there are some new companies out there that are starting to attack this space, and I’ll mention one. Largely because it looks pretty good, but also because it is Estonian. I’m married to an Estonian and rate the home of Skype highly as an innovator in technology. The company is called Funderbeam (http://funderbeam.com) and it describes itself as “Startup intelligence to wealthy
individuals and professional investors”. So pretty-much perfect. I am now on a campaign to leverage my institutional contacts to turn their gaze to the opportunities in the equity crowdfunding space. My arguments will include things like ‘it’s tiny money’, ‘you can use familiar techniques of opportunity assessment in a niche market using some cool new technology’, ‘it’s socially useful’, ‘you could make your investments regional and derive huge CSR benefits from such investments’,…and so on.
I’ll let you know how it goes.