WTF is…equity crowdfunding?

You might know of crowdfunding as a way to get a product idea funded, an excellent fundraising tool for charities or a way to purchase your next cool Christmas present.

But did you know that businesses are now raising equity investment capital in the same way?  More businesses are realising that they can convince their thousands or millions of customers to invest in them – which sounds really exciting.  But is it the right thing for you?

How does equity crowdfunding work?

Normally, a business wanting to expand (to new products or places) needs to raise cash.  This can be the owners’ savings, a loan from a bank, or finding some other investors who are prepared to take a share of ownership in return for…well hopefully, dividends.  Usually, a loan will be secured against the assets of the business, and there is a contractual obligation to pay it back with interest.  But a share of ownership gives you the right to a share in profits (if there are any after costs, loans and taxes are paid) – it’s a little different.  Equity stands behind debt in the line of ‘who gets paid first’.  In fact, equity stands last in line.

Usually, the best way to raise money is to find a small number of investors with a lot of money each.  But crowd funding works the opposite way.  Lots and lots of people put in small amounts of money – occasionally it can be as little as £100.  Awesome – you think – let me at it!

But – hold on a sec.  Just because you can, it doesn’t mean you should.  In fact the FCA (the UK’s Financial Conduct Authority) thinks that companies have been getting a bit too cute with their fundraising methods, and apparently sent a ‘Dear CEOs’ letter to express their concerns that retail investors are being inappropriately targeted through crowdfunding.  There is little evidence that crowdfunding equity has been successful for retail investors.  In fact there is a high risk of failure – and investors end up losing all their money (that’s what that ‘capital at risk’ phrase means).  But these high risks are rarely mentioned in plain English.  There is a low chance that investors can make exceptional returns – but those events are…well…exceptional.

Cons of investing in equity crowdfunding

#1 – you never know when you’re going to get your money back – if ever

An equity investment is unsecured – that is, it’s a promise and not much more.  You get shares in the company – usually represented by a share certificate (this can be digital or on actual paper).  If you buy shares on an exchange – like the London Stock Exchange – then there’s a market established so that you can sell your shares at the prevailing price.  That means you are likely to be able to find a buyer for your shares (the lingo for this is the ‘secondary market’).

However, with crowdsourced shares, there may be no market to sell your shares.  The company may agree to buy your shares back if you need some cash.  But if they are the only buyer, you can bet that the price will be in their favour.  The company might be relying on a buy out in order to get their investment return.  This means that you, as the tag-along investor, could wait on someone else’s timetable and be selling someone else’s price.

#2 – dividends are a promise, not a commitment

Dividends paid from profits only occur after all other costs have been paid.  That is, after all costs of running the business, any loans that the business holds, and any tax they need to pay on profits, and any other ‘preferential equity’.  Depending on the contract you agree to, this usually means that any big investors will get their share of profits first.  And then, there’s you, last in line.

#3 – you will be treated like a mushroom

As a teeny tiny investor, you are not very important to the company.  That £1k might be a lot of money to you, but to a company with £1m in turnover (and really, it should be at least that big) it’s barely a drop.  It is likely that you will get limited financial information – and certainly not anything interesting.  And you won’t get any say in how the business is run.  There may be a pretty presentation once or twice a year – but you should expect to be kept in the dark, and fed sh!t.

#4 – you should be a certified High Net Worth investor

That is, you have an income of over £100,000 per year or have net assets of over £250,000.  Interestingly, the FCA does not say whether your income is net of tax or not – so a lot of people could still qualify.  The issue is, many equity crowdfunds require you to make a self declaration – and they are not obliged to check that you have told the truth.  Given how slick some of these equity raising websites are, you may be tempted to simply click through that very important declaration.  Once you do so, you give up any protective rights you have as a retail investor – so beware!

So – that’s the bad stuff.  Is there any actual upside? 

Pros of investing in equity crowdfunding

#1 – the returns could be exceptional

And I mean truly exceptional – in two ways.  If everything goes swimmingly well, and the company you invest in eventually goes large – you could make back multiple times your initial investment.  But when I say ‘exceptional’ I also mean – this is the exception, not the norm.  Most companies that raise this kind of equity funding are essentially start ups – they may be 2 or 3 years old with perhaps a couple of funding rounds under their belt

#2 – it’s a great way to learn about private equity and start ups

If you want to know about how start ups raise funds, or how private equity houses work their magic – then this is a great way to get a peek at that world. Yes, you may only get restricted access – but it’s a start. Think of it as an investment in your education – so how much would you want to spend?

#3 – it’s getting easier and easier

Start ups are being supported by platforms which are making it easier to raise money in this way and that means it’s easier for YOU the investor to get a piece of the action.  Information is sent by email, you get access to an investment platform – and the process can be seamless.  But beware – read ALL the fine print and make sure you understand the details.  Just because it’s easy, doesn’t mean it’s meant for you.

#4 – you get to support businesses you believe in

If you can afford to lose your investment, and you want to support a business – then this is a great way to do it.  Your money can make a difference in getting a well-needed product to a wide market. If you believe in the company – then invest!  What’s the point of having money if you don’t use the power of it to promote and support the causes you believe in?

Is crowdfunding a good investment for me?

If you meet the certified High Net Worth investor requirements,  you’ve sorted your pension out, got your emergency fund filled up, invested in a diversified portfolio of publicly traded stocks, sorted life insurance – and just about everything else – AND have a bit of money left over to splash about, then maybe this is something for you.  I totally believe in learning by doing when it comes to investing – and this is a great way to learn about how start ups raise their money.  However, I would not recommend investing any more than 2% of your investment portfolio in such a high risk investment.  In fact, there is a good argument for not including Equity Crowdfunding as an investment in my opinion.

Having said that…

I am willing to support an equity crowdfunding when the right one comes along.  There are a few start ups that I work with, and I would be happy to increase my connection with them through a crowdfund.  But – I would not call it a financial investment.