How Does Equity Crowdfunding Work? All You Need to Know

In this article, we uncover the ins and outs of equity crowdfunding and the key considerations and regulations to keep in mind.

Equity funding is used to help businesses raise funds by selling shares to an investor in exchange for a cash investment. This means that the business receives the money it needs to grow whilst the investor owns shares in the business.

The investor is then tied to the success of the company. The investor will hope to be able to sell the investment if it is successful which would include the sale of shares possibly to another individual, a share buy-back or a buyout from internal or external parties. As an equity owner the investor may also receive income in the form of dividends.

This is very different to debt financing as a loan where the business borrows money but does not cede any control of the business by selling shares which ultimately are able to vote in company affairs.

The main advantage of equity funding is that there is no obligation for the company to pay back the funds as is the case when taking a bank loan and there is no immediate financial burden on the company.

A reason for offering an equity stake might be because a business may not be in a position to access traditional debt funding due to not meeting the necessary requirements to successfully apply for a business loan. This can happen with startups. Investors in equity are far more likely to invest in a loss-making early-stage business if they believe that the idea is a good one and could prove successful in the long term. Whereas a bank will normally only lend to a profit-making business because they want their interest and repayments to be made regularly with little risk of default.

Businesses owners want the business to be a success and therefore entice the equity investors with promises or expectations of a good return on their investment either through dividends and/or capital growth potential. However, raising equity funding means losing control of part of the business and usually means giving investors a say in how the business is run. On the flipside, the right equity investor can bring more than money to the table and help drive the success of the business.

The type of equity finance that a business seeks may vary depending on the age and type of the business. Historically, those seeking equity funding would have reached out to angel investors, venture capitalists or perhaps at the earliest stages of a new business to friends and family.

One of the newer ways of obtaining equity funding is through crowdfunding. In the early days of crowdfunding this method of raising finance only attracted a very niche selection of companies and investors but now this is quite commonplace with multiple crowdfunding websites allowing individuals to invest as little as £10 per investment. Crowdfunding can be an interesting way of sourcing funding.

Crowdfunding refers to lots of people providing usually relatively small amounts of money rather than one or two major investors. Crowdfunding usually takes place online via a website acting as an intermediary that is also regulated with the FCA . As a business looking for investment, crowdfunding website will typically look to ‘sell’ your idea to potential investors and this can also result in valuable free publicity. The online crowdfunding platform also manages the online investment payments and may include other elements such as social networking and allowing contact with investors.

Crowdfunding can be raised from individual, business and institutional investors as well as the general public. There are many different crowdfunding options to choose from. This can include reward crowdfunding where investors do not receive any equity in the business for investing but may be offered a reward of some sort, such as a free gift or tickets to an event. There is also debt or land-based crowdfunding where investors help fund a project in a similar way to taking a loan through the bank and crowdfunding for charitable causes. However, it can be difficult to be included on a crowdfunding platform as not all applications are approved.

There are many online crowdfunding platforms such as Seedrs, Kickstarter, Crowdfunder, GoFundMe,  etc that specialise in this form of fundraising. These platforms have different fee structures for pricing their services and this also depends on how actively they are helping to raise funds.

The fees can include arrangement fees, platform fees, funding goal fees, legal fees and success fees. There are also other fees such as credit card processing fees to consider. For example, if you incur fees of 5% for an online platform and 2% for taking credit card payments you would pay £7,000 in fees for every £100,000 raised. Even so, equity crowdfunding can be a fast way to raise investment with little or no upfront fees and, in return, crowdfunding platforms usually provide a secure and easy to use service.

Crowdfunding is mostly unregulated in the UK. However, the Financial Conduct Authority (FCA) started to regulate some forms of crowdfunding in the UK in April 2014.

The FCA regulates:

• loan-based crowdfunding: also known as ‘peer-to-peer lending’, where consumers lend money in return for interest payments and a repayment of capital over time
• equity crowdfunding: where consumers invest directly or indirectly in businesses by buying investments such as shares or debentures

These are regulated activities under the Financial Services and Markets Act 2000.

The FCA also regulates payment services provided in connection with:

• donation-based crowdfunding: consumers give money to enterprises or organisations they want to support
• pre-payment or rewards-based crowdfunding: consumers give money in return for a reward, service or product (such as concert tickets, an innovative product, or a computer game)

The FCA points out the following areas to be aware of when investing in an equity crowdfunding campaign:

• Most investments are in shares or debt securities in start-up companies and will often result in a 100% loss of capital as most start-up businesses fail.
• You will not be repaid and/or dividends will not be paid if the company you invest in fails or there is a fraud.
• If you hold shares in a business or project, it is unlikely that income in the form of dividends will be paid. The value of your investment may be diluted if more shares are issued, and this is likely as many start-up businesses undergo multiple rounds of funding.
• You should be prepared to wait for a return on your investment, as even successful start-up businesses tend to take time to generate income.
• If firms do handle clients’ money without the FCA’s permission or authorisation, there will be no protection for investors. This is a particular risk if a platform fails and becomes insolvent.
• Most platforms do not have a way you can cash in your investment (a secondary market).

Under the FCA’s regulations firms are only allowed to promote crowdfunding offers to certain investors. This includes experienced and / or sophisticated investors as well as ordinary investors who confirm that they will not invest more than 10% of their net investable assets.

These investments can be risky and there is also a risk that the crowdfunding platform itself may go bust. However, equity crowdfunding allows investors to diversify risk and represents a way to invest small amounts in new businesses. If the investment proves successful, then the financial rewards can be significant for both the business and the investor.

If you have any questions about the issues raised in this article, we at Key Business Consultants can help. Get in touch with us today or call us directly on 02037 282 848.