An adviser on equity crowdfunding explains how it works and some of the pros and cons

The economic climate has made raising finance an ever harder challenge. As a result crowdfunding, among other forms of non-bank finance, is playing an increasingly important role. Recent statistics from the US indicate that $1.5 billion was raised over 1,000,000 campaigns in 2011, and these figures are expected to double in 2012.

Traditionally investors in businesses were venture capitals and angels – a small number of people investing a large amount of money in return for equity in a company. Conversely, crowdfunding involves a large number of people each investing a small amount of money by contributing to a specific cause, project or business. Rather than seeking finance from traditional investors, the general public are asked to contribute. The typical method of communication to raise awareness of a crowdfund campaign is through the internet.There are many different types of crowdfunding. The most successful have been:

  • Donation – where people make donations or pledges towards a project;
  • Reward – a non-monetary reward in return for investment; and
  • Equity – a share in a company is offered to a potential investor in return for money.

Equity crowdfunding

Equity based crowdfunding is the fastest growing category. It allows individual members of the public to invest in a company in return for a shareholding. The number of shares that an individual receives will, like any investment, depend on the valuation of the company and the amount the individual is willing to invest.

At the start of April 2012, President Obama (who incidentally used donation crowdfunding to finance his presidential campaign) signed the Jumpstart Our Business Startups Act (“JOBS Act”), which will make it possible to raise up to $1,000,000 per year through equity crowdfunding in the USA. The Act does not come into force until 2013.

In the UK, the legal framework surrounding crowdfunding is complex and highly regulated. The most significant regulatory issue is that it is deemed a financial promotion, which is heavily regulated by financial services legislation. Breaching the financial promotion rules has potentially significant consequences, including possible conviction of an offence punishable by up to seven years in jail. The financial promotion rules and regulations are designed to protect individuals who are deemed not to fully understand a promotion from financial harm by losing the funds invested.

The term “financial promotion” is commonly used to describe the communication of an invitation or inducement to engage in investment activity. Typically you can promote to high net worth individuals (income over £100,000 per annum) or “sophisticated investors” (individuals deemed to have sufficient investing experience). This is contrary to the whole idea of crowdfunding, which is that everyone is included.

For this reason, each individual business plan will be approved by a financial services approved person.

In addition to the investor receiving shares in the company, thought should be given to whether rewards should be offered. The rewards, ideally, will be a mix of tangible rewards (e.g. discount on the product) and intangible rewards (e.g. meet the founding director and shareholder). As the company will wish to attract the widest possible spectrum of people to invest, the rewards should reflect this and be varied. Statistics show that the most successful crowdfunds are those which offer between three and eight rewards.  

Advantages of crowdfunding

  • It can secure investment without giving away voting rights in your company.
  • It can be a means to spread the word and gain publicity around your business.
  • It can be done relatively quickly.
  • Professional fees can be relatively low in comparison to angel or venture capitalist funding.
  • It allows businesses that would not traditionally attract angel or venture capitalist funding to raise funding.
  • It is a way of measuring how responsive your future client base will be to your company.
  • It allows market testing of your product and feedback.
  • The public enjoy becoming an investor and being part of something.

Disadvantages of crowdfunding

  • If the crowdfund is unsuccessful (i.e. it does not reach target), there will still be some professional fees to pay.
  • If the crowdfund is unsuccessful there could be a stigma attached, as the company has failed to raise the funds it was looking for.
  • The company’s business plan is in the public domain, therefore intellectual property could be at risk.
  • It creates a huge number of shareholders and therefore increases the administrative burden on companies going forward.
  • The company only gains money from the investment and there is no wisdom attached to it to help guide the business.
  • There is a risk as to the view future investors will take.

As such, whilst equity crowdfunding will not be suitable for every company, it is another avenue for raising investment in what is undoubtedly a challenging market.

The Author
Paula Skinner is a partner with Harper Macleod LLP, and advises Entrepreneurial-Spark on equity crowdfunding
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