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