The Venture Crowd - Crowd Funding equity investment into business by Nesta

Aug 19, 2012 | Publisher: manojranaweera | Category: Finance |  

The venTure crowd Crowdfunding equity investment into business The venTure Crowd Crowdfunding eQuiTY inveSTMenT inTo BuSineSS Liam collins and Yannis Pierrakis July 2012 2 The venTure crowd Crowdfunding equity investment into business About Nesta nesta is the uK's innovation foundation. we help people and organisations bring great ideas to life. we do this by providing investments and grants and mobilising research, networks and skills. we are an independent charity and our work is enabled by an endowment from the national Lottery. nesta operating Company is a registered charity in england and wales with a company number 7706036 and charity number 1144091. registered as a charity in Scotland number SC042833. registered office: 1 Plough Place, London, eC4A 1de wwww.nesta.org.uk Nesta 2012. The venTure crowd Crowdfunding equity investment into business 3 EXECUTIVE SUMMARY Crowdfunding is big business. The idea of financing projects or businesses with small contributions from large numbers of people is catching on in a big way and now accounts for significant amounts of money. In 2011 alone, 1.5 billion was raised through crowdfunding for projects and businesses in need of funds. Not only does the model provide finance but also access to a large number of people who can test and market an idea. Crowdfunding takes a number of different forms, the most successful of which has been the rewardbased model where participants receive nonfinancial rewards in exchange for donating to a project. The model effectively harnesses not only the contributors' desire for the reward but also the intrinsic or social motivations to back a project. Other forms of the model are, however, also growing rapidly. The most recent of these is equity crowdfunding, where individuals receive small stakes in a privately owned young business in return for investment. while equity crowdfunding shares many of the features of the reward model, one significant difference is the combination of both financial and nonfinancial motives for investing. The model also differs from other forms of equity financing. Crowdfunded businesses do not have to adhere to the strict accounting standards required of public companies and unlike other risk capital providers, crowdfunding investors may have no experience in making such investments. Form of contribution Form of return Motivation of funder Donation donation intangible benefits intrinsic and social Crowdfunding motivation. Reward donation/ rewards but also Combination of intrinsic Crowdfunding Prepurchase intangible benefits. and social motivation and desire for reward. Crowdfunded Loan repayment of loan Combination of intrinsic, Lending with interest. Some social and financial socially motivated motivation. lending is interest free. Equity investment return on investment Combination of intrinsic, Crowdfunding in time if the business social and financial does well. rewards motivation. also offered sometimes. intangible benefits another factor for many investors. 4 The venTure crowd Crowdfunding equity investment into business The process investment via equity crowdfunding is facilitated by online platforms, which allow entrepreneurs to connect with potential investors and seek funding from the crowd. Although there is some variation in how platforms operate, the process usually follows the following steps: Application to platform: Platforms vet submitted applications and decide which businesses to allow on the site. Raising the funds: Businesses create a pitch with information relevant to the fundraising and have a certain amount of time to raise the capital. They market the campaign through their networks and beyond, and interact with potential investors to address any questions. Fundraising closes: if the target has been reached by the end of the period they receive the funds following some further vetting by the platform. if they fail to reach the target money is returned to investors. Postinvestment: investors continue to have the option to interact with the entrepreneur. in some cases they also receive voting rights. Crowdfunding investment into business equity crowdfunding has the potential to be a complementary source of risk capital to the traditional providers in the market, offering finance to many businesses currently struggling to source investment. one such cohort of businesses is those seeking investment in socalled equity gaps where it is difficult to get finance from traditional risk capital providers. Another is businesses that do not fit the highrisk, highreturn profile served by the traditional risk finance providers mentioned above, but still face financial constraints. These businesses may not have the potential to deliver the exceptional returns of venture capitalists targets, but they may also be less risky and still provide significant value to the economy. Some challenges faced by the model Multiple motives. Managing coinvestment between various investors with different motivations for investing is one task that businesses and platforms will need to master. As more evidence becomes available about the mix of factors that drive crowdfunding investment behaviour, it will become clearer how this can be achieved. Refining the process. during fundraising, it is important that investors make use of all of the information available when assessing business pitches, and are active in interacting with entrepreneurs to find answers to any questions they may have. Being able to use tools to assess the reputation and expertise of entrepreneurs and fellow investors, would be an aid to the evaluation process. Platforms also need to find the best ways of stimulating collaborative evaluation by the crowd to give them every chance of selecting the best ventures. The process will need to continue to iterate in order to find the best ways to vet businesses for fraud, assign fair valuations to businesses and ensure that managing many shareholders does not become a burden. Getting the right participants. other challenges include attracting highcalibre businesses and investors to platforms. More experienced investors would be helpful in providing evaluation support for smaller investors and platforms may want to consider how to entice them. Attracting The venTure crowd Crowdfunding equity investment into business 5 the right businesses is another important task. not all businesses will be suited to crowdfunding and as the model develops, evidence needs to be generated to indicate what businesses it works best for. This will include the identification of those ventures that are most successful at harnessing the nonfinancial contributions from the crowd. Regulation. one of the main barriers to the growth of the model thus far is regulation, which has hindered the expansion in the number of equity crowdfunding facilitators. As interest in the model grows, there is a greater need for clear legislation in the area and an efficient process for authorising platforms. This report provides the first account of how the crowdfunding model operates in practice as well as some of the variation in the operating models of the platforms. drawing on several interviews conducted with key stakeholders, the report looks in detail at the opportunities for equity crowdfunding, the challenges it faces and provides recommendations as to how some of these can be addressed. 6 The venTure crowd Crowdfunding equity investment into business ACKNOWLEDGEMENTS The authors are grateful to the following people for their contributions to the report. Martijn Arets (Brand expedition) Jon Bradford (Springboard) Albert BravoBiosca (nesta) Stuart Chapman (dfJ esprit and BvCA) Kristof De Buysere (university of Tilburg) Guillaume Desclee (MyMicroinvest) Simon Dixon (Banktothefuture) Ragini Ghosh (CrowdMission) John Gibson (no 10 downing Street) Maurits Groen (wakawaka) David Gudgin (Albion ventures) Robert Hayes (investor) Sebastian Lewis (getSiteTracked) Jeff Lynn (Seedrs) Louise Marston (nesta) Matthew Mead (nesta) William Reeve (dfJ esprit) Ami Shpiro (investor and founder of innovation warehouse) Norbert Toepker (innovestment) James Watt (Brewdog) Darren Westlake (Crowdcube) Stian Westlake (nesta) Korstiaan Zandvliet (Symbid) The venTure crowd Crowdfunding equity investment into business 7 CONTENTS 1. The rise of crowdfunding 8 2. What is equity crowdfunding? 10 2.1. The stages of equity crowdfunding 12 Box 1: Case study of 'getSiteTracked' on Crowdcube 13 Box 2: Matrix of currently operating equity crowdfunding platforms in europe 16 3. The market opportunity for equity crowdfunding 17 3.1 . The equity gap 17 3.2. The riskreward opportunity 18 3.1. what types of ventures may seek equity crowdfunding? 19 Box 3: Case study of wakawaka light Crowdfunding socially focused ventures 20 4. The crowdfunding model faces several challenges 21 4.1. The regulatory environment 21 Box 4: The current regulatory environment 21 Box 5: Case study of Brewdog's 'equity for punks' 22 4.2. Challenges with operating the model 23 4.2.1. Setting valuations 23 4.2.2. fraud detection, selecting businesses and the wisdom of crowds 24 4.2.3. investor types and visibility 25 4.2.4. The potential for coinvestment with professional investors 26 4.2.5. Postinvestment support and business governance 27 4.2.6. Consequences of openness 28 4.3. Potential returns from equity crowdfunding 29 5. The future for the model 31 6. Endnotes 33 8 The venTure crowd Crowdfunding equity investment into business 1. THE RISE OF CROWDFUNDING on 8 february 2012 doublefine studios launched a campaign on Kickstarter, a crowdfunding site, to raise $400,000 to finance a new game they hoped to develop in exchange for rewards to donors such as copies of the completed games and lunch with the creators. while doublefine were permitted 32 days to raise their target, they surpassed the $400,000 in just eight hours. By the end of the 32 days they had raised over $3.3 million from people contributing on average less than $40 each. This fundraise was the highlight in what has been a period of extraordinary growth for crowdfunding. The concept of crowdfunding finds its root in the broader concept of crowdsourcing, which uses the 'crowd' to obtain ideas, feedback and solutions in order to develop activities. in the case of crowdfunding, the objective is also to collect money from the crowd who can often participate in strategic decisions or even have voting rights in a business.1 As well as permitting entrepreneurs access to a new pool of capital, the model allows them to connect with potential customers or users and test ideas before proceeding with the project. it also gives investors the opportunity to feel part of the project from its very early stages. Figure 1: Annual growth in the number of crowdfunding platforms worldwide Growth 2007 2008 2009 2010 2012 (Est.) 2011 54% 60% 47% 45% 38% Source: www.crowdsourcing.org The venTure crowd Crowdfunding equity investment into business 9 Crowdfunding has been growing rapidly in the past few years as advancements in technology and the growth of social media has made it far easier for entrepreneurs to reach large amounts of people at far less cost. The fundraising itself is usually facilitated by online platforms operated by third parties who manage transactions and vet projects before presenting them to the public. Crowdsourcing.org, an industry website focused on crowdsourcing and crowdfunding, estimates that there were 453 platforms active at the end of 2011 and in that year they raised 1.5 billion in project and business financing.2 And demand does not look to be slowing. Kickstarter, the marketleading platform, is on track to facilitate the raising of $150 million of project finance for its participants in 2012, more than the national endowment for the Arts budget in the uS.3 To date, projects with a creative or social focus, where nonfinancial rewards(e.g. Cd, ticket to a play) are offered in return for donations, have been the most successful at raising finance from the crowd. however, while crowdfunding has been primarily through the reward model, other forms, offering the option for financial return, are also growing fast. Crowdfunded lending to businesses has grown in recent years as an evolution of the more established model of peertopeer lending. Platforms give credit scores to businesses seeking loans and lenders can buy loan parts at an interest rate which is often adapted to the market demand. fundingCircle, a Londonbased provider of crowdfunded loans, has facilitated over 35 million worth of loans to date. The form of financing that platforms have found it most challenging to facilitate is investment from the crowd for equity stakes in businesses. unlike the Kickstarter model where donors receive rewards for their contributions, equity crowdfunding allows anyone to take a stake in a young business in the hope of making a financial return if the business does well. however, like the reward model, in many cases investment will also be motivated by nonfinancial aims as the model taps into the subsection of the public with an interest in entrepreneurship. The intrinsic motivation to become a part of an entrepreneurial venture or to support a particular individual or business, will play a significant part in many investors' decisions to invest. The extent to which this occurs will determine the level of returns the model is expected to deliver. while web 2.0 has provided a transformative effect in bringing large numbers of people together, regulation has made it difficult for businesses to tap into these online communities for investment and currently only a few platforms facilitate this process. Legislative changes recently passed in the uS have paved the way for growth in the model there, and the interest in the model on this side of the Atlantic will likely increase as a result. however, there are factors other than regulation that have also limited the growth of this model. These include investor worries about how much protection they have against fraud, business concerns about making sensitive information public on platforms and how to manage large numbers of shareholders. The growing popularity of crowdfunding has increased interest in exploring how the model works but research on equity crowdfunding has, to date, been very limited. Although, as Box 2 on page 16 illustrates, the model is yet to have a significant impact on the market in terms of the amount of investment it has facilitated, it has the potential to deliver a lot more. This report aims to highlight the merits and also the limitations of this new form of financing and its potential to become a significant source of finance for innovative businesses. interviews with key stakeholders including platform operators, entrepreneurs, and investors have been conducted, in order to identify the challenges faced by the model and what solutions it can adopt to overcome them. 10 The venTure crowd Crowdfunding equity investment into business 2. WHAT IS EQUITY CROWDFUNDING? for the purpose of this report, equity crowdfunding is defined as the offering of securities by a privately held business to the general public, usually through the medium of an online platform. The model permits anyone to acquire a share in privately held businesses, i.e. those that have yet to float on a stock exchange, by allowing a business to offer a certain proportion of its equity for a set amount of capital it is aiming to raise. investors can then, through the platform, buy small parts of this equity stake. while some may define investment into public companies on stock markets as a form of crowdfunding, the definition used in this report differs from this form of investment in several ways. first, acquiring shares through a stock market is already an established practice where public companies are required to adhere to strict reporting standards. Private companies seeking crowdfunding do not have to adhere to these standards. Second, companies in the stock market are significantly larger and more developed than those seeking finance through equity crowdfunding platforms. And third, unlike stock market investing, crowdfunding platforms offer the opportunity for direct interaction with both the entrepreneurs and other likeminded investors interested in investing in the same company. other models that may be deemed as forms of crowdfunding that lie outside of the definition of equity crowdfunding used here, are those that restrict membership of the crowd. Most notably this includes those platforms that only allow accredited investors to participate in investing such as northern ireland based Seedups,5 Circleup6 or startup and investor community Angellist7. These platforms are a welcome innovation to the field of business angel investing, bringing transparency to what is an opaque process and greater visibility of potential investors for startups. They also promote more opportunities for syndication amongst investors, creating a better connected investor ecosystem. while this is a positive development and many businesses have had been very successful in raising capital in this way, unlike crowdfunding, it does not necessarily facilitate the tapping of new pools of capital for investment in innovation. it also doesn't face the barriers equity crowdfunding does when dealing with nonaccredited and large numbers of investors. The venTure crowd Crowdfunding equity investment into business 11 2.1. The stages of equity crowdfunding8 Plan for fundraising submitted Platform performs some level of vetting and decides whether pitch will go live on to platform Business application to platform Business needs to share all relevant information with prospective investors The entrepreneur needs to publicise the fundraising within their networks and beyond to get potential investors interested Interaction with potential investors to answer questions throughout the funding window is an important part of ensuring success Investors also benefit from questions posed and information provided by other investors If target not reached, money is returned to investors If target is reached platform performs more vetting before releasing funds to business Interaction between investors and business continues. The extent of which is dependent on how passive or active investors chose to be In some cases investors receive voting rights and will have a vote on important decisions in the business. Investors continue to be advocates for business Funding window closes Post investment Pitch goes live Getting on to a platform The first step of the crowdfunding process involves a business submitting its proposal to a platform. The platform operators will then look at the plan and perform some level of vetting of the business, looking at factors such as the likelihood the business could be fraudulent, the business's suitability to crowdfunding, the reputation of the entrepreneur(s) and other factors. They then decide whether or not to allow the pitch to go live on the site. Some platforms like exeterbased Crowdcube do the majority of their vetting beforehand having a 75 per cent rejection9 rate for applicants. others favour checking the business later, like dutch platform Symbid who perform due diligence once the target has been successfully raised but before they release the capital to the business. 12 The venTure crowd Crowdfunding equity investment into business Box 1: Case study of 'GetSiteTracked' on Crowdcube In 2010, GetSiteTracked founder Sebastian Lewis noticed that like many sole traders his father was finding it difficult to adapt to using the internet to source new business. The majority of sole traders, he discovered, didn't have websites for their businesses as most web hosting providers offered services that were overly complex and quite expensive. Out of this realisation came the idea for GetSiteTracked, an online provider of affordable and easyto use websites for sole traders. Like most young entrepreneurs, Sebastian needed to raise external capital to get his business off the ground. He was advised not to approach banks as without a sizable asset he would be very unlikely to secure any amount exceeding 10,000, and in his search for alternatives he came across CrowdCube and decided to try raising capital through crowdfunding. In March 2012, over the course of ten days Sebastian raised 100,000 from 29 investors in exchange for 33 per cent of his business. Recognising the difficulty in setting valuations on seed stage businesses, Sebastian used the feedback from investors to judge what amount of equity investors were willing to accept in return for investment, increasing the amount he was initially intending to offer. According to Sebastian, one of the main benefits of crowdfunding is that once a round is raised it opens doors to other sources of finance. An additional benefit that Sebastian received from the process was the uncovering of a valuable mentor who wanted to get involved in helping the business as well as providing investment. "While it was not something I expected to attain from the process, Rob's advice has been of enormous value to the business." Robert first came across Crowdcube in a local magazine and was intrigued by the prospect of being able to invest directly into a startup having successfully built a business himself. Through the platform, he reviewed pitches and contacted the entrepreneurs behind some businesses he was interested in. After discussing GetSiteTracked with Sebastian he decided to both invest and to come onboard as a mentor to the business. Getting in touch with the entrepreneurs, he felt was a key part of making the investment decision. Robert also points out that wouldbe investors should always have an idea of how they expect to make money from their investment i.e. via dividends, trade sale etc., before they invest. While Robert was a heavily involved investor, the majority of Sebastian's investors were quite passive in their approach. Providing information to investors once accepted onto the platform, pitches are uploaded for prospective investors to browse. These are usually in the form of a video or text description explaining the business's model, its roots including some background on the business owners, how much capital it is seeking to raise and The venTure crowd Crowdfunding equity investment into business 13 what it needs it for. Another important disclosure is how much equity it is offering, with each investor getting a pro rata share depending on the proportion of the target amount they commit. There are a number of ways entrepreneurs can decide on the proportion of equity to offer, occasionally using the help of the platform and investors. 14 The venTure crowd Crowdfunding equity investment into business Connecting with investors while some investors may browse the platform for pitches,10 the entrepreneur needs to make a conscious effort to market the pitch as widely as possible outside the platform. They need to tap into their network and beyond, to get people interested in the business and in becoming investors. As the campaign advances, it is important that interaction between the entrepreneur and potential investors continues via discussion forums on the platform or via email, phone or even meeting in person to address questions and give updates on the fundraising progress. The venTure crowd Crowdfunding equity investment into business 15 The 'allornothing' model A specific time allowed for the raise or the 'funding window' is also set in advance with platforms usually having either a standard 'funding window' or a limit on the time that can be taken. London based platform Seedrs, for example, operates a three month standard funding window. As is prevalent in the 'reward' model of crowdfunding, all equity crowdfunding platforms currently in the market operate the 'allornothing' system of funding where the venture has until the end of the funding window to raise its target or else it receives nothing and money is returned to investors. it can also raise no more that its target. The fees charged largely depend on whether funding is successful or not, with platforms usually charging businesses a percentage of the amount raised should they reach their target. Some also charge investor fees as Box 2 illustrates. After the target is reached The facilitation of the actual money transfer usually involves an escrow account,11 12 independent of both the investor and business, where the investment is held until the total target is reached, or failing that, returned to the investor. Postinvestment practices are also varied depending on the approach taken by a given platform. Seedrs, for example, operates a nominee and management system where it represents the interest of the investors with the business whereas others like Crowdcube and Symbid allow the entrepreneurs to manage their own interests. in the latter approach, investors have the option to be as passive or involved in the business as they choose. As is explored later, there is similar variation across sites in terms of voting rights. 16 The venTure crowd Crowdfunding equity investment into business Box 2: Matrix of currently operating equity crowdfunding platforms in the Europe13 Capital raised so far Vetting/Due Decision on how through the How investment dilligence much equity Funding Post Location platform Fees is facilited by platform to offer window investment CrowdCube uK 3.7m for businesses: 5% of Both investor and vetting done entrepreneur 60 days Business amount raised + 1750 business become before businesses decides. Can as decides legal fees if successful members of accepted on increase equity standard threshold Crowdcube Ltd platform during funding for voting for the period of window rights the raise Symbid nether

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About manojranaweera

Founder of UnifiedVU and Venture 9. Previously Founder and CEO of edocr.com 

Help companies with digital and business transformation via process optimisation and system design, especially in the areas of bringing everything together for increased productivity and revenue growth.

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