The idea of individuals grouping together to raise grass-roots investment is not a new one. The first known building society was established as long ago as 1775 in a Birmingham pub. However, the growth of modern day crowdfunding – by which we mean internet-facilitated fundraising by businesses seeking investment or borrowing – has completely changed the investment landscape.
Today, crowdfunding is an increasingly popular and attractive tool for both investors and ambitious growth companies. It is estimated that £3.2bn was invested through crowdfunding in 2015, and a 2016 University of Cambridge report suggested that year-on-year growth in the sector was almost 84%. A World Bank Report has suggested that global crowdfunding investment could grow to $90bn by 2025.
The UK government are keen to support crowdfunding initiatives – particularly following the 2008 financial crisis – and the availability of tax incentives such as EIS and SEIS relief, which can allow losses to be offset against an individual’s tax position, would suggest that the pool of money being made available domestically through crowdfunding is only going to increase in the coming years.
Peer-to-peer loans or equity investment?
The two most popular forms of crowdfunding are peer-to-peer business loans and equity investment. Much in the same way as traditional equity and debt financing, there are clear advantages and disadvantages to both options.
Peer-to-peer business loans – which are increasingly likely to take the form of secured lending, typically against property and business assets – offer businesses the opportunity to borrow from a wide range of sophisticated investors (“the Crowd”) in circumstances where traditional bank lending might not be available to them. In 2015 there were around 10,000 peer-to-peer business loans to SMEs in the UK (excluding real estate lending) and around 23% of loan applications were accepted. The average loan was for around £76,000 and funded by 350 lenders.
Equity-based crowdfunding involves members of the Crowd investing in shares in a company. This carries higher risk for investors, because there is no clear timetable for their capital to be returned to them, but this is counterbalanced by the potential for large gains and the reality that many investors are inherently curious about the companies that they are investing in. In 2015 there were 720 successful equity raises, indicating that equity investment makes up a much smaller slice of the crowdfunding pie than peer-to-peer loans.
Outside London and the South East, the South West remains the most active crowdfunding region in the UK, from both an investor and fundraiser perspective. This is indicative both of the wealth of sophisticated investors in the South West, the number of innovative growth businesses based in the region and the fact that crowdfunding particularly suits consumer-facing businesses. Earlier this year, for example, one of our clients raised over £700,000 through Crowdcube, whilst another has just raised more than £450,000 through Seedrs.
What are the advantages of equity-based crowdfunding?
Most companies are well versed in the mechanics of obtaining debt finance, and in this respect peer-to-peer loans aren’t fundamentally different from traditional bank lending. Equity-based crowdfunding, however, represents an attractive opportunity for many early and mid-stage companies who are looking to raise capital
Some of the obvious advantages of equity-based crowdfunding for growth companies are that it is generally considered to be:
- Affordable. Fundraisers are often only charged a fee by crowdfunding platforms if their campaign is successful. Many growth companies would not have the cash or inclination to risk incurring significant finance related costs without being certain that they will ultimately receive investment. A further attraction is that there is anecdotal evidence that crowdfunding valuations tend to come in higher than those from traditional angel investors (albeit this can impact upon future investment and investor expectations).
- Flexible. Fundraisers choose how much capital they wish to raise and how much equity they are prepared to part with. This will be much less fiercely negotiated than traditional equity finance. Many crowdfunding platforms also give fundraisers the option to set minimum/maximum investment thresholds for each investor.
- Control-retaining. Whereas venture capitalists will expect to receive significant voting rights and influence/control over the running of the fundraising company, crowdfunding tends to take a different approach. Those members of the Crowd investing much smaller amounts are unlikely to want or expect this kind of control. As a result, the pre-raise shareholders can potentially retain much of their control over the company.
- Less onerous than raising venture capital. Whilst crowdfunding platforms are required to carry out due diligence on the fundraiser before offering the investment to the crowd, this is typically less extensive than in a more traditional venture capital or angel investment transaction. This helps to keep professional fees to a minimum. However, the company should be aware that crowdfunding will still require a significant time commitment in relation to due diligence, producing marketing materials and liaising with the crowdfunding platform. A further advantage of crowdfunding is that private companies are unable to offer their shares to the public without complying with a substantial number of requirements set out by the Financial Conduct Authority. When using an established crowdfunding platform this burden can be avoided.
- Lower risk than debt finance. Equity-based crowdfunding is generally perceived to be lower risk for the recipient company than debt finance; the investors understand at the outset that their capital is at risk. However, it is important that directors remember that they are burdened with extensive duties under the Companies Act, including the pervasive obligation to act in the best interest of the company’s shareholders (of whom there may now be many).
- High profile. Crowdfunding provides companies with an excellent marketing opportunity and an opportunity to raise their profile. Preparing for a crowdfunding pitch often forces early-stage growth companies to clarify and focus on their marketing efforts and business plans in a way that they wouldn’t necessarily have done otherwise. Following the raise, investors will want the company to succeed and will want to tell others about it as a result.
Equity-based crowdfunding: Legal issues to consider
Despite the various attractions of equity-based crowdfunding, there are various legal issues that companies should be aware of. Some of these are relatively straightforward – although they might impact upon your choice of crowdfunding platform – but other factors might cause you to seriously consider whether equity-based crowdfunding is the best way for your business to funds.
- Will you need to change your constitution? Most crowdfunding platforms will have bespoke articles of association which participating companies are required to adopt. This is attractive in some ways, because you don’t have to go through the extensive negotiation which often accompanies third party investment, but equally there is the risk that you lose a measure of control over the company.
- What about shareholders’ agreements? If there is an existing shareholders agreement this will need to be disclosed to the crowdfunding platform. You will need to consider whether the shareholders’ agreement restricts the company’s ability to raise investment, and whether the investors will be required to sign up to the shareholders’ agreement (assuming it is in a suitable form for them to do so). It is also important to consider how the fundraising process generally – including any changes to the articles of association – will impact upon the terms of the shareholders’ agreement. It may be necessary to terminate or vary the shareholders’ agreement prior to raising funds from the Crowd.
- Do you hope to attract further investment? It is important to consider whether raising funds by equity-based crowdfunding now will make your company less attractive to potential investors further down the line? Brewdog succeeded in raising £213m from a US private equity firm despite previous raises coming from crowdfunding, and many companies who have benefitted from crowdfunding once will be keen to explore a further crowdfunding raise in the future. However, there remains some uncertainly around whether institutional investors are averse to investing in a company partly owned by the Crowd. Ultimately it is likely to depend on the level of Crowd investment and the level of control that is given to the Crowd.
- Will there be difference classes of shares? The company will need to decide whether it wants to offer a different class of shares to investors to those held by the founders. Some crowdfunding platforms are very prescriptive about the class of shares that are to be offered to investors. Typically a company may not want the Crowd to have voting rights, for example, although bigger investors might expect to have voting shares and some platforms use a nominee structure which does confer voting rights on the Crowd.
- Are you ready for the additional strain of corporate governance? Whilst crowdfunding platforms typically take some of the hard work out of post-raise administration (such as providing share certificates to investors and providing the company with the relevant information for its statutory registers) there may nevertheless be administrative and compliance implications for the company to consider. What happens if a member of the Crowd chooses to sell their shares? Giving notice of general meetings, for example, is much more complex if you suddenly have hundreds or even thousands of members. You will also need to think about how you are going to communicate with the Crowd, who will understandably expect to be kept regularly informed about the company’s progress.
- Are there any potential reputational risks? Equity-based crowdfunding is still an emergent, relatively new concept, and the first 2 successful UK exits only happened as recently as 2015. Difficulties may arise further down the line where members of the Crowd start to become disillusioned at a lack of dividends or their inability to readily resell their shares. The crowdfunding platforms are likely to bear the brunt of such frustration, but nevertheless this is something that fundraising companies should consider prior to a raise.
- Will the Crowd qualify for EIS/SEIS relief ? If so, investors can benefit from the potential for significant income and capital gains tax, making the investment much more attractive. However, tax advice will need to be sought and an application made to HMRC.
Is crowdfunding a good way for businesses to raise funds?
Equity-based crowdfunding is an increasingly popular way for growth businesses to raise funds and investors with an appetite for risk to make tax-efficient investment. However, whilst the benefits are clear, that isn’t to say that crowdfunding is the right option for every business. The experience and advice that can be gleaned from a traditional angel investor, for example, may far outweigh the advantages to be sought from a crowdfunding raise.
As with any form of third-party investment, it is important that companies carefully review the legal and commercial factors prior to engaging in crowdfunding. Taking legal and accountancy advice at the outset of any fundraising venture helps to affirm whether it is the right decision and avoid the risk of nasty shocks arising further down the line.
To discuss this article or any other corporate matter please contact the corporate team 01392 210700, email solicitors@stephens-scown.co.uk or via www.stephens-scown.co.uk