Is Equity Crowdfunding Right for Your Small Business?

11-April-2018 16:13
in Equity Financing for Small Businesses
by Admin

Small businesses today are faced with a bewildering and ever-expanding range of financing options.  Every one of these options has pros and cons that are not necessarily obvious at first glance.  To make it even more difficult for small business owners, there is often a stark difference between the expectations created by carefully calibrated marketing and the reality once they start down a particular financing path.  Consequently, it can be very difficult for small business owners to understand which of the numerous available options would be the best fit for their specific circumstances.  The purpose of this article is to shed light on one of the latest financing options to gain prominence in both the UK and United States: equity crowdfunding. 

Debt and Equity Financing   

Finding the right financing option for your business starts with understanding what’s available to you.  Small business financing can be divided into two different categories: debt and equity financing.  For many small businesses, debt financing is easier, quicker, and more practical.  Most business owners don’t own companies that fit the mould that’s right for equity financing, especially for the way that the equity financing industry has worked historically.  Equity financing is a way to secure capital by selling ownership in your company.  In exchange for money from investors, you give them a portion of ownership and control in your business.  Traditionally, these investors were angel investors, venture capitalists, or even a family member or friend.

The Emergence of Equity Crowdfunding

Over the course of the last few years, equity crowdfunding has changed the face of the equity financing industry.  Equity crowdfunding platforms such as Crowdcube and Seedrs in the UK and Crowdfunder, EquityNet and Wefunder in the US have leveraged the internet and tapped into the unprecedented level of public interest in investing in private companies created by TV shows such as Shark Tank and Dragons Den.  These platforms facilitate the sale of securities (e.g. shares, convertible notes, debt, and more) in private companies to the general public (the "crowd"), making equity financing available to a much broader range of companies and investors than was ever previously possible. 

What Was Wrong With the Existing Equity Financing Options?

Existing equity financing options such as Angel Investing, Venture Capital and even taking equity investment from friends and family all had their drawbacks.  Chief amongst them was that there was little or no mass market for this type of investment which meant that companies could only approach a small pool of potential investors and that only an elite group of industry professionals was ever granted access to best companies.   

Before equity crowdfunding burst onto the scene, it was generally impossible to invest in the next Facebook, Amazon, Netflix or Google unless you are a UHNW (ultra-high net worth) individual or a VC yourself.  The closest that the general public could get to investing in a high growth potential startup is when they file for an IPO, at which point they, strictly speaking, are no longer a start-up.  Back when the retail investor could still do really well in the public markets, this wasn't too bad.  The likes of Amazon, Apple, Google, and even Facebook all saw their stock price increase to levels that were many times higher from their IPO prices. 

When Amazon first went public in 1997, its stock was priced at just $18 per share.  By virtue of the three stock splits that took place between 1998 and 1999, a single Amazon share would have become twelve.  The share price closed today (11th April 2018) at $1,427 per share.  In other words, a single Amazon share purchased on the day of its IPO for $18 would have over the course of the last twenty years have become worth $17,124.  That means an IPO investor who had the incredible foresight to hold Amazon shares for the last twenty years would have realised almost 1,000x gain over the initial $18 investment and the price seems likely to continue its upward trajectory over time. 

Today, the above scenario is fantasy.  Amazon's market cap on the day of its IPO was $438M, which came three years after it was founded.  Apple and Netflix both went public within five years of their founding at modest valuations.  The new norm is that companies stay private for longer and most of the real investor gains happen before they IPO.  The big tech IPO of 2018 thus far was Spotify whose market cap on the day of its IPO was $9.2B.  Even in the most optimistic of scenarios, a 1000x gain would be impossible.  Indeed, given the IPO price, even a 10x gain would be remarkable for Spotify investors. 

Equity Financing had become a "closed shop" in which only the "insiders" graced with early access to the best investment opportunities are able to capture the majority of the financial gains.  Meanwhile, only a tiny percentage of businesses were able to access any form of equity financing.  

Enter Equity Crowdfunding...

The fundamental question posed by the founders of the major equity crowdfunding platforms was "In a world where the internet makes it easy to offer these investment opportunities to more people, why should only UHNWs and VCs be able to invest the next great companies whilst those companies are still private entities"?  Equity crowdfunding champions the retail investor, providing the average person the chance to own a part of a business that might just turn out to be the "next big thing".

Despite the fact that equity crowdfunding has existed in a meaningful way for less than a decade in the UK and only a few years in the US, there are already some examples of equity crowdfunding unicorns.  There are already two equity crowdfunding unicorns from the UK:

  1. Brewdog - Brewdog is a Scottish craft brewer whose business has expanded dramatically in recent years, in part due to their success at engaging with customers as potential shareholders via the Crowdcube platform and their own crowdfunding platform, Equity for Punks.  In April 2017, TSG Consumer Partners invested £217 million for 22% of the company, which implies a company valuation of greater than $1 billion. 
  2. Revolut - Revolut raised money via both major UK equity crowdfunding platforms (Crowdcube and Seedrs) in 2016 and 2017 respectively.  With a strong base of evangelistic small investors in place, Revolut set-off to revolutionise the world of personal and business banking.  Their most recent valuation ($1.7 billion) comes from a $250 million Series C round that completed just a few days ago (April 2018). 

There are a few other companies that may become Unicorns in the next year or two, including one of Revolut's main direct competitors, Monzo. (EDIT: In October 2018, Monzo closed an $85 million funding round at a valuation that makes the challenger bank the third UK crowdfunding unicorn). 

Meanwhile, the biggest success story so far for equity crowdfunding comes from the US.  Investors on the Wefunder platform participated in the Zenefits seed round in 2013 at a $9m valuation.  That business was valued at $4.5 billion at its peak (May 2015) although the company was hit by a significant scandal in 2016 which has seemingly tempered investor enthusiasm for the business since then.             

Of course, not every company that lists on an equity crowdfunding platform has the potential to become a "unicorn", "decacorn" or "hectocorn".  Indeed the obsession with finding the next big thing was one of the weaknesses of the traditional equity financing model.  Top Angel Investors and Venture Capital firms reject dozens of businesses that seem likely to deliver strong, albeit unremarkable, returns of 2x - 5x return on their investment in the search for the next "home run" investment that delivers returns of 50x or greater.  Equity Crowdfunding offers these companies access to equity investors who are willing to invest in a diversified portfolio of good companies rather have to try to attract the attention of a small group of professional investors whose business model causes them to fixate on finding the next Facebook.        

Although some business owners turning to Equity Crowdfunding have good companies that just did not meet the investment criteria for many professional equity investors, other companies are turning to equity crowdfunding out of necessity.  Their business model is fundamentally flawed or they have a weak leadership team or are operating in small, shrinking markets or hyper-competitive industries and would, therefore, stand little or no chance of persuading professional investors of the merits of their business.  These businesses are attracted to Equity Crowdfunding because the average investor there is not as sophisticated as the professionals and they are more likely to get funded despite some serious weaknesses in their business.   The key in equity crowdfunding, as in any type of investment, is to conduct your own thorough due diligence before making a substantial investment.  

So, in principle at least, equity crowdfunding is democratising equity financing by making equity investments of this kind available to more people and a viable option for more businesses.  However, just because a financing option is innovative and seems to be gaining popularity with both companies and investors does not mean it is worthy of the time and attention of all small business owners.  We will examine below the various pros and cons of equity crowdfunding from the perspective of a typical small business owner with a view to helping you make a determination whether this type of equity funding seems like something that might work for you.

But first, before delving into the details, please pause for a moment and carefully answer the following question.

Should I Even Be Looking for Outside Financing?

All forms of financing, be it debt or equity financing, ultimately depend on the ability of your business to sell products and/or services to customers at some point.  Debt investors are backing a company’s ability to sell things to customers so that they can be paid back with at the agreed rate of interest.  Equity investors are backing the company’s ability to build a system of selling things to customers so that their equity stake increases in value.  In short, both debt and equity financing are effectively borrowing against your future ability to sell things to customers.  So, why not just raise money by doing what you will ultimately need to do to repay your debt/equity investors; sell things to customers? 

To those of you wanting to better understand what it really means to have customers fund your business, I wholeheartedly recommend John Mullins' excellent book, The Customer-Funded Business, in which he shares several great insights about how you might make customer-funding work for you.  I would strongly recommend you give serious consideration to these ideas before seeking equity financing of any kind.  Ultimately, though, whether you choose to bootstrap is a matter of personal preference which will depend on a number of factors such as risk appetite, the breadth and depth of your connections and the fundamental strength or weakness of your business idea.

Advantages of Equity Crowdfunding

There are several advantages of equity crowdfunding relative to other business financing options which we will examine in more detail below:

  1. Access to a New Capital Source - The most obvious advantage of equity crowdfunding is that it provides businesses with access to a new source of capital.  Rather than fight with numerous other businesses for the attention of a small number of prominent angel investors or venture capital firms, business owners can reach out and take small amounts of money from a wide range of investors.  Without the various equity crowdfunding platforms, it would be difficult or impossible for companies to do this themselves so they are providing access to funds that would be otherwise could not have been invested in the small business ecosystem.    
  2. Access to Significant Capital for Businesses That Are Not Eligible for Debt Financing - For almost all small business owners, there is no possibility of non-recourse debt financing.  In other words, any money lent by the business will need to be personally guaranteed by the business owner, making debt finance essentially the same as using savings, personal assets or credit cards to fund the business.  If the business owner is not deemed to be personally creditworthy, the small business has little or no chance of receiving the debt finance it seeks.  Equity Crowdfunding opens up a new source of investment to businesses for whom debt financing is not an option. 
  3. No Need To Pay Investors in Full Until a Liquidity Event - It is often said that one of the advantages of equity financing is that it does not need to be repaid.  Please don't say this around potential shareholders!  Investors do expect to be repaid and to make a substantial profit but are almost always happy to defer any payments until the business is profitable.  Once the business is profitable, they will likely expect to be paid dividends in line with the size of their ownership stake in the business.  In most cases,  investors are only cashed out in full, including the capital gain in the value of their shareholding, during a liquidity event such as a business sale.        
  4. Equity Crowdfunding Process is More Transparent Than Traditional Equity Financing - Traditional equity financing options such as Angel Investors or Venture Capitalists have opaque processes with uncertain timelines, costs, and commitments.  Equity Crowdfunding is transparent in all three of these important aspects.  Each platform varies slightly in terms of their specific processes but they are usually laid out clearly in advance.  In terms of time, most Equity Crowdfunding campaigns take about two months to create and three months to run.  The costs vary from platform to platform but they are clearly laid out ahead of time with almost all of them coming on the backend of the campaign.  Finally, having a fixed timeline for an equity crowdfunding campaign and a good idea in advance of the resources that need to be deployed to successfully raise the financing sought allows the company to manage the fundraising process more efficiently.  A leadership team engaged in perpetual fundraising with no clear end date is unlikely to be sufficiently focused on running their business to drive the growth outlined in the business plan used to support the equity crowdfunding campaign.
  5. Business Owner Typically Secures an Equity Crowdfunding Investment on Better Terms than Other Types of Equity Financing - In an equity crowdfunding campaign, the business dictates the valuation and terms of their offer and it is up to the "crowd" to either accept or reject the terms of that offer.  If a campaign is not gaining sufficient traction at a particular valuation, the offer is sometimes improved but, generally speaking, the business has pricing power in equity crowdfunding in a way that would not be possible with the traditional equity financing options.  Angel investors and Venture Capital firms invariably dictate the terms of any investment and businesses are left to either accept or reject the term sheet offered to them.  Unsurprisingly, business owners tend to value their companies higher than investors that are able to dictate the terms of the deal would be willing to accept.  This higher valuation can then be used as a starting point for discussions with angel investors and venture capital firms in larger future funding rounds.      
  6. A Large Number of People Are Invested in Your Success - One of the most important and underlooked assets in any business is loyalty.  One of my favourite business books is The Loyalty Effect by Frederick Reichheld.  The basic premise of this book is that companies that have loyal customers, loyal employees, and loyal owners outperform companies that don't and that loyalty is a key driver in performance improvement.  Equity crowdfunding enables both customers and employees to own a small slice of the company and thus have a financial interest in a company’s long-term success. It thus provides a powerful incentive to stay loyal.  Successful equity crowdfunding campaigns bring together hundreds or even thousands of small investors, creating a substantial audience that wants to see a company succeed.  These investors can then, with a little encouragement and support, become staunch brand advocates, help beta test new products and services or new features and reliably market messages on behalf of the brand on social media.
  7. Equity Crowdfunding Campaigns Can Win New Customers - Whilst this is not necessarily the case for some more niche B2B businesses, one of the happy side effects of Equity Crowdfunding is that their campaign will capture the attention of potential investors and potential customers alike.  During an equity crowdfunding campaign, the company is basically selling its value proposition to the public.  This campaign is directed to potential investors, but will also reach potential new customers, employees, and partners.  In other words, a strong equity crowdfunding campaign can combine the benefits of a marketing campaign with those of a fundraising campaign.

So, given the significant merits of equity crowdfunding for small business owners, why wouldn't a small business owner want to take advantage of this financing option?  Some of the principal challenges and disadvantages of equity crowdfunding are detailed below: 

Disadvantages of Equity Crowdfunding 

  1. Most Campaigns are "All or Nothing" Propositions and Many Fail - Most equity crowdfunding campaigns are operated in a way such that the business owner sets a fundraising goal and keeps nothing unless the goal is achieved.  of course, there is no guarantee of hitting your investment target. Platform success rates range from somewhere around 20% up to 70+%, meaning that somewhere between 30 and 80% of raises will not hit their target and thus not reward with any funds the significant expenditure of time, effort and money that goes into an equity crowdfunding campaign.   
  2. The Campaign Itself Can Be All-ConsumingA high level of effort is required to answer questions and promote the campaign whilst it is open for investment.  Particularly in small businesses where there is often barely enough resources to adequately perform the day to day operations of the business, the three month period of the campaign becomes all-consuming and can cause other important work to be delayed. 
  3. Large Numbers of Shareholders Are Harder to Manage Than Just a Few - One of the chief merits of equity crowdfunding (i.e. you are tapping into a large investor base) brings with it one of its most serious disadvantages.  Once your campaign is successful and you have the money you raised, you’ve also suddenly got a much wider audience of people with whom you need to communicate regularly and appease.  Inevitably, there will be some investors who will be much more vocal than you’d like, some that want to be more actively involved than you like, and some who just take up lots of time with endless questions.  It is important going into this process to set reasonable expectations with potential shareholders before they invest.  Many equity crowdfunding platforms put investors into a nominee structure.  This works well for most businesses, but it will put off a portion of potential investors, especially the larger investors amongst the crowd who will want to make sure that their sizeable investment gives them a voice in the business.
  4. It Can Make the Company Less Attractive to Institutional Investors - Doing an equity crowdfunding round may decrease your chances of receiving subsequent venture capital funding.  The reasons for this are that the VC firm will not want the hassle of dealing with a large number of shareholders, especially given the possibility that the shareholder base includes unsophisticated individuals who will make it more difficult for everyone going forward.  Of course, if VC funding is not something that interests you as a small business owner, then this may not matter at all.
  5. Limited Expertise and Connections Compared with Professional Equity Investors - One of the chief merits of working with an angel investor or venture capital firm is the experience and mentorship they can provide.  Many investors you get from the crowd are unlikely to add value beyond their cheque books.
  6. You Will Need to "Prime the Pump" with Your Own Customers and Connections - At the end of the day, the vast majority of the money raised in any equity crowdfunding campaign comes from the messaging done to a company’s own user and social base.  Any traffic from the media or money from random investors must be considered icing on the cake and cannot be relied upon.  Business owners relying on random crowd investors for the majority of the money they are seeking to raise in a campaign are sure to fail.  Equity crowdfunding campaigns are strictly governed by the law of ‘social proof’.  Small investors only want to invest when other people have already invested.  That law gets stronger the more unfamiliar a person is with a company.  In order to be successful, a company must break this cycle by focusing on persuading their core followers to back the campaign first, in the hope that others investors that use the platform on which the campaign is hosted will follow suit in sufficient numbers for the campaign to achieve its fundraising goal.      

Equity Crowdfunding is a welcome new arrival to the equity financing industry and offers significant advantages over debt financing and some of the traditional equity financing options.  However, it is not a panacea or "cure-all" for small business owners and comes with significant disadvantages that need to be weighed up.  Equity crowdfunding is best for companies that meet certain criteria.  Equity crowdfunding platforms are not magic fountains of money that companies can automatically plug into. Like any fundraising effort, it requires a solid foundation and a lot of work. 

We have followed the Equity Crowdfunding industry since its inception in 2011 in the UK and have watched its expansion in the US with keen interest.  If you are considering equity crowdfunding but need help putting together your pitch for your platform of choice and the business plan that you will send to all interested parties as their interest in investing in your company deepens, then reach out to Continuous Business Planning today.  We can help you polish your pitch to perfection and increase the odds of your campaign reaching its fundraising goals.