Introduction
Equity-based crowdinvesting allows individual investors to invest directly in businesses by buying investments such as shares or debentures. Businesses receiving funding are usually small and medium-sized enterprises (SMEs) and start-ups, though some platforms provide finance for properties or green infrastructure projects.
Equity-based crowdinvesting business models tend to be relatively simple. These platforms act as a conduit, giving investors a route to see and assess information about underlying investment opportunities. Investors choose what they want to invest in, and typically purchase an equity security.
In the UK, the most popular equity-based crowdfunding platforms include Crowdcube and Republic Europe (formerly Seedrs), though numerous other platforms are also available.
How Equity Crowdfunding Works
Equity-based crowdfunding involves pooling funds from a group of individuals who, in return for their investment, receive an equity stake or debenture. The terms of the investment are governed by investment contracts and relevant securities laws and regulations.
The Platform's Role
Equity-based crowdinvesting platforms are typically simpler than P2P lending platforms and generally adhere to a standard business model:
1. Discovery: The investment platform presents a variety of investment opportunities from which investors can choose 2. Due diligence: The platform may conduct due diligence on potential investment opportunities on behalf of the investor 3. Facilitation: The platform assumes the administrative role of facilitating the investment on behalf of the investor 4. Price discovery: It serves as a conduit, showcasing investment opportunities without involvement in setting the investment's price 5. Administration: Primary function is to facilitate the investment process and assume administrative responsibility
UK Market Size
In 2021, Crowdcube facilitated 234 announced funding rounds, amounting to £198m worth of investment into UK companies, while Seedrs facilitated 272 deals, worth £126m in total.
The Risks of Equity Crowdfunding
Equity-based crowdfunding involves investing in shares or debentures of start-up companies and comes with significant risks.
High Failure Rate
If a start-up fails, investors could face a total loss. Start-ups, especially in their early stages, have a high risk of failure—almost 60% of small businesses in the UK fail within the first three years.
Long Time to Returns
Even if a start-up succeeds, it takes time to grow and generate income. Investors might not see returns or dividends for several years, and the lack of "liquidity events" like a sale or IPO can make it challenging to cash in on shares.
Dilution Risk
The value of shares may decrease if more shares are issued. Start-ups often undergo multiple funding rounds, leading to this dilution effect that reduces your ownership percentage.
Selection Bias
As venture capitalist (VC) funds often back promising start-ups, there's a risk that crowdfunding platforms attract lower-quality businesses, increasing the chance of investing in ventures with limited growth potential or higher failure risk.
A selection effect is also perceivable in terms of industries: 71% of crowdfunded businesses are B2C companies, with segments like food & beverage being significantly over-represented compared to VC-backed companies.
Key Takeaway
Investors should approach equity-based crowdfunding with caution, understanding the unique challenges and uncertainties associated with start-ups. Thoroughly evaluating the risk-return dynamics and being aware of potential dilution and liquidity challenges is crucial.
Equity Crowdfunding vs Venture Capital
Equity crowdinvesting has become a key part of the UK's early-stage venture founding ecosystem with 21% of investments funded (partly) by the Crowd in 2021. However, it differs significantly from traditional venture capital.
Key Differences
| Factor | Crowdfunding | Venture Capital | |--------|--------------|-----------------| | Median deal size | ~£500k | ~£2.0m | | Typical stage | Seed/Early | Series A+ | | Company type | More B2C (71%) | More B2B | | Due diligence | Limited | Extensive | | Investment style | Deal-by-deal | Portfolio approach |
Historical Performance
Research from finance data provider AltFi Data and law firm Nabarro showed that crowdinvesting has underperformed in early years. Of 367 companies funded via top crowdfunding websites in the UK between 2011 and 2013: - Nearly 20% went out of business - Only 16% went on to raise additional capital at higher valuations - Only 0.2% (one company) exited
This is significantly worse than data observed for the Venture Capital industry over the same period.
More Recent Data
Data from Beauhurst shows significant differences in progression rates between crowdfunded and VC-backed companies: - IPO/Acquisition rate: 5% crowdfunded vs 17% VC-backed - Progression rate: 18% vs 22% - Insolvency rate: 20% vs 12%
This aligns with more extensive due diligence by venture capital firms and the greater likelihood of false information and fraud on crowdfunding platforms.
Platform Track Records
Individual platforms also report data on their investments, though comprehensive empirical data is limited.
Crowdcube
Of the firms who raised investment from 2011 to 2019: - 80% are still trading - 6% have delivered financial returns to shareholders through exits, bond repayments and dividends - Total returns: £60m
To put this in context, Crowdcube states that over £1bn were invested via the platform since inception in 2011.
Republic Europe (formerly Seedrs)
Seedrs doesn't frequently publish data about their track record. In 2020, they reported: - Over £1bn of total investments - 17 company exits in total - Over £4m in returns to investors
The Power Law
Despite lower progression rates on average, research shows that placing more bets significantly increases the chance of getting at least average returns. The "Power Law" in venture investing states that single outliers in a portfolio drive portfolio performance almost entirely—so placing many smaller bets on crowdinvesting platforms might still be a feasible strategy.
When Crowdfunding Makes Sense
Both crowdfunding and VC fund investment can be appropriate ways to get exposure to early-stage companies. Crowdinvesting provides: - A more accessible entry point for individual investors - The ability to pick companies aligned with personal interest, expertise and values - A more inclusive financial sector, offering funding to companies excluded from traditional capital
However, it comes with higher risk, less control, and historically lower success rates than VC-backed investments.