Crowdfunding – or bust? Should we be investing hard-earned money via equity crowdfunding?

There's been lots of coverage around the benefits for startups of the flourishing equity crowdfunding market. But what about investors? Idealog wonders is there anything in it for them?

So... You are a 25-year-old with a bit of spare cash. You invest $10,000 compounded on an annual basis over the course of 40 years at a 5% interest rate (yawn). At the end of 40 years, you have a nest of just over $70,000.

Alternatively, you could invest your $10,000 via equity crowdfunding in a few startup ventures. Thirty years later, you could find yourself with $6 million (as Microsoft’s original investors have). Or (much more likely) you could end up with nothing.

Equity crowdfunding (like any early stage investing) is an inherently risky business. UK research shows the majority of startups fail. Yet New Zealanders – almost half of whom haven’t invested in private companies before – are rushing to put their money behind companies with only a minimum of solid financial information – and no security at all.

Three to five years down the track, as the first of these equity crowdfuded companies fail (as some of them surely will), will we be left with a load of unsophisticated investors wishing they’d put their money in Kiwisaver?

Or a lot of people who’ve had fun helping companies they believe in, learnt a bit about investments in a non-critical environment, and who knows, maybe made a killing?

New Zealand’s equity crowdfunding market is booming. While angel investment is down 20%, according to NZ Venture Investment Fund figures, and the stock exchange’s year-old alternative NXT market has a measly two companies listed, equity crowdfunding – the startup investment darling – is on a roll.

Snowball Effect, which was the first crowdfunding platform off the ramp in August 2014 and has around 70% of the market, has had over 1500 investors put almost $10 million into 10 Kiwi companies. PledgeMe, which launched in September 2014, saw investors give $600,000 in the first seven months, and a further $350,000 in the last two months.

The newest platform, Equitise, has already raised $750,000.

There has been plenty of coverage of the benefits for the companies raising money. Since being made legal by changes to the Financial Markets Conduct Act in 2014, equity crowdfunding has become a relatively easy, cheap way to get investment, and the concept has brought a whole new group of wannabe venture capitalists into the market.

Companies don’t need a complicated prospectus, or detailed financial projections, or an investment bank certifying they have set a fair price for the shares on offer.

Instead, to raise up to $2 million, companies need little more than a beguiling idea, a great video, a pitch, a business plan and a few largely unverified financials.  

And there’s the rub.

A company listing its shares on the stock market for, say, 50 cents each, needs that offer price certified by an investment bank, says Hardjo Koerniadi – a senior lecturer in the Faculty of Business and Law at AUT University. The investment bank will look at expected future cash flows of the company and check the listing price is fair.

But no such checks are needed for a company which offers shares via equity crowdfunding, Koerniadi says, meaning there’s a risk the listing price could be easily inflated.

“It’s very risky. If you don’t have the financial reports, profit information, future growth targets, you are investing in the dark. You don’t know if the offer price is a fair price.”

In fact, investors might not know whether it’s a fair price until a company lists on the stock exchange, or gets bought out by a third party.

A NZ Herald comparison of Invivo Wines (which raised $2 million through Snowball Effect) and NZX-listed winemaker Delegats, shows Invivo valued at 26 times its forecast earnings before interest, tax, depreciation and amortisation (ebitda), for the year to March 2015, but Delegats trading at a price-to earnings ratio of only 13.6.

Inflating the value of an offering has the obvious advantage of giving existing shareholders more money on paper, and a bigger equity stake of a post-crowdfunded company.

But Snowball Effect co-founder Josh Daniell says there are also incentives for companies to set a fair valuation.

That includes the risk of a crowdfunding round failing if sophisticated investors (who might look closely at the numbers) believe the company is over-valued, and decide not in get involved. In addition there’s a chance subsequent rounds of funding might fail if investors feel they were duped on the first round, Daniell says over 50% of Snowball investors have invested in private companies before, “and the larger investors are typically experienced in this asset class”.

In addition, while companies set their own valuation, Snowball Effect engages with companies to help them set a reasonable valuation, Daniell says. This includes: encouraging companies to take independent financial advice; arranging for “lead investors” who take a significant stake and help set value; using an independent valuation panel; and suggesting deal structures that give some protection for investors – for example, offering shares based on a conservative, rather than an aggressive, forecast scenario, or suggesting a liquidity preference clause where investors get preference in the case of a company failing.

And fail many of them will. A UK report, "Siding with the Angels", found 56% of early stage businesses don’t give investors their money back, 44% make a little bit of money for investors, and only 9% generate returns in excess of 10 times the capital invested.

“The key thing is ensuring that investors have the right expectations,” Daniell says. “Early stage companies are typically a ‘high risk and high reward’ proposition. Investors should be clear about their reasons for investing, and should be investing money they can afford to lose.”

Koerniadi agrees.

“Is this suitable for mum and dad investors? Definitely not. This is suitable only for seasoned investors who know the product or the industry sector.”

The trouble is, if almost 50% of Kiwi equity crowdfunding investors are new to the sector, that indicates many are far from “seasoned investors”.

“They are too excited, they want to become investors, but they may not fully understand the risks involved,” Koerniadi says.

In fact, one major selling point of equity crowdfunding is that companies are encouraged to target their own networks – family, friends, customers, potential customers, like-minded individuals – encouraging them to invest in a story they believe in.

As advertising agencies know, people buy stories. But some putting in their money may not be clear that there’s a good chance that’s the last they will see of it.

True, the sums are often fairly small – anecdotal evidence suggests $500-$2000 investments are common. Still, Snowball Effect figures suggest 20% of its investors have put money in two or more offers, and almost 14% have invested over $10,000.

Unlike with other investment categories, New Zealand’s financial watchdog, the Financial Markets Authority, has very limited powers to protect investors using equity crowdfunding.

Instead its main role is to make sure companies are providing adequate warnings around the risks, says media relations manager Andrew Park.

“The important thing for us is around the warnings provided to investors in terms of what kind of investment they are going into. It’s fundamental that investors understand these are new companies, which haven’t built up a track record.

“Of course people will lose money – not every investment turns into a profitable enterprise. [Our role] is to make sure people are going into these investments with their eyes open; that they given the message “Do not invest money you can’t afford to lose.”

In the UK, which is about three years ahead of New Zealand in terms of the history of equity crowdfunding, several crowdfunded companies have already collapsed, taking their investors’ money with them.

These include Ovivo Mobile, which collapsed in March 2014, just six months after raising £414,000 ($890,000 in today’s dollars) through crowdsourcing website CrowdCube.

Then there was Bubble & Balm, a crowdfunded fair trade soap manufacturer, and one of the earliest UK equity crowdfunded companies. In 2011, the Bubble & Bain raised £75,000 from 82 investors in return for 15% equity, with investment amounts ranging from £10 to £7,500. By 2013 it had failed.

Whether these sorts of failures are widespread is yet to be tested. Early stage companies take time to grow, and few – even in the UK – have developed to the point of paying out returns.

That might not matter, says Aaron Titter, a Wellington-based partner with audit, tax and advisory company BDO.

With his corporate hat on, he recognises it  might be more “sensible” for many investors to avoid equity crowdfunding. But with his human hat on, he’s enjoying the excitement of the odd flutter.

Titter has put smallish sums ($500-$2000) into Renaissance Brewing, Yeastie Boys (another beer company), Invivo Wines and UK crowdfunding sensation BrewDog (“you may be seeing an investment pattern here”).

“I like the concept of craft beer and wine, and I like to see people giving it a go. And if they need money, instead of making a donation to make sure the company goes OK, I invest.

“In the back of your mind it would be nice if they went big. But realistically, I think a high proportion of people do it because they like the person, the idea or the industry, not because of the fundamental economics.

“There is a risk that people that can’t afford it will invest. There will some people that will be aggrieved if the companies fall over. But I believe most people who put $2000 into a craft brewer, even if fell over and they were left with nothing but the three dozen beer they had been sent over the years, will be saying ‘That was fun. I owned a brewery.’”

 All photos courtesy of Shutterstock