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Crowdfunding: the new way to invest in start-up companies

Crowdfunding is transforming venture capital. It's still high risk, but smaller scale. And if early-stage investing has never been to your taste, it now comes with a sugar coating of tax breaks
November 15, 2012

There's a new way of investing in start-ups, one that allows you to sit back, flick through an online catalogue of early-stage companies and make anything from one to dozens of small investments in the ones you like.

It's called crowdfunding, a phenomenon that began in the US as 'social investing'. With this earlier type of crowdfunding, investors were invited to inject money into innovative new companies that could not afford, or were refused, bank loans in exchange for rewards, usually products or services.

But crowdfunding has now evolved in the UK into a system that offers returns in the form of equity stakes – although rewards-based crowdfunding can still be accessed through platforms such as KickStarter (kickstarter.com). For example Good & Proper Tea, which is aiming to become the "Monmouth Coffee Company of the tea world", offers investors on KickStarter different reward packages starting with a supply of tea rations, all the way up to having them serve at a party you're hosting.

 

Spirit maker Alex Kammerlings raised £180k for 23 per cent equity through Crowdcube

 

New incentives

If you would prefer monetary incentives, then platforms such as Seedrs (seedrs.com) and Crowdcube (crowdcube.com) offer private investors access to new companies seeking investment. Both are UK-based and, unlike in the US, are allowed to accept capital in return for equity stakes.

Using platforms such as Seedrs you can invest lump sums starting from as little £10 into new companies which hope that their product, invention, idea or service will take off, propelling them into the premier business league. By allowing you to commit small amounts of capital each time, the platforms argue that it becomes easy to build a well diversified portfolio of start-up companies, boosting your chance of success. It's an appealing idea but don't underestimate the risks.

Seedrs is FSA authorised; Crowdcube is not. Seedrs says it worked hard to achieve this. It helped that it emphasises the risky nature of start-up investment to new members by spelling out the dangers and by asking them to take a test that has to be passed before they are allowed to join, although applicants can self-certify that they are sophisticated investors. The aim of the test is to make new members aware of the high-risk nature of seed capital investing by reminding them not to expect dividends and that the risk of losses is high.

 

 

Sowing the seeds

Seedrs was started by Jeff Lynn, a former US lawyer who specialised in corporate finance but had the idea for what would develop into Seedrs when completing an MBA at Oxford's Saïd Business School. "I knew that start-ups were tremendous creators of value but that the failure rate was high, which made it a fool's game. And yet as an asset class the data was showing that the returns are fantastic," says Mr Lynn. Studies by a US professor, Robert Wiltbank, showed that in the UK the overall IRR was 22 per cent a year from seed and early-stage investments, and that the multiple was 2.2 after 3.6 years. But the research also revealed a skewed set of returns: 81 per cent of profits came from 9 per cent of companies - so you need to invest in a high number of companies to achieve overall healthy returns.

Including start-ups as part of a portfolio made perfect sense to Mr Lynn, and he puzzled over how to make it available as broadly as possible. "I decided to create a platform like Zopa [the middleman-free peer-to-peer lender] but for equities. We'd screen companies and we'd screen investors to make sure they understood the risks," he says. The low minimum investment ensures that the crucial ingredient of diversification can be added to every portfolio.

Seedrs launched in July this year and now has around 3,500 members. It has fully funded six start-ups, including an avatar-based educational video games company built by frustrated teachers and another, Digital Spin, that creates better CAPTCHAs (those letter and number puzzles that you sometimes have to decipher when making a booking on a website). Currently it has 29 live fund raisings. The average investment is £500 but the median is £100. Members are 90 to 95 per cent male. Start-up companies can ask for up to £150,000 and Seedrs, which conducts legal due diligence, allows the crowd to decide which companies win funding.

If the capital asked for is raised within three months, Seedrs buys shares as the legal shareholder and the investors as beneficial holders. "We structured it this way so that the company would only have one point of contact for votes and consents, and so that we could co-ordinate in protecting investors' rights. We try to make sure that our stake isn't diluted at a later stage because that kind of thing can happen when no one's minding the store," says Mr Lynn. As the nominee, Seedrs makes small decisions but bounces big questions back to the investors. Seedrs charges the entrepreneurs 7.5 per cent of the funds raised, and it also takes a 7.5 per cent carried interest in each funding. This means it is entitled to 7.5 per cent of any profits made on an investment.

 

Prove you're a human the Digital Spin way. The company's puzzles can be themed to reflect what the website is about.

 

Follow the Crowdcube

Crowdcube was launched early in 2011. “We hoped to create a new type of angel investor,” says co-founder Luke Lang. It operates a different model. It doesn't perform an intermediary role after the funding has completed, for example, and it allows funding pitches from trading companies. In fact one company that applied to investors had been trading for 20 years. Around two-thirds of the pitches come from companies with an established trading history; the rest are pre-revenue start-ups. There is no limit on the amount being raised, either. Crowdcube insists that all pitches include a business plan, financial projections and a video presentation and, while it vets applicants, it doesn't determine whether they're a good or bad investment. "Around 75 per cent of companies applying are initially turned down," explains Mr Lang, "often because their business plan is weak or incoherent."

So far it's funded 30 companies and raised around £4.5m from its 5,000 or so active members (out of a membership of 25,000). Crowdcube takes 5 per cent of the money raised. The average investment size is £2,400, and the average age of its entrepreneurs is 40, with the youngest being 20. Once the funding target has been met, the Articles of Association are drawn up and sent to the investors who have seven days to review them, and withdraw if they wish. Otherwise the shareholders are registered and receive their certificates. Typically the equity issued takes the form of non-voting ‘B’ shares.

Both Seedrs and Crowdcube have facilities so investors can probe the companies further using public Q&A forums. At Crowdcube, meetings and phone calls can also be arranged and Seedrs is about to add a direct messaging facility to its website. Currently, it’s happy to contact the companies with individual questions.

 

 

Unknown territory

Joel Finningley, an entrepreneurial consultant who's studied crowdfunding, describes it as a new financial ecosystem. It fills a gap in early-stage financing and allows investors to support the economy. He doesn't agree with the point that a £100 investment might not be worth the bother, saying: "If you put £100 each into 20 companies, your returns could be exponential, while your risk is low."

Still, it's worth bearing in mind the risks that accompany start-ups. First, it can be many years before returns, and there may be no way to exit your holding in the meantime. You will be making a judgement on the company in the absence of an operating history, and any financial projections might be meaningless. You could lose all your capital and your stake could be diluted through further fund raisings. With crowdfunding, you're with the crowd, not an experienced venture capital manager with a record of picking winners. An entrepreneur might have a good idea but that’s not enough on its own. US venture capitalist Ben Horowitz, whose own tech start-up company Loudcloud caused him to say "I sleep like a baby. I wake up every two hours and cry", knows about the difficulty of making a start-up a success. Another of Mr Horowitz's comments - "There is no number two in tech" - is also worth repeating.

 

 

The UK leads the way

But crowdfunding is still in the experimentation phase and, for once, the US is a step behind the UK. "Everyone is waiting for the US to move," says Mr Finningley, who expects the door to equity-based crowdfunding in the US to be pushed open in 2013 now that the JOBS (Jump Start Our Business Start-Ups) law has been signed by President Obama. "This will open up the huge US market."

Seedrs' chief executive Jeff Lynn was called before the politicians drafting the JOBS law. "There are two things you never want to see being made in close up: sausages and laws," say Mr Lynn who fears that the rushed legislation has ignored some good advice. US investors might be restricted in the amount they are permitted to invest, and the legislation might also prohibit any involvement by an intermediary afterwards, which is the Seedrs model.

UK investors would likely relish the opportunity to invest in US start-up tech firms once those companies are allowed to start pitching for capital, but Mr Finningley thinks it's unlikely that the offers will be available outside the US. But if Silicon Valley start-ups are going to remain out of reach, at least investors here can access the digital start-ups increasingly clustered around the UK's Silicon Roundabout.