An Entrepreneur’s Top Crowdfunding Questions Answered, From A Legal Perspective

Crowdfunding is clearly a viable alternative source of finance for businesses and a potential source of income for investors, but as with any form of finance or investment,...

Photo: Christopher Jones, commercial lawyer at Wright Hassall LLP, Source: Courtesy Photo
Photo: Christopher Jones, commercial lawyer at Wright Hassall LLP, Source: Courtesy Photo

Crowdfunding can be broadly defined as a form of finance whereby entrepreneurs and businesses can raise funding from a large number of investors, each of who typically invest relatively small amounts of money.

Crowdfunding can be a particularly attractive form of finance for young businesses, and it can therefore be distinguished from forms of finance such as traditional bank lending and venture capital investment which typically require a more mature business that has a proven track record of delivering strong economic performance and returns on investment. It can also be distinguished from so-called “angel investor” funding, which usually involves a single, high net worth individual taking a significant shareholding in a company.

Having first appeared in the late-1990s, crowdfunding levels are now very high. Today there are over 500 crowdfunding companies (known as “platforms”, many of which are online and which act as investment middlemen), multi-million deals are commonplace. For instance, in the UK alone, in 2014 the total amount raised through crowdfunding was over £1.2bn. Reports estimate that the overall global crowdfunding market will reach $1 trillion by the year 2025 (My Private Banking Research).

Crowdfunding is clearly a viable alternative source of finance for businesses and a potential source of income for investors, but as with any form of finance or investment, it is important that it is structured correctly and that the potential risks and rewards are understood by all involved.

 

What forms does crowdfunding commonly take?

Crowdfunding can be divided between debt and equity finance:

Debt – also called “peer-to-peer lending”, this involves a group of investors collectively acting like a bank in making a loan to a business. Loan conditions will stipulate the repayment terms together with fees and interest due and the business is then required to make payments on the loan from cash flow before profits are distributed to shareholders.

Equity – this involves investors buying shares in a company and therefore becoming part-owners of the company. They make a return on their investments either by being paid a dividend from the distributable profits of the company or by selling their shares when the company’s value has increased (sometimes back to the founder of the business to return him or her to sole ownership).

Compared to debt crowdfunding, equity crowdfunding offers investors less certainty as to the amount and time frame of any return, so it is therefore riskier for investors and should offer a higher potential return. However a business can offer some signposts for investors by setting out an exit strategy based on levels of profitability and growth – most equity crowdfunding investors will look for an exit in four to six years.

 

What types of business are well-suited to crowdfunding?

In theory any business can crowdfund, although crowdfunding investors may be more likely than more traditional investors to invest in a business for reasons that are not purely financial (for example, a startup business making interesting, innovative products to which the investor can relate), giving an edge to certain types of business.

As any business supported by crowdfunding grows, the original crowdfunding can be replaced with more traditional forms of financing that may offer increased and/or cheaper funding.

 

What are the advantages of crowdfunding for a business?

Crowdfunding can provide a simpler and quicker way to raise finance. It can offer sources of funding for younger companies and, in the case of startups, can provide a clear message to potential clients or suppliers that the business is an attractive proposition.

For slightly older businesses, as compared with a longer process of bank due diligence and credit scoring, crowdfunding platforms can provide financing within a matter of days or weeks and the financing is usually more flexible, requiring less day-to-day scrutiny of the business than would be the case with a bank loan. Costs may be higher than elsewhere, but those costs are still fairly predictable and can be modeled against anticipated business performance.

 

Are there any disadvantages of crowdfunding for a business?

A company will usually have to give security over its assets to help ensure repayment of crowdfunded debt upon a default or other failure of the business; also common are personal guarantees from the business founder and/or directors of a company, thus exposing him or her to the threat of personal bankruptcy upon a failure of the business.

It is very important to remember that, although obtaining finance thorough crowdfunding can be a simpler and quicker process, it is not a step for any business to take without careful consideration.

The terms of an equity crowdfunding investment can be made to fit the circumstances of any particular business. However any sale of equity in a business will dilute the holdings of the existing shareholder(s) and may therefore impact on the size of their return, and any grant of voting rights to investors may impact the ease of running the business (although both of these issues can be effectively regulated through a shareholders’ agreement).

Ultimately, the key for any business is to ensure that the equity dilution and the funds it injects are used to grow the business, so that the diluted existing shareholder(s) are ultimately in a better position for the crowdfunding.

 

What are the advantages of crowdfunding for an investor?

In the present climate of low interest rates, crowdfunding should offer investors higher rates of return than traditional savings accounts.

 

Are there any disadvantages of crowdfunding for an investor?

Equity crowdfunding is inherently riskier than debt crowdfunding – shareholders rank below secured then unsecured creditors of a company so, on its insolvency, they are near the end of the queue for payment – while the threat of business failure makes debt crowdfunding riskier than depositing into a savings account (hence the higher returns offered to investors).

 

This article has been edited and condensed.

Christopher Jones is a commercial lawyer with Wright Hassall LLP. Christopher advises on many types of corporate transactions for businesses and organisations, but has particular expertise in banking and finance. He has extensive experience of a very wide range of financial transactions, including secured lending, property and development financing, asset-based lending, invoice discounting and supplier financing. Connect with @wrighthassall on Twitter.

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