FOLLOWING THE CROWD

“It might look like an easy way to raise  funds, but most crowdfunding platforms  require the company to have found  a sizable amount of the investment”

So many entrepreneurs and start-ups are all looking for funding.  In recent years, many businesses have taken advantage of the looser angel investment scene resulting from  the advent of EIS. But for some this isn’t  a solution and they decide to consider crowdfunding. My usual response is to suggest they look anywhere else! But are there really problems with this way of  raising funds?

Crowdfunding works by using a regulated platform to provide a marketplace to raise funds from small investors. The pluses are obvious: access to a large pool of investors putting in small amounts of cash, meaning that raising the necessary funds looks like  an easy achievement.

But what about some of the potential problems with crowdfunding?

• A company that undertakes to raise funds by crowdfunding can end up with hundreds, if not thousands, of small investors. If these investors have taken voting shares in the company, then that company’s management will find themselves with a much bigger shareholder base to deal with than they  are used to. This is a particular problem  if the company has more than one class  of share or other shareholder restrictions and must get shareholder approval for any future funding round.

By way of example, if a company has 10% of its shareholding held by crowdfunders and it wants to issue more shares (requiring 75% consent), it is quite  likely that the crowdfunders won’t respond to any of  the communications sent to them – how likely would you be to open post and  respond if you had invested as little as £25  in a company? This leaves a company with an issue that I call ‘dead shareholders’ and means the management has to work its engaged shareholding a lot harder to pass  a 75% resolution. This can prove a real and persistent nuisance for management.

In my experience, there are ways to resolve this issue, but it often involves  a fight with the crowdfunding platform provider that the company is not prepared for and often doesn’t realise can be won.

• It might look like an easy way to raise funds, but most crowdfunding platforms require the company looking to raise  money to have found a sizable amount  of the proposed investment from key individuals before they will agree to put them on their platform.

Moreover, as much as 5% of the funds raised will go to the crowdfunding platform itself, so the investment may be far more expensive than the company had originally contemplated, and certainly more expensive than angel investment.

• The crowdfunding industry is still in its infancy and few crowdfunding companies have been sold to date. When they do,  there are likely to be additional costs  and practical issues.

Companies usually have drag rights that allow the majority of shareholders to drag the minority on a sale and provide for the ability of the company to sign transfers where those minority shareholders  refuse to do so. However, most buyers  are unlikely to accept the use of a drag and will insist on the sellers obtaining the signatures of every last crowdfunder  who, because they have only invested  a small amount and are not hugely  interested in the sale, may be difficult to track down. This may involve the sellers in  a costly extra headache at the time of sale.

To sum up, crowdfunding may not be  the quick and simple solution to raising  cash that many companies expect. While I wouldn’t say don’t do it – some of my clients have done well on crowdfunding platforms (£1m-plus) – I would think quite carefully before you ‘follow the crowd’ and ensure you have a lawyer on your side to negotiate the  terms with the crowdfunding platform.