All About Equity Crowdfunding: Teaming Up With Others To Fund Startup Ventures

9 mins

All About Equity Crowdfunding: Teaming Up With Others To Fund Startup Ventures

Crowdfunding basics

In the last few years, you might’ve heard of crowdfunding: platforms like Kickstarter or Indiegogo where you give money to a company in exchange for some kind of reward (a branded t-shirt, or a discount on the product’s retail price). With these platforms, thousands of people come together to show their love for a product, often before it’s even been built, bringing ideas to life. (Anyone remember the Pebble smartwatch?!)

It’s a lovely idea, but it’s not really investing. It’s more of a transaction – you give money, you (hopefully) get a fixed reward, and that’s that. If the company goes on to be worth billions, you don’t get anything out of their future success.

But there’s a new way of funding that does let you participate in any future gains: equity crowdfunding.

How is this different? As the name suggests, equity crowdfunding is similar to normal crowdfunding – tons of people come together, each putting in small amounts of cash to support a company. But the difference lies in what you get in return. Equity crowdfunding investors get equity: shares of the company they’re investing in.

In recent years, equity crowdfunding has sprung into life as an accessible and low-cost way to get involved in startup investing. There are now tons of platforms that let you invest as little as $10, and there have been some big hits: challenger bank Monzo and billion-dollar Scottish beer producer BrewDog both raised a chunk of change through equity crowdfunding.

What’s in it for me? Equity crowdfunding allows you to play at being an investing bigshot for the day, by dipping your toe into the glamorous world of venture capital. It’s an investment class that has the potential for very high returns – these are often fast-growth companies that could become worth hundreds of millions in a short space of time. But that potential for fame and fortune comes with correspondingly high risks: you could very likely lose everything you invest.

In this pack, we’ll take a closer look at equity crowdfunding: exploring the kinds of companies that use it, what you need to look out for as an investor, and how to get started. Next, we’ll examine the types of opportunities you might find.

Why crowdfund?

Small companies in need of cash have a few options: taking on debt by seeking a loan (usually from a bank), or selling part of the company’s ownership to a wealthy individual (often called an angel investor) or an investment fund (known as a venture capital fund). But thanks to equity crowdfunding, more and more companies are trying something a bit different.

Why would a company use equity crowdfunding? There’s an obvious disadvantage to choosing equity crowdfunding over angel or venture-capital investment. The latter give a company access to a wealth of experience and advice from their investors, which can be invaluable to a growing startup. Equity crowdfunding, meanwhile, only offers cash (some disparagingly call it “dumb money”).

But look a little closer and you’ll start to see why some companies find equity crowdfunding so appealing. For one thing, it means entrepreneurs don’t have to negotiate with professional investors. In venture capital financing, the company’s valuation (and therefore how much of the company the founders have to give away) is arrived at through a long negotiating process which tends to favour the investor. In equity crowdfunding, the founders just get to decide their valuation – assuming they can find buyers!

There’s also a big marketing bonus to raising on crowdfunding platforms. Thousands of people will find out about your product through the fundraising process, which can be a big boon to consumer-facing companies. The fundraising platform might help you with advertising too, and having a group of guaranteed product evangelists can help spread the word and grow a business.

Professional investors are picky about what they fund – especially if a company doesn’t meet their criteria for an ultra high-growth business. It might be easier to convince a pool of less-experienced investors to part with their money instead.

What does that mean for me? It means you should probably be a little wary about the companies using these platforms. Try to figure out a company’s motivations for using equity crowdfunding: do they want to raise their profile, or are they trying to take advantage of people’s naivety?

Next, we’ll look at other ways of managing your risks.

Managing risk

Because equity crowdfunding tends to involve investing in early-stage companies, the risk of collapse is super high: the majority of startups end badly, with some estimating that the failure rate is as much as 90%. When investing in these kinds of companies, the general rule of thumb is to assume that you’ll never see that money again – it’s a massive gamble.

Are there any other risks? Oh yes. Even the companies that don’t fail could cause you problems. One thing to worry about is dilution. As companies grow they tend to seek further rounds of funding, and when they issue new shares existing investors’ shareholdings shrink. You could end up with your ownership stake diluted to basically nothing, meaning that your returns if the company does succeed will be proportionally tiny too. Some platforms give you “preemption rights” which allow you to participate in future investment rounds to maintain your stake, but that will require you to invest more cash. Be very wary of platforms that don’t offer these rights.

Equity crowdfunding is also very illiquid: once you’ve given up your cash, you’re potentially stuck owning those shares forever. You can’t just sell it on the open market like with a publicly-traded company. You might get an exit opportunity (when a company gets bought or floats on the stock market), but there’s no guarantee of that happening – so even if the company’s doing well, you might not see any return (they might give you dividends, but they aren’t obliged to!). Some platforms now have a secondary market where you can offer your shares for sale, but it’ll be harder to find buyers than it is with publicly-traded stocks.

How can you mitigate these risks? One strategy is to copy professional venture-capital funds and spread your bets widely. Instead of investing $1,000 in one company, invest $100 in 10 companies – or even $50 in 20 companies. This way you’ve got a greater chance of one company succeeding, which might bring in the returns you need to cover the losses you’ll make elsewhere.

There are also some tried-and-tested ways of assessing individual investments: go on to learn these top tips.

How to vet an opportunity

Investors can look at tons of different criteria to assess smaller companies, but there are some that are particularly important:

Team: Do some research on the people behind the company – do they have the skills and experience needed to pull this project off? Experience is a particularly important one: if they’re trying to launch a drinks brand, for instance, you’ll want to know that they’ve got some idea of what that entails.

Market: Don’t just take the company at its word when they say the market is desperate for their idea. Do your own research: figure out who the competition are and whether there are enough potential customers for the growth the company is forecasting. If you can specialize and get a really good understanding of a particular sector, you’ll have an advantage in evaluating companies.

“It’s very, very difficult to assess a private company, unless you’re very close to it or unless you’re a real expert in the field. It’s like anything – whether buying a flat or eating at a restaurant – the more of it you do the better you can become at judging where it sits on a scale. For most people, who are just going onto somewhere like Crowdcube, you get very, very limited information about the company. And because they haven’t seen that many investment opportunities it’s hard to place them on a scale.”

Expert quote

Product: It’s well worth trying to get your hands on the product the company’s making. Ultimately, if no-one wants what they’re selling then there’s no point investing, so you’ll want to use your best judgement to figure out if they’re making something valuable. You’ll also want to think about what’s stopping a competitor from doing the same thing – is there some kind of patent, brilliant route-to-market, or other unfair advantage?

Valuation: As we said in the second session, with equity crowdfunding entrepreneurs get to set their own company’s valuation. You should try to figure out if this valuation makes any sense: look at those of similar companies and see if what you’re being quoted is similar.

Share rights: All shares are equal, but some shares are more equal than others. Some don’t have voting rights (that let investors steer company policy), and some don’t have the “preemption rights” we talked about in the last session. You should make sure that you know exactly what you’re buying into – and if it’s worth it.

There’s no such thing as too much research – the more you know the better, and the more confident you can be in your investment. Now, we’ll look at how you can get involved with equity crowdfunding.

Getting started

If you want to take the plunge, there are tons of platforms available for equity crowdfunding. Which ones you can use will vary based on what country you live in and your investing experience (some platforms have rules limiting them to only certified investors, which normally means you have to have a high net worth or some kind of serious financial experience).

What are my options? Some of the most popular platforms are Crowdcube, Seedrs, Republic, Wefunder, and SeedInvest. The minimum investments a platform will allow vary wildly – Crowdcube lets you start with £10 and Republic allows $10 investments, whereas SeedInvest’s minimums are around $500. The platforms will typically have some kind of vetting process for the startups that are allowed to use them, though their stringency varies somewhat.

It’s worth registering for multiple platforms and looking at the available investment opportunities for a while before making any decisions to invest. Doing this will give you a better idea of the kinds of opportunities out there and what valuations you should be looking for – and you’ll hopefully get better at understanding business plans. Never rush into a deal: you need to try and be as rational as possible.

Ultimately, you should expect to lose everything you invest into equity crowdfunding. But that’s not a reason to not do it! It can be a fun experience, and you get to say that you’ve helped entrepreneurs build their dreams. Just make sure that you’re going into this for the right reasons – it’s not a guaranteed get-rich-quick scheme.

If you do decide to get involved, then good luck! And if you’re so excited by this that you’d like to start putting even more money into startups, then check out our pack on Angel Investing – the next step up.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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