Equity crowdfunding is great - at its core it brings democratisation to investing in startups and allows more entrepreneurs the opportunity to raise finance for their respective businesses. Entrepreneurs who in the past would not have been able to raise equity finance from experienced Business Angels can now turn to a crowd and ask them to invest from as little as £10. However, think about it for a minute… a crowd investing upwards of £10 may sound great now but sooner or later the lack of adequate due diligence, supervision and support from experienced Business Angels (in the form of adequate corporate governance) is likely to lead to unfortunate losses that may tarnish the equity crowdfunding scene.
Valuation - when a business is listed on an equity crowdfunding platform, the valuation has been set by entrepreneurs. However as Richard Farleigh's very compelling post "Your idea has no value" explains, startups are worth a lot less than most people think, especially entrepreneurs. Without the right valuation crowd investors will fail to get the right returns from the successful companies that allow experienced investors to make a tidy profit after covering the losses that they will inevitably shoulder from other deals. The presence of experienced Business Angels as lead investors overcomes this problem for sophisticated crowd investors.
Inadequate due diligence - 'Siding with the Angels' is a report by NESTA/BBAA that shows that on average Business Angels achieve an annual return of over 20%. The report also shows that 20 hours or more of due diligence yields far better returns than lower levels of due diligence. However in equity crowdfunding there is little meaningful due diligence that is carried out by investors and this omission is likely to result in losses that could be avoided by detailed due diligence by an experienced investor. Crowdfunding investors should be worried; people turned away by detailed due diligence by experienced investors may turn into equity crowdfunding to raise the finance they want and this will skew financial returns in favour of angel investors.
Lack of financial discipline - if there is nobody representing their own investment, who is going to ensure that the money is spent wisely? For inexperienced entrepreneurs it is easy to lose financial discipline when a big chunk of money infuses the company bank account; splashing out on nice furniture and expensive marketing exercises only improve vanity-metrics but do not add much value to the business. An experienced investor can be fundamental in ensuring that a company does not waste investors' money and that it stands a chance to survive the lowest cash-flow point before it has the opportunity to gain traction and become successful.
Poor understanding of finance - one of the major reasons for failure of new companies is a poor understanding of finance by the management team. Having Business Angels with financial expertise at the board can be a huge help to new management teams. Again, this is something that equity crowdfunding platforms are missing at the moment.
Lack of adequate corporate governance - Business Angels are particularly keen to ascertain that the companies which they invest in have adequate corporate governance in place. This is for a good reason; for these companies corporate governance ensures that their management team is constructively challenged by more experienced investors who are genuinely interested in the success of the company. Following their investment business angels usually appoint or take the role of investment director, non-executive director or board observer. None of this occurs in the current equity crowdfunding platforms, which wash their hands from this issue by saying that this is the problem of the investors and that the 'wisdom of the crowd' overcomes this problem. However having a crowd of investors is not equal to having at least one large investor actively taking care of their investment and, as a result, helping the company succeeding. Many Business Angels are themselves successful entrepreneurs with extensive experience of building businesses - an invaluable resource for new CEOs that is missing from many crowdfunding platforms.
Poor communication between company and shareholders - the lack of a structure for companies to communicate with their shareholders brings me to the last of the hidden problems with equity crowdfunding. Some platforms are already addressing this issue by providing a 'post-raise' area and hopefully other platforms will follow suit shortly. An entrepreneur needs effective communications with shareholders throughout the entire journey. Otherwise the management team will suffer a lot of frustration and take up time placating worried shareholders at a time that they cannot afford it, i.e. when the ride is getting tough and they need to focus on the business. If communications are well managed, shareholders are more likely to be willing to help the company during tough times rather than trying to allocate blame or interrogating the management team.
Syndicate Funding 2.0: could this new model of finance be the answer?
On the 19th of March a new online equity investment platform called Syndicate Room launched in the United Kingdom that created a new model of finance based on the well-established process of investor's syndication. This platform allows its members to co-invest alongside Business Angels, who become the lead investors of the funding round. This resolves the previously mentioned key issues of equity crowdfunding:
- Business valuation - the valuation is not set by the entrepreneur. Instead, sophisticated investors invest at the same valuation as the Business Angels (lead investors), a valuation which is the result of negotiations between the Business Angels and the entrepreneur and likely to be considerably lower than what initially asked by the entrepreneur (hence better for investors). Sophisticated investors are therefore more likely to get a larger upside from successful companies than crowd investors.
- Due diligence - whilst for legal reasons investors cannot rely on each other's due diligence, there is a clear alignment of interests between different investors. Business Angels will be investing significant amounts and therefore carrying out their own due diligence whilst the sophisticated crowd of investors represent a 'reality-check' that votes with their money.
- Somebody is actually looking after their own money - Business Angels will be looking after their investment and whilst they are not responsible for investment by any other investors, with such a strong alignment of interests and the same economic rights, if they make money, so do sophisticated investors that invest alongside them. Sophisticated investors share the risks with seasoned investors that are looking after their investments rather than with a crowd where nobody is actively looking for their investments.
- Adequate corporate governance - it may sound pointless for innovative startups to have formal board meetings but having the involvement of the right Business Angels can be the difference between spectacular success and resounding failure. Which boat would you put your bet on - one full of rowers without a cox and no way of knowing where the next bend is or one with a fully synchronised team of rowers and a cox calling out the danger ahead and steering towards the finish line?
Syndicate Funding 2.0 is not for the wider '£10 crowd' with investment starting at £1,000. As a result of every deal posted having to already have lead investors putting forward significant amounts of capital, members get to see far fewer deals than in crowdfunding platforms. Syndicate Room highlights that Syndicate Funding 2.0 is about deal quality, not quantity, aiming for a funding rate of well above 80% in sharp contrast with current crowdfunding platforms that have a funding rate of 20% or less. Such a high funding rate will attract smart money and as a result a more sophisticated level of entrepreneurs.