From minimising exposure to failure to ensuring adequate protection against dilution, there are ways to prepare before making your crowdfunding investment
THERE is a lot of noise around the heightened risk investors are exposed to on crowdfunding platforms. But crowdfunding is venture capital, and venture capital is all about taking a higher level of risk than usual to achieve a higher level of reward than usual.
The Financial Conduct Authority (FCA) recognised this in rules designed to limit investors’ stake to what they can afford to lose. The rules, introduced in 2014, restrict equity crowdfunding platforms to dealing with retail investors who have certified that, in the previous 12 months, they have not, and in the following 12 months will not, invest more than 10 per cent of their net assets in unlisted securities. Crucially, the new rules require equity-based crowdfunding platforms to assess whether the retail investor has the necessary experience and knowledge to understand the risks of making an investment of that nature.
The collapse of Bubble & Balm in July 2013, one of the first companies to raise money via platform Crowdcube, supports the FCA’s approach. And one thing is certain – many more companies that have raised crowdfunding will follow. This is the nature of venture capital. Many companies fail, some perform adequately and a small number deliver spectacular returns.
There are three key questions for investors: how do you minimise your investments in companies that fail; how do you maximise your investments in companies that succeed; and how do you make sure that you receive your fair share of the exit proceeds when the company is sold?
PICKING THE RIGHT COMPANIES
Crowdfunding platforms have not yet been around for long enough to provide stats about returns delivered to investors. So for now, investors are having to make their own judgement calls on which host the best investment opportunities and which of those to invest in.
In making this call, an investor needs to consider a platform’s position in the market, its structure and its business model: is it attracting the best deals to its platform through its reputation and brand? How robust are its internal processes for weeding out weaker candidates for investment? Does the approach of the platform lean towards maximising value for the investor or, instead, for the entrepreneur?
Outside crowdfunding, any angel or venture capital investor does its homework on a business before investing. This can involve a great deal of time with the founders, kicking the tyres on its intellectual property and route to market, speaking to customers, as well as legal diligence on the company’s share capital, indebtedness, contracts with employees and third parties.
A typical investor on a crowdfunding platform does not get the opportunity to do this. That means they should consider how curated the investment opportunities on the platform are (e.g. what diligence the platform does), look for the positive correlation between curation rates and funding success rates and, more generally, think about how the platform educates its investors and encourages them to make intelligent and informed decisions. This will help to demonstrate how it fosters a culture of transparency and accountability for the long term.
RECEIVING YOUR FAIR SHARE AT EXIT
Different platforms offer different terms of investment – from warranties, voting rights and pre-emption rights on follow-on fundraisings, to veto or consent rights, and the right to “tag” along on any proposed change of control or exit.
Being a young, most likely pre-profit company, the business will probably go through further rounds of fundraising before it reaches an exit. As an investor, you should consider whether the terms of investment offered by a platform provide adequate protection against dilution of your shareholding on those rounds of financing. And whether, at the exit, you have the right to participate in it and sell your shares at the same time. Crucially, though, the terms of investment must be consistent with venture capital market norms. It is in no-one’s interest that future venture capital investors – whose money may well be vital to taking the business from promising startup to global success – are put off investing by the control given to a long tail of small crowdfunding investors.
Crowdfunding platforms have, in a very short space of time, become an important part of the UK’s tech ecosystem. They will continue to thrive as they refine and add to their approach, driven in no small part by investors making increasingly well-informed decisions about where to allocate their funds.
Adrian Rainey is partner in the corporate technology practice at Taylor Wessing, which has just partnered with SyndicateRoom for the launch of their educational platform, the Investor Academy.