A lot has been written on crowdfunding recently so let’s explore a more niche variant: Equity crowdfunding – small investments in exchange of shares of a business – is a niche but probably a more interesting part of the industry. Is equity crowdfunding a good thing? We’ll examine some of the key issues below and why we believe, despite these issues, equity crowdfunding is here to stay for the long haul.

The crowdfunding concept has been around for quite a while (in tech-years) with a number of websites including as Kickstarter and Indiegogo becoming (tech) house names. These websites allow an individual to raise finance for a project from ‘the crowd’, i.e. the general public. In exchange for their money (as little as $10) the crowd gets certain perks such as discounts on future purchases, the opportunity to name a character in a book or any other perk that entices the crowd to put money in. The crowd generally knows what they hope to get in return for their pledge so they put their money into projects that appeal and then wait for their package to arrive.

A new model has appeared, called equity crowdfunding, and it allows the crowd to put money into early stage startups in return for shares in the company in hopes of the startup doing well and one day selling off to a large private investor or going public through an IPO). The UK equity crowdfunding sector currently leads the way as the the many other nations governments are waiting on further research and regulation to be put into place before giving the go ahead. The crowd waits, particually in the USA where a bill that would allow raising finance for startups from the general public has been in the pipeline for quite a while.

The first issue is whether it is legal to raise finance for unlisted companies from the general public without issuing a prospectus (a disclosure document that describes a financial security for potential buyers) which is horrendously expensive to issue and usually only done for listed companies to raise much larger funding rounds.

The Independent and the Telegraph have written articles based on the FSA warning on how online investment in small businesses should not be promoted to amateur investors. However it can be argued that this type of investment is in many ways a more transparent investment than investing in many financial instruments such as some investment funds out there. Or even worse, how can people argue that equity crowdfunding presents a huge risk to the general public when one can bet £100 on any high street with the risk of addiction due to the instant gratification that these high street betting shops offer?

Hopefully concerns by some people will vanish now that both main UK equity crowdfunding platforms are FSA authorised.

Financial returns

According to the report Siding with the Angels by NESTA, Business Angels achieve an average financial return of 2.2x with a holding period just under four years, resulting on a 22% Internal Rate of Return (IRR). What’s more, many of the angels are able to claim back much of their investment in the form of tax liability reductions that are offered through the UK government’s Enterprise Investment Scheme and the Seed Enterprise Investment Scheme.

This highly attractive return may tempt you to immediately jump on the opportunity but a word of caution is required. Business Angels know their game and are very selective regarding their investments.

So if you know how to choose good deals and you build a good portfolio to spread your risk you could, in theory, equal or improve on the Business Angels return by investing using equity crowdfunding platforms, right?

Wrong! Or at least highly unlikely.

The trick you will always be missing with the existing equity crowdfunding platforms is that you cannot negotiate the companies’ valuation and that makes a huge difference on your potential financial returns. This is one of the key reasons why Business Angels are not exactly queuing to invest in crowdfunding platforms and until it is possible to negotiate the valuation on the equity crowdfunding platforms there is little room for a reasonable likelihood of financial returns anywhere similar to Business Angels’ returns.

All you need to do is to watch a couple of episodes from BBC show ‘Dragons Den’ to see the Dragons in fierce action when they are interested in investing. Business Angels carefully negotiate the companies’ valuation to make sure their upside if the investment goes well covers for the losses of other investment deals that will invariably go pear-shaped and gives them a tidy return on top of all the other losses incurred.

Richard Farleigh (Mr Nice Guy from Dragons’ Den), whom I’m a big fan of, is one of the most prolific Business Angels in the UK and he has a blog well worth reading. He has written a very compelling post on business valuation called ‘Your idea has no value‘ that explains why startups are worth a lot less than most people think, especially entrepreneurs.

Milo Yiannopoulos has written an interesting article albeit an inflammatory one on the Kernel on the risks of investing through equity crowdfunding platforms, comparing professional private investors with amateur investors. He strongly believes equity crowdfunding will attract ‘fools money’, people will lose all their money and then there will be many lawsuits in the next 10 years. This is hard to imagine as most people will invest such small amounts that does not justify a lawsuit but that doesn’t make equity crowdfunding right.

As long as entrepreneurs are the ones setting the value of their business without any negotiation with real potential investors taking place, crowd investors are unlikely to see any returns from their investments. For investors that put small amounts of money in to support startups they believe in, this is not a problem. However, smart investors looking for real returns should be looking at somewhere else like syndicate investment clubs or business angel networks.

Lack of guidance for entrepreneurs

Raising finance through equity crowdfunding platforms has an upside that some entrepreneurs love - money with no strings attached. There is hardly anybody that they have to report to for the money and there isn’t anybody that will ask them tough questions as they are ticking along. However entrepreneurs that love the idea of not having anybody asking the tough questions are bound to be far more closed to new ideas than entrepreneurs that recognise the value in having somebody on the board that will ask tough questions in a constructive manner. I know which horse I’d bet on between the two and it isn’t the one that is closed to new ideas or feedback.

Having some sort of guidance from more experienced people is a huge benefit for startups and the entrepreneurs involved and this is a key advantage of having the right Business Angel or experienced person on board. Crowdfunding doesn’t provide entrepreneurs with any guidance or a robust network of contacts whatsoever and for high-growth startups that is likely to hinder a rapid expansion.

Conclusion

Equity crowdfunding is a very recent concept that has yet to prove itself. All in all, at least in the uk equity crowdfunding is here to stay and is clearly beneficial for entrepreneurs and for entrepreneurial activity and for that alone is worth having.

Entrepreneurs that find hard to raise finance are, without a doubt, the main beneficiaries of equity crowdfunding. They get quicker and easier access to capital with a better valuation than they would with private investors and with less questions about their future performance. Better access to capital will result in new companies creating new jobs and that cannot be a bad thing.

Investors can have a great ‘feel good’ factor attached to their capital. However I would stop short of calling it an investment due to the referred concerns regarding the likelihood of financial returns.

This is the key problem with equity crowdfunding - it provides entrepreneurs with access to capital resolving a real problem for entrepreneurs, but it fails to address a problem for potential investors due to a low likelihood of financial returns.

Lastly, until other governments act, the UK equity crowdfunding sites will continue to lead the way and ultimately put them in a position to be succesful in other markets when those governments finally choose to allow this form of investment.