So, you want to crowd-fund?

Posted by Martin Kay on
The basics of crowd-funding, the options, the issues and how Blake Morgan can help.

Crowd-funding online OED definition: the practice of funding a project or venture by raising many small amounts of money from a large number of people, typically via the internet.

Crowd-funding (sometimes known as crowd-sourcing) has received a great amount of press attention over the last six months, with few articles actually explaining how it works and the advantages and disadvantages of it. This article gives a concise overview of methods of crowd-funding for the company looking to raise money or set up a crowd-funding platform and the investor thinking about dipping his/her toe in the crowdfunding ocean.

Overview

In order to crowd-fund you first need a crowd-funding platform. A crowd-funding platform is somewhere where companies looking to crowd-fund and potential investors can meet, allowing a large pool of potential investors to invest in companies looking to raise money. All of the established crowd-funding platforms are web based and the most appropriate one will depend on the amount looking to be raised, the way it is going to be raised and sometimes the sector in which the company operates in.

Any company looking to crowd-fund must first decide how it is going to raise the money required, broadly speaking there are three methods of crowdfunding; equity (share) based, debt based and advanced/forward order based. The details below summarises the three methods.

The three methods of crowd-funding

Equity based

How does it work?

The company looking to raise money offers shares in the company in return for the investment.

Example

BrandNewApp Limited may seek to raise £100,000 and offer a maximum of 10% of its issued share capital. If someone invests £10,000 they would receive shares in the company equal to 1% of the issued share capital.

Debt based

How does it work?

The company looking to raise money asks for loans to the company with a set repayment period and interest rate and sometimes some sort of “perk” for lending to the company.

Example

NewWidget Limited may seek to raise £100,000 and will offer 100,000 x £1 loan notes which have a three year repayment period and an annual interest rate of 8%. It may also offer a perk such as if you lend over a £1,000 you get 50% off the NewWidget when it is launched.

Advanced/forward order

How does it work?

The company looking to raise money asks those interested in the product it is developing to place (and pay for) advance orders.

Example

NewWidget Limited wants to raise a minimum of £100,000 to develop and launch its new product. It might ask people to place an advanced order at a cost of £100 in return for receiving the New Widget when it is launched (which may usually retail at £125).

Advantages and disadvantages

There are numerous advantages and disadvantages for both company and investor in opting for different types of crowd-funding, these can be broadly summarised as follows:

Equity based

Advantages for company/existing shareholders

  • No obligation to pay money to new shareholders (which will be by way of dividends) and only able to declare a dividend if and when the company is profitable.

Disadvantages for company/existing shareholders

  • Reporting and other company law obligations towards new shareholders.
  • Dilutes existing shareholders’ shareholdings.

Advantages for investor

  • Owns a % of the company.
  • Chance of capital appreciation in shareholding as well as future income stream through dividends.

Disadvantages for investor

  • If company fails you are less likely to get your money back as you rank behind all other creditors before payment.
  • No set time period for you to see a return.
  • Income stream is based on the company becoming profitable.

Debt based

Advantages for company/existing shareholders

  • The shareholders retain 100% ownership of the company.
  • The company knows the exact cost of raising the finance.

Disadvantages for company/existing shareholders

  • Contractual obligation to make repayments and pay interest, regardless of whether the company is profitable.

Advantages for investor

  • Defined fixed rate of return over a certain period.

Disadvantages for investor

  • No opportunity to benefit further if the company is a success.
  • Do not own any part of the company.

Advanced order/forward order based

Advantages for company/existing shareholders

  • No dilution of ownership.
  • No obligation to pay interest or dividends on money paid.
  • Positive cash flow implications as orders are paid for before costs incurred.

Disadvantages for company/existing shareholders

  • Only really suitable for companies developing a product tailored at a large consumer market.
  • Success largely dependent on interest in the product as opposed to the business model.

Advantages for investor

  • Chance to receive brand new product before anyone else and potentially at a discount.

Disadvantages for investor

  • Risk that product may not get to launch stage.
  • Do not own any part of the company.
  • Return on investment is limited to receiving the product.

Existing crowd-funding platforms

Once a company has decided on the method of crowd-funding (or combination of methods) it must then decide on a crowd-funding platform. Some examples of existing platforms include:

  • for equity based crowd-funding - Crowdcube
  • for debt based crowd-funding – Fundingcircle
  • for advanced order crowd-funding, the US site Kickstarter is the most established.

Which companies raise money through crowd-funding

Due to crowd-funding platforms being internet based and largely dependent on social media, there has been an attraction to crowd-funding by new tech start-ups as these types of company often struggle to get access to early stage financing and understand the potential and impact of social media as a method of reaching people.

However, crowd-funding has proved successful for a vast variety of different companies in different sectors. At the time of going to press, the largest successful crowd-fund for a UK company was by the [Rushmore Group] Limited an owner/operator of private members’ clubs which raised £1 million through www.crowdcube.com in November and the largest crowdfund worldwide was for a total of over $10 million by [Pebble Inc] through www.kickstarter.com which underwent a crowd-fund on an advanced order basis for the development of a new watch capable of syncing with an iPhone.

The attraction of crowd-funding is that due to the different methods and variations of crowd-funding available it can be suited, in one form or another, for an extremely wide range of companies spanning almost any sector and in different stages of the business cycle from start-ups through to established SMEs.

FSA regulation

There are a number of important considerations that need to be given by both a company looking to set up a crowd-funding platform and a company looking to raise money via a crowd-funding platform. Depending on the business model of the crowd-funding platform, FSA regulation may be required, particularly where the crowd-funding platform is deemed to be arranging or executing an investment activity, engaged in financial promotion and/or handling client money. A company looking to raise money via a crowd-funding platform needs to be satisfied that it is not obliged to produce a prospectus and that it can satisfy other relevant regulatory requirements.

Summary

Crowd-funding is an exciting opportunity for companies who may struggle to access the more mainstream methods of funding such as venture capital/private equity or bank lending, however it requires careful thought by both the company and the investor as to how they should go about it and an understanding of the risks involved.

Above is only a very concise summary of some of the considerations that need to be given, it is possible to have variations of the methods of crowd-funding or even a combination of them. Although the concepts may seem reasonably straight forward the devil is in the detail and advice should be sought to ensure that there are no business, tax or legal implications in offering a crowd-funding platform, raising money by crowfunding or investing in a crowd-funded company.

How can Blake Morgan help

If you are company thinking about crowd-funding or setting up a crowdfunding platform we can advise on all aspects of this. We have extensive experience in fundraisings, debt finance, FSA regulation and authorisation, tax and implementing innovative corporate and commercial projects, including acting for early stage internet start-ups. As a full service law firm we can advise on all aspects associated with crowd-funding and companies looking to get involved in this exciting new sector and financing in general.

About the Author

Martin heads the Corporate team in London and advises corporate clients and not-for-profit and public bodies, including universities, on a range of corporate and commercial issues.

Martin Kay
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020 7814 6919

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