Equity-based Crowdfunding Explained

08 March 2016

R_mcallister

Until recently, financing a business has involved asking a small number of people for large sums of money.  Start-up companies are often reliant on banks to provide a significant loan to allow it to get off the ground.  However, demands that a company must have sufficient assets to back a loan (which is particularly unsuited to tech-based companies) or a certain level of profits often means that the banker feeds the relevant information into the computer and the bank says ‘no’.

In the absence of bank funding, only high net-worth individuals, sophisticated investors or investors with certified investors could purchase equity in an unlisted company.  Following the economic downturn, entrepreneurs have generally found raising seed capital through such avenues to be an increasingly challenging prospect.

However, alternative funding options are gaining pace.  As a product of the internet age, equity-based crowdfunding is one such funding option which has turned the approach to financing on its head, becoming established as a legitimate alternative or supplement to more traditional forms of financing.

What is it and how does it work in practice?

Equity-based crowdfunding is a way of raising finance whereby a larger number of people (the “Crowd”) invest smaller amounts of money in an unlisted company in exchange for shares in that company. Crowdfunding provides the opportunity for companies to take control of fundraising from their own network of friends, family and customers as well as the general public. 

In practice, the company seeking investment creates a campaign on a recognised crowdfunding website which is marketed via PR and social media.  The company may upload a short video pitch which will then be viewed by potential investors. If a viewer likes what they see they can to invest in the company directly through the website and become part of the Crowd.  If the campaign fails to reach its target within the set timeframe the Crowd will money paid by the Crowd will be refunded.

Once part of the Crowd, if the company receiving the investment succeeds the shares owned by the investor will become worth more than that originally paid for them.  However, if the venture fails, any investment made in the company may be lost entirely.

Can anyone be part of the Crowd?

Equity-based crowdfunding is now regulated by the Financial Conduct Authority (“FCA”).  The FCA has issued rules that state that, given the risks investors face when investing in unlisted companies, such crowdfunding should only be promoted to a restricted category of investors who:

·  are sophisticated or of high net worth;

·  have received advice from an appropriate adviser in respect of their investment; or

·  are investing no more than 10% of their net assets (excluding homes and pensions).

Investors who have not been advised will need to pass an ‘appropriateness test’ that they have the knowledge and experience to understand the risks associated with crowdfunding.

Is equity-based crowdfunding right for my business?

Equity-based crowdfunding is primarily used by start-up or early stage companies.  It can be used by such companies as part of its marketing strategy, providing an opportunity to engage with the potential customer base and to validate demand for the product or service provided by the company.

Crowdfunding has also been used by larger companies to the same effect.  However, as banks are often more willing to lend money to such established companies, it may be prudent to avoid parting with equity in the business unless absolutely necessary as doing so will also dilute the shareholding of the founders who have invested significant time and money into the company.

Crowdfunding works best for companies that have a story to tell.  People need to feel inspired to invest so it is best to have either a charismatic pitch or be able to display evidence of outstanding innovation.  Pitches that are uninspiring or struggle to explain a complex business idea are more likely to struggle to attract funding.

However, crowdfunding is not without risk. An unsuccessful campaign may damage a company’s reputation and potentially deter future investors.  With that in mind, here are some dos and don’ts to bear in mind when considering equity-based crowdfunding.

DO

Have a proper business plan:Many companies that want to raise money via crowdfunding are unprepared.  Not having a proper business plan is like having a car with no wheels, you won’t get very far.  Realistically planning short and long-term goals for your business is essential.

Build your network before you need it: If you’re not prepared, don’t expect a Crowd.  In order to be successful in online fundraising you need to prepare a database of people you can contact.  Before launching your campaign you need to get involved with social media, e.g. Twitter, Facebook and LinkedIn.  Your connections will already know you and are more likely to invest in what you’re doing.  This network will help you to spread the word when you launch your campaign.

Produce a short ‘elevator pitch’ video: First impressions are everything.  Produce a compelling promotional video which showcases your product or service and allows the general public to connect with you.  If you’re not a technology minded person who can produce their own video, find someone who can!

Choose the right platform: While the general outcome will be the same (raising funds), different platforms offer different services. A prime example is the difference in the model used for investors between two of the major platforms, Seedrs and Crowdcube. Crowdcube allows all investors to become shareholders in the company. However, only the largest investors’ shareholdings will grant voting rights.  Seedrs operates a ‘nominee’ system whereby the crowdfunding platform buys the shares on behalf of the investor. The investor becomes a beneficial owner, while Seedrs acts as the legal, ‘nominated’ shareholder. While this means that the business will only have to deal with one legal shareholder, the Seedrs model conveys voting rights to all the beneficial owners.  Seedrs also requires amendment to the Company’s articles of association, which can prove difficult where the company has already gone through an investment round via another route. These models can have a significant impact on the future running and decisions of the business as well as its ability to raise future investment. 

Be realistic: You do not want your campaign to fail.  Choose a realistic financial target which you think is achievable and will provide the company with the funds that it needs to move forward.  You also need to choose a realistic timescale.  You do not want your campaign to lose momentum.  Equally you do not want the timeframe to be so short that you do not have time to maximise marketing.

Don’t

Slow down:Market your company shamelessly and relentlessly.  You must commit the necessary time and resources into generating and maintaining momentum via social media, news articles and any other resources available to you. Crowdfunding campaigns that involve simply posting the pitch then waiting for investors are likely to fail.

Forget the power of notable investors:  Often people don’t want to be the first person to invest in a new idea.  However, if you have notable people within your network who are willing to invest even a small sum of money, ask them to do so.  You can then spread the word of those investments via social media to validate your idea to others and convince them to invest.

Forget to protect your idea: Seeking funding for a business that is currently only at the concept or idea stage can prove risky. Ideally, finance should be sought for a business that has produced or created something that can be protected through copyright, patent, trade mark or design registration.

Exclude other options: Crowdfunding may not always provide the best financing option. Business owner’s should thoroughly research all the options available, including the more traditional sources of raising capital.

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