JOBS in your mum’s cake shop: the fallacy of equity in crowd-funding startups

By on May 11, 2012

Introduction

The JOBS act in the US has led to an absolute explosion of interest in crowd-funding for startups, and has been matched by an explosion in the number of US-based platforms readying themselves for the newly minted concept of “crowd-financing”. There are already several UK platforms that offer crowd-funding for startups, despite its questionable legality in the UK. The concept is spreading like a rash…

The general idea is simple: the entrepreneur puts up a pitch of his/her company on the internet for all to see, and anyone out there can view it and decide to invest small amounts of money in it. Why?

  i. The entrepreneur loves it because it opens up the pitch to a huge number of people, giving a vastly bigger pool of funding options and finance for early-stage ventures, allows them to demonstrate interest and traction in their ideas, and enables them to potentially connect with early customers.
  ii. The “public” loves it because it turns each and every person into an investor, much like the popularised “Dragons’ Den” series in the UK. Who doesn’t watch that program and feel a sense of envy at the wealthy “self-made millionaires” who get to make or break the future of a “budding” entrepreneur?

What could be better than such a democratisation of the funding process for startups? It sounds too good to be true.

Unfortunately, it is. The devil is in the detail.

The Devil

Firstly, let’s look at it from the public side. The concept of allowing the general public to invest in startups has been banned for a long time, and the main reason is – put simply – that the process is too easy for a skilled pitcher to scam. If anything, the web actually makes the whole process of scamming the general public much easier – as once a few people get hooked, the “crowd” mentality affords legitimacy to the proposal, and encourages others to follow suit in a way that was never possible before such wide web adoption.

And yet – despite this – this is not my main objection. “Professional” investors – established angels, seed funds, and venture capitalists, have due diligence processes they often follow to make sure that the pitch stacks up, that the people are not scammers, and that the evidence given is true and accurate. They have experience spotting scammers and know how to avoid them. However, there is – as yet – no evidence to suggest that one cannot crowd-source this expertise. With 200 investors each giving £1000 to a new business, there is – one would hope – as good a chance of one of them digging up any problems with the pitch or the founders as any professional investor. The point is that this point is debatable. The crowd, whilst vulnerable to crowd-instincts, might also benefit from crowd-knowledge and crowd-research, and weed out the scammers faster than a professional.

That leads us to the real problem, which has been widely overlooked by more conventional media coverage. The real problem is the financial instrument: equity.

Equity is not the instrument of the masses

Equity (one or more shares) in a company – in its simplest form – gives the holder the rights to receive a proportion of the distributable profits or proceedings of the liquidation of the company. However, shares almost never exist in their simplest form. Equity funding was designed for sophisticated investors. It is complex to understand. There can be (and usually are in startups) classes of shares, pre-emption rights, dilution, pre/post-money valuations, preference shares, carve outs, etc. These are a nightmare to get right even for experienced entrepreneurs and experienced investors. It takes lawyers to make sure terms, shareholders’ agreements and share issues are correct, and it can often go to court if things go wrong. Most angel investors don’t fully understand all the complexities of shares. Seed funds and VCs often rely on their lawyers to get them the best terms. In short – even sophisticated investors often struggle.

So how can you expect the general public to have a clue?

The answer is that you can’t. Equity funding was designed for a different purpose: it was designed for professional investors who (for the most part) understand the sophisticated instrument they are buying, and generally insist on clauses to protect them in the future as a result.

So people don’t get it? Let’s educate them!

It isn’t as simple as people “not understanding”. It’s actually even worse than this. Here’s the big problem. Most tech companies – exactly the kind of startup that everyone wants to invest in because they are the ones that often deliver outlandish returns to early investors – require at least 2-4 rounds of investment before they hit a serious enough revenue stream that they can dictate their own terms with any investors, in an effort to protect any of their earlier investors.

Whilst the very early stages can be financed by crowd-funding, the latter stages cannot (currently – though this will persist for many years). Even the new bill passing through the US doesn’t solve this problem, because it prohibits the later stage rounds (anything over $2m)). This means that in the lifetime of a company, it will have to take investment – at some point – from “professional” investors. Those professional investors will want not only a huge slice of the pie (massively diluting the crowd-funders, who will likely have no real rights to defend themselves against such a dilution), but they will also want to introduce new classes of shares, preferences, carve-outs etc. These mechanisms have been designed to ensure that later stage investors with more cash can lock out the early-stage investors from receiving their fair share.

Can’t we protect early investors with clauses to prevent predatory later-stage investors?

No. Here’s why.

As an example, let’s say I crowd-fund my new company, X, for equity, and agree with the investors at that stage that there will be no preference shares introduced – everyone will be on the same class of share. They get 25% of the company in return for their first £50k. I retain the other 75%.

Then in 6 months’ time, I need to raise a £500k round for a big global launch. I go to a number of seed funds and try to raise the cash. Finally, I am told by one of them that I can have the money, but I need to give them 50% of the company AND give them preference shares.

Now my options are 1) fold the company, so everyone loses or 2) screw my initial investors (which will probably lead to me getting sued – particularly in the US – even if the other option is for the company to fail). Worse still, this analysis assumes I am honest!

Imagine I were instead a bit of a crook (or as most economists would call it, a “rational agent”). I could do a back-handed deal with a new investor that includes a massive dilution of all existing stock (including my own), but ensure that my own shares are topped up post-round so that even though there was massive dilution, I ended up keeping about the same (or more!) % of the company as I held before, with my crowd-investors keeping (e.g.) just 1% between them. None of the early investors could afford to take up their pre-emption rights and participate in the round, so they will all be diluted to virtually nothing, but I keep my shares and the new investor takes over almost all of the shareholdings of the crowd-funding partners.

They have been squeezed out using terms that are fairly familiar in VC funding deals. This kind of thing already does happen, but at the moment it happens to a small number of angels who are aware of the risks. When this kind of thing happens to a few thousand people at a time, it will be explosive. And it could spell the end for the whole concept of crowd-funding startups.

So is equity really dead as an instrument?

In short? I can’t really see how equity crowd-funding can be made to work for high-growth tech companies. Crowd-funding with equity might work for companies which only need a single round of investment – companies like “your mum’s cake shop” – where there won’t be another big equity investor later in the day. And we can see examples of these companies already – very much like the ones that have already gone through CrowdCube (a UK investment platform) – where there is a bubble bath company, a distillery, etc. These typically need a single round of investment to finance set up costs, and once they are up and running they start turning enough revenue that they can fund future expansion mostly through bank loans or supplier credit. This means crowd-investors have less to fear from later, more predatory investors.

What can we do about this? Does that mean the whole concept is dead?

No. We just need instruments that people can understand. This is going to take time and creativity. The good news is that the door is open for people to create and design these instruments. The bad news is that the clock is ticking and unless we get on with it, we’re going to see some explosive court cases or implosive startups that could kill the whole idea.

Some examples.

Here’s what most of us understand: betting. They understand basic things like: if I put in £5 at 20/1, then I get back £105 if I win. We also understand things like: (basic bonds) if I loan this company £100, then I will get £5/year for the next X years, and at the end I’ll get my £100 back too. They might understand one or two other simple instruments too.

So what we really need – if crowd-financing is to succeed – is to create financial instruments that can fund companies that:

  i. Are easy to understand, model and predict for non-sophisticated investors;
  ii. Protect said investors against things like dilution and preference shares etc (which when coupled with crowd-funding scream lawsuits to me);
  iii. Are legal in as many countries as possible (this is a massive issue, as at the moment the law is different in almost all jurisdictions);
  iv. Can be combined with equity investments or other instruments that other, more “sophisticated” investors will want to use, with minimal legal complexity.

So am I pessimistic? Not at all. Not if we can act quickly and pop the overblown bubble of equity crowd-funding, and start focusing on the real question: What is the correct set of financial instruments for “social funding” of startups?

Conclusion and Call to Arms

There are all sorts of ways of designing financial instruments and to my mind, there is a huge opportunity for creating the right kind of instrument that enables a marketplace for:

  i. Crowd-financing high-growth multiple-round startups.
  ii. (Possibly) creating a secondary market for these instruments, so that early investors can buy and sell these instruments more easily, making them less vulnerable to long-term risk and better able to judge what return they are willing to take.

Equity just isn’t it. It’s too flawed. And unless we wake up to the fact – and quickly – we’re going to find the “social funding” movement swamped in court battles and negative PR that could drown it before it has barely got started.

This is a call to arms to all those out there who do want to change the world. We need to gather together, quickly, and start discussing ways to make this fledgling concept fly before it dies in the nest.

Get in touch if you want to be a part of it.

Jonathan May

Founder & CEO at Hubbub
Founder of Hubbub and digital fundraising strategist and technologist. I work with nonprofits globally to leverage digital as a fundraising and campaigning channel.

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