Thursday 10 March 2016 5:01 am

Why equity crowdfunding platforms must take due diligence more seriously

The growth of equity crowdfunding has been spectacular. It has delivered the kind of shot in the arm for the funding of small businesses that policymakers have been seeking for decades. And what is particularly interesting is that crowdfunding has done this without two components that most investors view as vital before they invest: proper due diligence and clear signs of profits, or a route to profitability. Should we be worried about this?

The recent failure of Rebus, a claims management company that raised £800,000 via an equity crowdfunding platform, has brought these issues into sharper relief. A study by Mattison Public Relations of 115 companies seeking crowdfunding on UK platforms in December 2015 showed that 90 per cent of them are either unprofitable or have no trading history. Too many platforms are asking their investors – whose levels of experience range from virtually nothing to expert – to invest their money in businesses that actually have zero revenues. So is it time to improve standards or are the naysayers yet again simply failing to get a new paradigm?

Failures of some crowdfunded businesses are inevitable, and investors know that, or should know that. However, it is worrying that this is a sector that often seeks to market its wares to very inexperienced investors without giving them the helping hand they deserve. Many investors on crowd platforms lack the experience or the time required to undertake a detailed examination of a company’s books, or to conduct the peer and sector analysis necessary as basic steps to appraise and value the business.

Passing the buck

The assumption among some is that, if the private investor is not doing that due diligence, surely the crowdfunding platforms are? Unfortunately not – many make it quite clear that they have no obligation to do this whatsoever. Based on many of the early-stage companies offered on these platforms, little effort has even been made to check if a realistic basic business plan is in place, let alone a proper business model and a roadmap towards an exit.

Without data and guidance, many investors have little more to base their investment on than a hunch – a worrying thought indeed when you are talking about hard-earned money.

As the sector advances, more of us in the industry are beginning to feel that crowdfunding platforms do have a duty to undertake the due diligence necessary to radically improve the chance of investors achieving acceptable returns.

Just filtering out the more obviously low quality companies will minimise the number of business failures which – if they continue – could lose this sector valuable popular and political support. This is not to say that the due diligence required would be without cost. Providing more robust checks requires platforms to employ executives with significant experience of working in private equity or corporate finance. However, these costs should easily be outweighed by the superior returns for investors that follow.

Private equity lead

At present, to the eyes of more experienced private equity investors, it looks worrying that crowdfunding platforms are so overstocked with loss-making businesses or businesses that have never sold a product or a service. There is a perception in some quarters that it is alright for startup businesses to take years to generate a return. Perhaps this is driven by the fact that some of the world’s most famous startups (and now big firms) are still more concerned with growth than profit.

Our contention is that those companies that can remain loss-making but solvent for years are an exception and not the rule. The rare success of Google and Facebook should not lead crowd investors to believe that investing mainly in loss-making companies is a sensible strategy. We fear that a little complacency over what is investment ready and what is not has crept in.

Companies that are loss-making need a more compelling and rigorously tested business plan before they can justify attracting investment. As investors experience more company failures, they are going to demand that platforms become more than just conduits for investment.

Platforms need to start undertaking proper due diligence on, and have ongoing involvement with, investee businesses. This approach should mean that those businesses are of a better quality both at the point of investment and as they grow.

The crowdfunding industry should take its cue from the approach used by private equity. Before any deal is made available to investors, platforms need to talk to the company’s existing customers – and potential customers the business didn’t secure to find out why. They need to know the company’s market in detail themselves. They need to compare the owners’ exit plans with similar deals in the industry to assess how realistic they are. They need to look into the owners’ backgrounds to see if they have suitable past experience.

And on an ongoing basis, platforms themselves need to be reporting to investors regularly on the performance of the businesses they funded – not just gently encouraging the businesses to report. They should be putting experienced board members in place, and giving the companies access to sector specialists to advise them on their growth. After all, apart from scale, what is the difference between an investor in equity crowdfunding and a private equity investor? Why should the former accept lower standards than the latter?