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- Kemp Little specialises in the technology and digital media sectors and provides a range of legal services that are crucial to fast-moving, innovative businesses.Our blend of sector awareness, technical excellence and responsiveness, means we are regularly ranked as a leading firm by directories such as Legal 500, Chambers and PLC Which Lawyer. Our practice areas cover a wide range of legal issues and advice.
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The maturing equity crowdfunding market
The recent announcement from PayPal that they are amending their Payment Protection policy (to withdraw protection for payments made to crowdfunding campaigns) signals the shift from crowdfunding as a fashionable method of raising money for tech ideas, hobbies and side-projects to a serious option for businesses looking to fundraise. This does however highlight that there are risks and uncertainties involved in contributing to crowdfunding campaigns.
Focusing on businesses (rather than charities and causes) there are two main approaches to crowdfunding. The first is seen as more of a purchase mechanism whereby consumers are invited to pledge money to a company in order to receive goods or services at a reduced rate; prior to them being available to the general public. Sites such as Kickstarter and Indiegogo dominate this area and consumers receive no equity in the companies that they ‘invest’ in. The second – and more business-focused approach is through sites such as Crowdcube or Seedrs whereby companies give away equity in their businesses in return for investment.
The risks involved with the first method of raising money are relatively minimal for companies aside from the reputational issues that arise from taking money and not delivering the product. According to a December 2015 study from Professor Ethan Mollick at the Wharton School of the University of Pennsylvania, approximately 9% of projects on Kickstarter fail to deliver their goods with the ‘investor’ losing out on their contribution. The terms & conditions of the marketplace sites govern what should happen in the event of a project not being delivered with the majority of these sites stating that they mandate the project creators must deliver their projects in full or provide reasonable efforts to do so. However, Kickstarter also goes on to state “the fact that Kickstarter allows creators to take risks and attempt to create something ambitious is a feature, not a bug” thereby providing its creators with a legitimate way out should their project fail.
In the US the Federal Trade Commission has started to protect users on Kickstarter from companies who go rogue with their money. Whereas in the UK the Financial Conduct Authority (FCA) has focused its efforts on equity crowdfunding as this is seen as more of an investment opportunity.
The equity crowdfunding industry grew 410% between 2012 and 2014 (source: Nesta) with Crowdcube having helped raise over £161m for 400 companies since launching in 2011.
Originally an alternative funding method best suited for startups, it’s now becoming recognised as a mainstream finance option. Hundreds of businesses of different sizes and stages of growth have successfully raised money, from a variety of investors. The speed at which equity crowdfunding has grown may initially have been driven by startups unable to access finance through traditional routes but is now being used more widely. Research from Growthdeck found that the average valuation of a UK crowdfunded business was £3.2m and that they typically gave away 12.4% of their equity to investors.
FCA regulation on equity crowdfunding states that investment should be open to anyone “who can demonstrate that he or she has the experience and knowledge required to understand the investments being offered.” This is called the ‘appropriateness test’ and is a self-certification for investors. The simplicity of crowdfunding websites – combined with the easy access has led to research from the Financial Times in February 2015 showing that 62% of funders on equity crowdfunding sites have “no experience of early-stage investment”. However, these investors have also been seen to be savvy and the amounts they contribute are lower than through other funding methods with more diverse portfolios.
Businesses such as the UK startup Mondo Bank raised £1m in 96 seconds, whilst JustPark – who had already taken investment from BMW and Index Ventures – went on to raise a further £3.7m through CrowdCube; and the founder of Easyjet, Stelios Haji-Ioannou, raised £1.3m for easyProperty.
The democratisation of investment through equity crowdfunding should be welcomed by investors and businesses as it creates a new pool of potential investors for companies, offers consumers a new method of increasing their wealth, provides a quicker timeframe for investment and should help to wake up well-established investors to a new way of thinking.
A growing trend that is expected to become more prominent in the future, is the institutionalisation of crowdfunding, notably in terms of the investors. A recent study by the Cambridge Centre for Alternative Finance and NESTA found that 45% of platforms in the United Kingdom reported institutional involvement, compared to 28% in 2014 and just 11% in 2013. Institutional involvement is particularly strong in consumer loans crowdfunding, while in equity-based crowdfunding a growing number of venture capital, angel investors and even government-backed investment funds are co-investing alongside or in parallel with ‘crowd investors'.
As Darren Westlake (co-founder of Crowdcube) points out, Crowdfunding investors are savvy. They know building a diversified portfolio of investments will spread the risk and increase their chances of backing a winner, and crowdfunding offers the best of both worlds. They can enjoy the thrill of helping to get new ideas off the ground, and also the reassurance of backing a venture with a proven proposition, that has already gained traction through generating sales, contract wins, or partnership agreement.
As the EC’s Commission Staff Working Document into Crowdfunding in the EU points out, the risks associated with crowdfunding include: investors losing part or all of their capital or not getting the returns they expect; dilution in the case of equity crowdfunding (if the company engages in further rounds of capital raising); inability to exit investments (e.g. for lack of a secondary market); insufficient information or inability to price correctly the securities invested in, or misinformation (both in the pre-investment phase and over the lifetime of the investment); conflict and misalignment of interests between issuers, platforms and investors; insolvency of the platform operators, in particular as regards the continuous servicing of existing claims (e.g. dividend and interest payments) and protection of clients' assets; security of client data; platforms may be used for illicit activities; fraud (both for the investors and for the project) and related reputational risk for platforms.
As with any new financial area as it grows it requires regulation and management. With banks and large financial institutions continuing to be complicated and risk averse it presents a real opportunity for businesses to look to crowdfunding to help them grow; both from seasoned investors and from a wider pool of less experienced smaller-value investors. However, at the moment relatively few of the crowdfunded companies have shown a return on investment for their contributors – a few large exits will help cement crowdfunding as a long-term viable option to connect companies and a wider pool of investors.
For further information, please contact Deborah Angel.