Equity crowdfunding explained
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If you’re starting a new business, need money to put into growth or development or you’re trying to raise capital for a new product launch, getting the funds together can be challenging.
Historically, founders and entrepreneurs have pitched to investors to persuade them to part with their cash on the promise of big returns. However, there is now a new option open to businesses. Thanks to the digital age and online platforms, masses of people can now invest in your business. This is called equity crowdfunding.
What is equity crowdfunding?
Equity crowdfunding is a way of raising capital from a ‘crowd’ of people. Also known as crowd-investing or investment crowdfunding, it is mostly used by startups and businesses not yet listed on the stock market that need to generate money. The ‘crowd’ are investors using an online investment platform. They could be anybody donating any amount of money in return for securities in the company. Each investor is then entitled to a stake in the company that is proportional to their investment.
How does equity crowdfunding work?
The process of equity crowdfunding takes place on online platforms and offers a more open way of financing, since anyone can tap into it.
Unlike traditional “dragons’ den” methods of pitching to a small group of professional investors, equity crowdfunding allows businesses and start ups to raise capital from small contributions made by a larger number of investors via a digital platform.
This is what equity crowdfunding looks like and how it works:
How is equity crowdfunding regulated?
In the UK, equity crowdfunding is regulated by the Financial Conduct Authority who enforce prospectus rules on crowdfunding figures that go beyond £5 million.
There are also regulations in place to protect all parties on each platform, as the platforms assess each business using documentation they must provide to ensure that each business complies.
However, every equity crowdfunding platform is different. You should always do your research before you sign up or invest any money.
Are there any tax incentives for equity crowdfunding?
Certain equity crowdfunding projects benefit from tax relief, which is, of course, appealing to investors. Put in place by the UK government to offset some of the risk of getting involved with companies in their infancy, these types of equity crowdfunds can offer some of the most generous figures in the world. The amounts are as follows, as of 2023:
- Up to £250,000 under the Seed Enterprise Investment Scheme (SEIS)
- Up to £5m a year and a maximum of £12 million in your company’s lifetime under the Enterprise Investment Scheme (EIS)
What are the different types of equity crowdfunding?
Within each funding mission there are terms to decide, and this is how to distinguish between the two types of equity crowdfunding.
Entrepreneur-led equity crowdfunding
Entrepreneur-led platforms offer deals to online investors who are going it alone. The entrepreneurs looking for investment set the terms of each deal themselves. This might include what the share price will be and how much the company is worth. The crowd can then choose which deals they want to back.
Investor-led equity crowdfunding
Investor-led platforms only list deals that have first been screened by experienced investors who are investing their own money, otherwise known as ‘angel investors’. The investor negotiates the terms with the business before the crowd has the opportunity to invest alongside the angels.
What are the risks of equity crowdfunding?
Just like any other form of investing, equity crowdfunding comes with risks, including the following:
1. It’s a long-term investment
Equity crowdfunding is often a long-term investment, unless your business happens to enjoy overnight success, which is extremely rare. Be prepared for your shares to take a long time to increase in value and be sure that you can afford to commit and lock your money away.
2. Equity dilution
If you make an investment in a company that aims to raise further capital at a later stage, more shares will be issued to new investors, meaning your stake in the company could be reduced or ‘diluted’. You can avoid this by making sure protections are in place against this before you invest.
3. There’s a significant risk of failure
As it’s a more informal way of investing, the startups on equity crowdfunding platforms don’t typically have access to the same professionals and insights as businesses that are funded through venture capital. This significantly increases the risk of failure, as the success of a business cannot be assured by funding alone, and you need to trust that the founder/s have good heads for business. Without an adequate business plan and support structure, even promising ventures can fail, meaning you might lose your money.
4. Fraud
The threat of being scammed is ever present in the digital age, which is why it is essential that you complete your due diligence before committing to anything online. Equity crowdfunding platforms do try to eliminate fraudulent behaviour, but it is always best to act with care.
5. Online security
In the same vein as fraud, online security is paramount. Cyber criminals are only becoming more sophisticated as the digital age advances, so you need to be sure that the platform you use has airtight security. It might be safer for your investments if you opt to use well-established, reputable equity crowdfunding platforms such as Kickstarter, Crowdfunder or GoFundMe.
6. Startups of poorer quality
You might find yourself skeptical about the quality of startups on equity crowdfunding platforms. If they failed to attract funding from conventional sources, such as angel investors and venture capitalists, you might think they won’t make a success from their business. This isn’t always the case, as giants like Innocent Smoothies and Oculus (behind the Oculus Rift headset) both started out with equity crowdfunding.
7. Illiquidity
You should be aware that securities purchased on an equity crowdfunding platform are highly illiquid, meaning your exit options are seriously limited or might not even exist. There’s no second market for this type of investment, meaning you’ll need to sit tight until the company floats on the stock exchange or pays out.
What are the benefits of equity crowdfunding?
As well as risk, equity crowdfunding does bring about benefits to both businesses and investors, such as the following:
1. High potential
Alongside the risk for failure is the chance for great success. Some of today’s biggest brands, such as BrewDog, grew through equity crowdfunding, lining the pockets of online investors.
2. Enables access to financing
Businesses who have struggled to be heard by select groups of private investors now have their own, online stage to sing from. Not only does this improve their access to capital, but it also creates more opportunities for amateur investors.
3. The business can take back control
In entrepreneur-led equity crowdfunding, the business has the ability to set the terms and have absolute authority over their business, as opposed to the investor wearing the trousers. Businesses could also use this form of funding alongside other means of raising capital, potentially making the process easier.
4. A more inclusive environment
Rather than the historical methods of select shareholder groups that you see with venture capital businesses, equity crowdfunding spreads the power across many.
5. Engaged investors on a level playing field
If ordinary people are choosing to invest and back your business, it makes for a more engaged audience. This new form of inclusive investment opportunity also allows novices to get involved in areas previously reserved for experts.
6. Regulated platforms
Equity crowdfunding platforms provide a regulated environment with access to help and advice for both investors and the business. This makes them an ideal space in which investors and businesses can connect.
7. A personalised option
Equity crowdfunding makes it easier for investors to put their money into something they truly believe in. For example, an investor looking to combat climate change can choose to invest in a business finding new ways to break down plastics or reduce carbon emissions.
Is equity crowdfunding right for me?
This depends on your own circumstances and your appetite for risk. Underneath it all, equity crowdfunding is an investment that requires you to lock your money away in the good faith that it will pay off. There’s no guarantee that it definitely will, but there is also a chance it could earn great returns.
It’s essential to determine your appetite for risk beforehand, or consider other forms of investing if you feel equity crowdfunding isn’t the right one for you.
Alternatively, you could opt to put your money into a savings account that offers a competitive rate of return. Fixed rate bonds, for example, carry much less risk than investing your cash, and FSCS protection means that £85,000 of your money is protected in the event your financial institution fails.