No big deal: Why there's no need to worry about the failure of a crowdfunded company

 
Dona Ardeman
It's not a firm going bust that investors should be worrying about (Source: Getty)

Equity platform Syndicate Room has had its first fail: Soshi Games, which fundraised in January 2014 on the platform and pulled in £285,000 from investors, has now closed down. The first failure on an equity platform – the fair trade soap manufacturer Bubble & Balm, which raised £75,000 in 2011 via Crowdcube, went bust in 2013 – sent tremors across the industry. Press commentary at the time was rife with jokes about bubbles bursting and alarm bells sounding for the end of the equity crowdfunding industry. Now, all bets are on as to whether this second fail will lead to a repetition of the same false alarms.

NATURAL COURSE

There is nothing particularly unusual about an early stage company not making it. A fair proportion of startups fail, and there is no reason why this should be any different for online deals. On the contrary, it is surprising that there haven’t been more. What’s more, for high net worth SEIS/EIS investors with a properly diversified portfolio of early stage investments, it may well be preferable to have the no-goers liquidate early on (taking advantage of the relevant loss reliefs sooner rather than later) and focus on the stronger candidates for follow-on investment.

From a legal perspective, there are alarm bells, however. They may be rather quieter, but they should be acknowledged: they relate to the interplay of some questionable financial promotions, obscure risk warnings, and investor-unfriendly deal structures.

PROMOTION KNOW-HOW

Under UK financial services and markets rules, there is a prohibition on financial promotions - i.e. communications to induce others to invest in securities, unless that communication is approved or an exemption applies. Most platforms are themselves authorised, or they collaborate with authorised firms to approve their own financial promotions. However, the companies seeking funds also contact their friends, family and other potential investors. They may rely on exemptions which might not fit what they are doing – or they don’t even realise that they are breaching the law.

Platforms take differing approaches on the degree to which they control or supervise company communications. So far, the FCA is taking a very light-touch approach, which has been great for encouraging sector growth, but not necessarily ideal for investors. Some of these regulatory loopholes now look likely to be tightened up.

WARNINGS & STRUCTURES

With respect to risk warnings, each platform again has its own approach for flagging risk to its investors. But sometimes, the platforms with the least sophisticated investors (putting in as little as £10 per “investment”) provide the most sophisticated legalese warnings. Conversely, some of the platforms with the most sophisticated investors (with far higher minimum investments) are giving more approachable warnings in layman’s terms.

Equity crowdfunding by nature must cater for a potentially large number of “crowd” investors. It doesn’t take much imagination to foresee the difficulties for an early stage company trying to, for instance, facilitate the sale of all of the shares on an exit with hundreds of minority shareholders. Different platforms adopt different structures to deal with this, from setting higher investor thresholds, to only offering second class non-voting shares to minority investors. They may also use a nominee who holds legal title to the shares on behalf of the investors.

Each of these solutions (and their variations) has its pros and cons. But, in the wild west of crowdfunding, some of the deals being offered may constitute investments where: little independent or comprehensive due diligence is performed; there is no realistic exit plan or investor representative board members to drive dividends or an exit; and/or the valuation is set by the company itself and doesn’t necessarily represent market price. Even where the company does not fail, there may be no immediate or obvious returns for shareholders with illiquid investments, and no ready market.

This is when the alarm bells sound. It may only be a matter of time before the shareholders in a crowdfunded company that hasn’t failed, but is not wildly successful either, are presented with the next investment round at a substantially reduced share price. At that point, they may begin questioning the financial promotions and risk warnings they received, and the “value” of the proposition that they were offered. Then the lawyers’ phones will start ringing.

LEGAL FIELD DAY

Let’s face it – there will be many more company failures. Nothing new there. But if and when litigation starts with one company, now that would be big news. If this happens, it’s not difficult to foresee that it could lead to the collapse of one or more equity platforms, as investors start looking more closely at the terms on which platforms they’ve invested through operate. Let the class actions commence.

Many deals offered on platforms are not very different to traditional investments – they just happen to take place online. But in other cases, some of the deals are investments by relatively unsophisticated investors in very small and fairly un-vetted companies. So it is vital that the financial promotions, warnings and deal structures are considered as part of the bigger picture when making investments, with an ear always pricked for those subtle alarm bells.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

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