What sort of final outcome can Equity Crowdfunding companies realistically deliver for their investors?
Equity Crowdfunding is defined by investors buying shares in a private company, usually a start-up or early growth outfit. The company receives a group of backers and cash, and shareholders receive a share certificate, and often rewards, related to the company’s activity. It is related to pure rewards-based crowdfunding (as seen on Kickstarter) and peer-to-peer lending, but the issue of illiquid shares for cash sets it distinctly apart.
Rewards aside, what would be considered a real return for this kind of investment? It can be high risk and has only been in existence in its current form (i.e. through online platforms offering numerous deals simultaneously) for 5 years. The risks are alleviated partly by the use of the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) tax reliefs and the ability to write off any losses against tax. However, as we shall see, the companies involved do not always consider the best interests of their shareholders if they are exiting via a pre-packed deal.
The full spectrum of outcomes has already been illustrated in its 5-year life. Many enterprises have closed, with the loss of all investment. This is to be expected with start-ups. However, on the upside, we have seen a low level of activity. There have been none of the promised ‘next Facebooks’ that some promoted. Companies that had well known business gurus backing them have failed. Companies that have had Government backing, VC backing and business angel backing have also failed. Some companies have failed and it appears that they have not always acted in the best interest of their shareholders. Some companies are under investigation. However, you are bound to have a few bad apples, and they of course do not make the whole thing illegitimate.
The main problem appears to be in the handling of expectations.
When a platform’s PR machine churns out press about the “next big thing” and mentions in its pitches that so-and-so from such-and-such is involved in this business, when in fact his involvement is minimal and irrelevant, then we are beginning to see a problem. When platforms use projections to show a company with a real value of £10k at a valuation pre-money of 300k, and sales going from £50k to £400k to £2m in 24 months, then expectations will be allowed to run riot. Investors start seeing pound signs and, despite all the evidence in the past 5 years, they keep piling in.
You could say that the sort of people who invest in Equity Crowdfunding are, by nature, risk takers. Given misleading information and false hope, many can be encouraged to invest in some real dogs, which inevitably go bust shortly afterwards or become zombies.
I have seen many of these since 2011 - and, at the rate that certain platforms continue to churn out the deals, we may see that number increasing.
So, to get back to the subject, what might sensible, experienced investors expect as reality?
The first point to emphasise is that very few, if any, companies start from point zero and sell for many millions just three years later. It is certainly not going to happen on a weekly or even annual basis, as some would have us believe.
To date, there have been a few successful exits but not one of them has chartered the course they set out in their equity crowdfunding pitch. Opportunities have appeared, as they always do, and these companies have grasped them. But we are talking about 6 or 7 ‘exits’. I believe the best one of these has been a 3.5 times return. So again, not exactly what some platforms’ PR had predicted.
One example, of the sort of exit we may see more often in the future, is occurring as I write. This company raised money on one of the UK platforms and then had an offer from a much larger, related party. This offer involved the investing company buying out a percentage of shares from existing shareholders. You may remember Brewdog did a similar thing at the turn of the year. In Brewdog’s case, the offer was perhaps more PR than substance, as the maximum amount you could sell was £550. In this new example, the company has been more generous and has also made this offer optional. In my opinion, there are far too many cases of shareholders being forced to sell at no great gain, when the company utilises its drag along clause.
So, this company funded via an equity crowdfunding platform just 14 months ago and is now offering its shareholders the chance to take a 3-4 time return on this investment. That is a great return over such a short period, minimising risk and giving the investment liquidity. By which I mean they can opt to sell some or all of their holding well before the company takes the often-long journey to profit and full exit. It is, in effect, a real partnership between the company and its shareholders. Being invested over a shorter timeframe also helps to de-risk the whole operation. If it could be planned in this way, it would be more akin to peer-to-peer lending but with far greater returns.
Of course, one issue with the quicker turnaround is that the reliefs gained by investors via the EIS and SEIS will no longer be available. Any sale of shares under both schemes within 3 years means that all related reliefs will be lost.
The problem of liquidity in this asset class is profound. Investors are locked in until such time as the company is sold or closed, but the above example shows that there are other ways to create value. A partial return, backed by the re-financing of the business. Of course, the one thing we have not mentioned here is that this example only works if you have a company that is worth investing in. Unfortunately, too many of the retail-facing equity crowdfunding platforms seem to have ignored this. I get to hear about numerous examples of companies that were very communicative when they were trying to persuade investors to part with their cash. Once the deal is done, shareholders are often left with little or no communication at all, unless they take the time to look the company up at Companies House. That is something the sector needs to address and, indeed, platforms that use a nominee system have already done so.
Secondary share markets have been attempted by some of the platforms. But activity is very low and it appears to be more of a PR exercise than anything substantial. The quality on offer says a great deal about the quality of businesses that have used equity crowdfunding to date – on the larger platforms. You cannot sell things people do not want.
So, a realistic view of returns for investors in the current equity crowdfunding industry is one where you are not going to come up with the next Facebook. There it is. The professional fund managers who make up the membership of the BVCA typically average a long term IRR of around 15% p.a. – which means about 2½ times money over 5 years. Perhaps that should be your benchmark. But that will include taking account of the inevitable failures, so your successes need to surpass that to compensate. Can an equity crowdfund investor make those picks? With some proper due diligence and, by choosing one of the better, small volume, professional platforms, you might get to realise some gains early on via a share buyback, whilst larger gains are going to take time. When I say time, I mean 5 years plus. Pick well and be prepared to sit it out.
7 September 2017
Who is Dexster?
Sometimes controversial, always trenchant, Dexster is Growthdeck's resident blogger. Dexster will bring you his/her views on the crowdfunding scene covering a wide range of topics, including the growth of the equity crowdfunding industry, the risks faced by platforms, how businesses are faring, what investors need to look for when choosing a provider and much more.