Changes to regulations in the UK have made it easier for investors to back new start-ups through crowd-funding platforms and potentially reap returns through equity shares.
The Financial Conduct Authority (FCA) changed rules regarding who can buy shares of equity in a new start-up as part of its move to issue further guidance while opening up the investment market to more consumers and introduced rules on peer-to-peer lending crowd-funding platforms. Donation- or reward-based platforms (such as Kickstarter) remain unregulated as the FCA felt they fell outside its remit.
Previously only high net-worth individuals, sophisticated investors (those with investing knowledge and experience) or investors with certified investors could purchase equity in an unlisted company.
As of April 1, 2014, any person can invest, but must keep each of their first two investments under 10% of their net assets (money that does not affect their house, pension, or life insurance).
After this, the investor can choose to self-certify as a sophisticated investor and put up as much money as they desire, says a spokesperson for the FCA.
“What the government is looking at doing is opening up or de-regulating crowd-funding so savers, people who put money into banks, can have a better rate of return,” says Darren Jordan, partner at Kingston Smith, an accountancy firm. “Currently if you put your money in the bank you may only get 1% per year. If you can put it straight into businesses, or peer-to-peer loans for businesses, you could quite easily get 1% per month instead of per year. It’s the government recognising that there are consumers looking for new ways to capitalise on savings.”
The crowd-funding market is small, but growing rapidly. Equity crowd-funding generated £28 million ($47 million) last year, an increase of around 600% compared to 2012, according to the FCA.
The market could eventually see as much as £31.4 billion ($52.9 billion) invested, according to a survey and analysis done by Volpit, an equity crowd-funding platform. A survey of 1,000 adults found that although 88% were unaware of the legislative changes that now meant they could partake in equity crowd-funding, 39% were interested in investing a minimum of £500 ($841.50) and 29% were interested in investing over £1,500 ($2,524).
Volpit extrapolated this out over the adult employed population of the UK to arrive at the £31.4 billion ($52.9 billion) figure.
But not everyone agrees the percentage of the general population that would – or should – invest through equity crowd-funding is that high. It is likely to remain a niche area of investment, says Jordan. Although there are potentially good returns, it is also extremely complicated and risky, he adds. (The FCA estimates the failure rate of new start-ups in the UK as between 50-70%.)
“It’s still similar types of people that will be attracted to investing in equity crowd-funding,” agrees Luke Lang, co-founder of Crowdcube, which calls itself the oldest and biggest UK equity crowd-funding site. “They’d need to managed their own investments and be interested in supporting businesses to fit with the strategy going forward.”
But that does not mean that equity crowd-funding is something that investors interested in start-ups should ignore or that the regulations have not opened up the equity crowd-funding market to a bigger crowd.
A large chunk of Crowdcube’s estimated 70,000 users would fit into the high net-worth or sophisticated investor categories. But many would not have got involved before crowd-funding platforms started to develop.
“Many investors would still be working or have other commitments and wouldn’t necessarily have the time to devote to it,” says Lang. Crowd-funding platforms have made it easier for these investors to participate without the full time commitment that many traditional angel investor networks would require.
A similar situation has been seen by Jeff Lynn, co-founder and chief executive officer of Seedrs, an equity crowd-funding site with a slightly different model that also places them under a separate set of financial regulations. (Seedrs pools funds invested into a new business together and then acts as a sole intermediary between the investors and businesses – giving entrepreneurs one stakeholder to deal with and eliminating the risk of dilution for investors.)
Seedrs has seen mid-interest investors become an important part of the community. These are people who invest through crowd-funding and want to get involved in projects but don’t have the time to sit on a board or mentor a start-up. Instead, they can invest and offer advice as and when they have the chance, without projects being too big a drain on limited resources, he adds.
The FCA’s changes to regulations will enable more people to partake in equity crowd-funding. “It’s a welcome addition to help businesses get funded,” says Jordan. “But I find it quite risky and I’m surprised at the amount of people going into it.”
“It also comes with a serious health-warning,” he adds. “The problem with this courtship of people who want money with those who have it is: Are those people experienced enough to ask the right questions to get the right information? Some might think they are but there is no guarantee.”
There are a number of ways investors can ensure they are better protected if the move into the equity crowd-funding market. Investors are required to make their own judgements. The more information they have to do it with, the better for them. Meanwhile, the more diverse their investments are, the better the chances of covering one which fails, says Jordan.
Future dilution of investments can also be a major risk, says Lynn. “Lots of bad stuff can happen to you as a minority shareholder in a private company,” he adds. “A great risk is being diluted out of existence.”
The Seedr model was designed to prevent that from happening. By acting as the sole intermediary, Seedrs can prevent a company from watering down equity shares of investors in future funding rounds. “Investing and losing it if it fails is part of the game,” says Lynn. “But what shouldn’t be is: If a company goes on to be the next Facebook and your shares have been water down out of existence.”
But dilution is a well known risk and investors should be prepared for it, argues Lang. Previous investors should be able to benefit from pre-emption and have the first opportunity to participate in future rounds, he adds. “Typically it’s a positive thing. It means that a company is gaining investment and improving in valuation, which means that it is moving in the right direction,” he says. “Although some people think it’s bad, it really means that the value of the investment has increased.”
Even with the risks, there is definitely something attracting investors to equity crowd-funding. Big names such as Steve Smith, the founder of Poundland and Kevin McCLoud, a British designer, writer and television presenter, have invested through equity crowd-funding, says Lang.
Similarly, Crowdcube estimates that 65-70% of monthly investments are made by repeat investors – demonstrating trust in the brand, a realisation of the importance of diversification to mitigate risk and investors seeing a long-term future in equity crowd-funding, he adds.
But none of the firms have yet to see the one thing that will most attract investors - a successful exit. All the founders point to businesses that have secured second-rounds of funding as examples of companies on the right track.
“We don’t have a straight answer or prediction for when we will see exit and pay-back,” says Lynn. “We have a number that I’m highly confident will, but I don’t know if they’ll sell soon and produce a small return or wait to produce a larger. As a seeding site, of course we’d like to see a successful exit. But actually the best result for everyone would be to hold on and see that bigger growth.”
So will smaller investors be put off by the lack of a successful exit pt for less-risky – but potentially less lucrative – opportunities? Or will they be more attracted by the potential in equity crowd-funding's big returns and continue to flock in ever bigger numbers? Tell us your thoughts in the comments.
This forms Part one of a two part series looking at equity crowd-funding. Click here for Part two, which looks at equity crowd-funding from an entrepreneur's perspective.
