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Avoid the sting in crowdfunding's tail

Avoid the sting in crowdfunding's tail
November 15, 2013
Avoid the sting in crowdfunding's tail

What happened to Saverin was that having invested $1,000 (£628.12) for his 30 per cent-plus share in the company he jointly founded with Mark Zuckerberg, his stake was later massively diluted by the issuance of fresh shares to new investors. In fact Saverin's share was watered down to less than 0.5 per cent, while Zuckerberg's share remained exactly the same. Saverin might have had a piece of paper telling him he owned a third of Facebook, but what he didn’t have were pre-emption rights. If he had, those rights would have prevented his original share from being diluted away to almost nothing.

Worryingly for devotees of equity crowdfunding in the UK, the risk of being written out of the picture at any point, including just ahead of a big flotation, is a real one. That's because start-ups will continue to seek new capital as they grow. And as they approach the stage where they look ready for a float, they will attract serious attention from canny venture capitalist backers who will demand preferential terms and will have no qualms about riding roughshod over your dreams. In other words your holdings will be drastically diluted while they walk away with the lion's share of any future float or sale, along with possibly preferential rights to dividends.

You can protect yourself from the risk by paying attention to the terms on which you are offered shares in a crowdfunded deal, and by securing the best class of share available even if this means investing more. Your holding can still be diluted as additional capital is raised by the company, but what you don't want to happen is new shares being issued in huge numbers with preferential rights to a select few investors.

Seedrs protects investors by using a nominee structure so it remains the representative of the investor and always enters into a subscription agreement (similar to a business angel agreement) with each investee company. This ensures that investors receive professional grade investor protection including anti-dilution and tag-and-drag rights. Jeff Lynn, chief executive at Seedrs, says that while a company's Articles of Association can appear to offer rights to the original shareholders, in fact the articles can be rewritten by shareholders with voting shares. "A subscription agreement is the only real protection," he says.

New entrant to the market SyndicateRoom also safeguards investors from the hidden risk of dilution. It's built on a very different model to both Seedrs and CrowdCube and only showcases companies which have already secured funding from business angels - in other words small investors come in as top-up investors. But crucially they do so on on the same watertight, heavily protected terms as the professional business angels.

In theory, the fact that due diligence has been carried out by seasoned professional investors should help to eliminate rubbish companies. "We think investors should be given a chance to buy into the top start-ups, and be guaranteed the same shares and the same economic rights as the lead investors," says SyndicateRoom CEO and founder Goncalo de Vasconcelos. He points to another advantage of the SyndicateRoom model, which is that companies will be steered firmly towards a float or sale by their professional owners, which is not something ordinary crowdfunding investors would have the power to do on their own. However the requirement for prior business angel approval is likely to mean a more limited range of opportunities compared with other crowdfunding sites, while the selected companies will also be at a later stage of development - you may not be getting in right at the start and you might not receive valuable SEIS tax relief.

Crowdcube does not have a Seedrs- or a SyndicateRoom-style agreement in place. Its investors who buy, or have bought non-voting standard shares are at risk of dilution later on. But Crowdcube investee companies can also offer a second share class with pre-emption and voting rights to larger investors. Crowdcube says it's up to the investee companies to set the investment level at which these shares are made available. The threshold for example might be £5,000.

 

How the crowdfunders compare

CrowdcubeSeedrsSyndicateRoom
Number of current available investments42305 (20 in pipeline)
Number of funded investments82481
EIS/SEIS availableYes, in most casesYes, in most casesYes
FCA authorisedYesYesOngoing process
Automatic protection from dilution?Only with A sharesYesYes - the terms offered to investors are the same as those agreed with professional business angels