Is equity crowdfunding too good to be true?

Think of crowdfunding and you might immediately think of throwing a few euro towards a new smartwatch or a plant pot that does double duty as an air purifier. Interactive wireless earbuds may be more up your street, or perhaps anti-snoring aids would fit the bill.

Crowdfunding has certainly found its niche. With sites such as Kickstarter and Indiegogo leading the charge, crowdfunding gives companies an alternative way to raise funds to bring their products and services to market. Get it right, and it could put your firm on track to bigger and better things; get it wrong and it could be a high-profile wipeout.

But not all potential backers want to add to their growing mountain of electronic devices or useless products. The alternative? Equity crowdfunding. Instead of buying a phone accessory that may or may not ship at some point in the future, you can buy a tiny stake in a company instead.

There are plenty of platforms open to start-ups seeking funding who, for whatever reason, aren’t going down the traditional funding route.

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Crowdcube is one of the most well known in the United Kingdom and Ireland. The company, which was established in 2011, gives investors the chance to put money behind some start-ups in return for equity or an annual return. More than £300 million (€344 million) has been invested through the platform, with more than 390,000 investors and 520 raises. In 2016 Crowdcube put itself up as a potential investment for backers, raising £8 million (€9 million).

Important funding source

For some companies, equity crowdfunding has been an important source of funding.

Banking alternative Revolut turned to crowdfunding through Crowdcube in 2016. The company, which is targeting 100,000 customers in Ireland, offers current accounts accessible through its app. It has since gone on to raise money through more traditional means, and is in the process of expanding its services.

“Until our latest Series C round, each successive funding round was paired with a crowdfunding offer enabling smaller investors to participate in a promising young firm,” Revolut said. “The crowdfunding investors who participated in this first round – and subsequent offers – have seen the value of their investment rise, highlighting the importance of these platforms in giving people the chance to invest in the next big thing.”

HouseMyDog is another business that has used Crowdcube to gain backers, as has Northern Ireland-based See Sense, which makes smart bike lights.

Crowdcube isn’t the only player though. There are plenty of platforms offering equity crowdfunding opportunities, from Irish-based Spark CrowdFunding to international firms such as peer-to-peer lender Lending Club and Seedrs. The latter has a secondary market where investors can sell their shares, attracting new investors to companies without having to do a full fundraising round.

But is equity crowdfunding too good to be true? Before potential investors part with their cash, it’s worth noting that it carries as much risk as regular investing – perhaps in some cases even more so, given that many of the companies are early stage. Start-ups have a high failure rate, something that seems to get lost in the crowdfunding gold rush.

"Start-ups are like experiments," said Mark Cummins, cofounder of retail technology firm Pointy. " You try something, it might work, it might not. Sophisticated investors understand that. The big successes pay for all the ones that don't work out, and there's no shame in that."

Crowdcube’s website carries a stark warning to that effect: “Investing in start-ups and early stage businesses involves risks, including illiquidity, lack of dividends, loss of investment and dilution, and it should be done only as part of a diversified portfolio.”

Translation: don’t put all your eggs in one basket. At worst, you may lose your money if things go a bit wrong, but you also run the risk of your stake getting diluted down to be worth less than you paid for it, and it may fail to make you any money in terms of dividends.

Risks

“Crowdcube is targeted exclusively at investors who are sufficiently sophisticated to understand these risks and make their own investment decisions. You will only be able to invest via Crowdcube once you are registered as sufficiently sophisticated.”

Translation: do your homework, because if it all goes wrong, it’s not our fault.

The downside of investing through crowdfunding platforms could be seen in the recent Sugru debacle.

The news that Sugru maker FormFormForm was selling up to German adhesives firm Tesa may have come as a surprise to those who followed the firm's crowdfunding campaign on Crowdcube in recent years. In 2015, FormFormForm raised £3.4 million (€3.9 million) through Crowdcube, and came back last year for another round, raising £1.6 million (€1.8 million).

By the time the company came to its 2017 raise, Sugru had impressive growth projections and a £3.5 million (€4 million) venture debt facility with Clydesdale Bank to back it. The company was forecasting 50 per cent growth year on year up to 2019, with plans for a new formula aimed at younger makers and an expectation that it would hit profitability this year.

But sales figures failed to hit their targets, although the company was still recording growth of 20 per cent. By December, the bank had pulled the second part of the debt facility, leaving Sugru exposed and looking for a solution.

That solution ultimately came with the sale to Tesa, which backers took a 90 per cent hit on their investment. For a large number of Crowdcube backers, the loss would have been small – about half of investors contributed less than £100 – with some in the £1,000-£2,000 bracket, and others investing significantly larger amounts.

Backers of the firm have had a mixed reaction to the news of the sale. While some accepted that it was the risk of backing a start-up on a crowdfunding platform, others demanded answers from the firm, particularly the backers of its 2017 round.

Sugru's case isn't unique. Pebble was another firm that found out that being a star on crowdfunding sites didn't necessarily translate into a sustainable business. The company initially went to Kickstarter in April 2012, when it raised $10.3 million (€8.9 million) in the space of a month and earned itself the title of most-funded project in the site's history. Six years on, Pebble still holds the record for most-funded project, with both its Pebble Time and Pebble Time 2 eclipsing the original watch's total. The Pebble Time is currently the record holder at more than $20 million (€17.3 million); the ill-fated Pebble Time 2 raised more than $12 million (€10.4 million).

Debts

But that wasn’t enough to keep the company going. In December 2016, Pebble said it was shutting down, refunding its Time 2 backers and selling some of its intellectual property to rival Fitbit. From a time when the offers for the company were rumoured to be about $740 million (€641 million), the company was eventually sold for an estimated $40 million (€34.6 million) – just enough to pay the firm’s debts.

For some firms, the temptation of crowdfunding was one they resisted. Pointy considered going down the equity crowdfunding route before it began fundraising. It last year announced a $600,000 (€520,000) funding round with investors such as Microsoft co-founder Paul Allen, the founders of Google Maps, Draper Associates, Frontline Ventures, Matt Mullenweg founder of Wordpress, Bebo founder Michael Birch, Web Summit chief executive Paddy Cosgrave and recently retired Ireland rugby captain Jamie Heaslip.

“We did think about it but we decided in the end not to go with it,” said Cummins. “It can complicate things for future investments. But I think it’s very good for certain kinds of businesses.”

He still sees a role for traditional investors in the market still, particularly at the larger end of the market. Some of these investors have looked at the crowdfunding model themselves through Crowdcube and other platforms. Last year, Crowdcube said the number of deals involving institutional investors had increased four fold in the previous two years.

That may not be a bad move. One thing that crowdfunding may not give start-ups that traditional investment routes can is expertise.

Enterprise Ireland's Gearoid Mooney pointed out that while crowdfunding will get money on board, it won't bring the expertise and mentorship that a traditional fundraising round is expected to garner, bringing in board members who could help develop the business. He said the body likes to see some professional investors on board, but wouldn't necessarily dismiss a company out of hand if it had some equity crowdfunding on board.

However, Enterprise Ireland has a spread of investments, meaning that any risk of losing money in one area can be offset by another success elsewhere.

“Any investor has to be prepared to lose everything. It’s a difficult place to be,” he said. Again, it comes back to the risky environment for start-up investors. Some businesses will thrive and do well. “But there will be losers as well,” he said.