Five questions to ask before investing in crowdfunding

Investors need to be better informed about the risks they are taking when crowdfunding, says Elliot Cowan. Here, he outlines five vital questions to ask before you hand over any money.

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Camden Town Brewery's crowdfunding serves as a cautionary tale to investors

When people look back on 2015, they may remember this as being the year that crowdfunding really took off and became mainstream. They will no doubt point to the monies raised by JustPark and Sugru (respectively £3.7m and £3.5m) in bothcases from over 2,500 investors.

While those involved in FinTech and alternative finance instinctively applaud this, if you go beyond the impressive figures, a nagging concern begins to fester. Do retail investors fully understand what they are investing in and the true value of the commercial proposition being offered by the company crowdfunding? Put simply, does Joe Public know what he's getting himself in for?

Companies undertaking crowdfunding make the relevant legal documents available to the crowd. Investors should review these (particularly the proposed articles of association) as they will contain details of the shares investors will be receiving. However, these documents are not always user-friendly, and are often written in legal jargon. So we thought it would be helpful to list some of the key factors eager investors should consider before agreeing to invest in the latest crowdfunding trendsetter.

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Willthe shares bediluted on a downround'?

This happens when, after completion of the crowdfunding, the company raises additional funds at a lower valuation than the valuation offered in the crowdfunding round. The net result of this is that the existing shareholders (including those coming in on the crowdfunding round) will have their shareholding in the company heavily diluted. In contrast, typically a venture capitalist (VC) or angel investor would expect to receive contractual protections, ensuring that if there were a downround, they would receive additional shares to offset the dilutive effect of the issue of cheaper shares.

Has the proposed valuation been properly scrutinised?

or is it simply based on an overzealous estimation of the company's revenue and potential growth? It is becoming increasingly clear that one motivation for companies choosing to crowdfund is that platforms are willing to market the company with a higher valuation than would be acceptable to a VC or an angel investor. The recent example of Camden Town Brewery serves as a cautionary tale the company gave itself a valuation of £75m when it crowdfunded, but within a couple of months it sold part of its business to a Belgian firm. Camden Town Brewery's valuation based on that transaction was £50m.

Do the shares have the benefit of pre-emption rights?

This means that if the company raises money in future, will all investors be entitled to participate in the fundraising in order to maintain their proportionate shareholding in the company? If not, then they will be diluted. Again, this is a protection that a VC or an angel investor would insist on.

What are the rights of the shares upon the sale or liquidation of the company?

Will the shares issued to the crowd only receive a payment if the holders of other classes of shares (often with some form of preference right) receive a specified amount first? If that is the case, the crowd may not receive any of the proceeds if the company is sold or is liquidated. This is the position adopted by Adzuna in their constitutional documents, a company that earlier this year raised just over £2m on Crowdcube.

Do the shares have voting rights?

If they do not, you will have minimal ability to have any influence or to exert even the most basic rights enjoyed by most shareholders. For instance, the usual position is that shareholders in a private company are entitled to attend, speak and vote at a general meeting.

Investors should be aware that it is unlikely that any secondary market exists for their shares, and therefore the shares may not be easily transferred. Therefore, the shareholder will not be able to cash in' their shares until either the company is sold or lists its shares on a stock exchange.

In our view, non-professional investors need to be better informed about the risks they are taking, and their expectations about the future performance of crowdfunded companies needs to be somewhat recalibrated. Otherwise such investors may soon start to become disillusioned with the crowdfunding model.

There is therefore a risk that, as opposed to being the moment in which crowdfunding entered the zeitgeist, 2015 may instead be remembered as the year in which Joe Public started to become more inquisitive about the propositions presented to them on crowdfunding platforms.

Elliot Cowan is an associate at Fox Williams LLP

This article was first published on Altfi.com

Elliot Cowan is an associate at Fox Williams LLP. His article sappear on Altfi.com