I took part last week in a discussion organised by the Centre for the Study of Financial Innovation, a well-connected City think tank, on equity crowdfunding, at which there was much discussion of the risks of equity crowdfunding for retail investors. Inevitably, the focus tends to be on the likelihood that many early-stage ventures will fail and the investors who backed them will lose their money. This danger is well known. Only about 50% of companies are still trading three years after they set up, which prompted regulators to demand that retail investors who register with equity crowdfunding platforms undertake not to put more than 10% of their investable assets into these high-risk ventures.  

 

Arguably, however, there are other dangers that are much less obvious to the unwary and that become an issue not when things go badly, but when they go well.

 

One of the few certainties of investing in small, private businesses – and one that is probably not understood widely enough – is that if a company succeeds it is inevitably going to need more money to fund further growth, meaning fresh rounds of fundraising. This process could lead to potential disappointment for less savvy investors for at least two reasons.

 

The first – and one that is gradually attracting the attention it deserves – is that companies that raise money on some equity crowdfunding platforms are entitled to issue more than one class of share. Typically, people who invest smaller sums will receive B Shares that do not carry voting or pre-emption rights (the right to buy further shares that the company offers for sale in proportion to one’s existing holding before they are offered to outsiders). Founders and larger investors will have A Shares that do carry these rights. This lack of pre-emption rights means that if the company decides to raise another round of funding at a higher valuation, these small early investors will see their stake heavily diluted by the new shares and will not have the right to prevent this by taking part in the fundraising. Consequently, they will end up owning a smaller slice of the company and are likely to realise a much lower value on exit than they might have hoped for.

 

However, this is not the only way that people could end up disappointed.

 

Even if they have bought a class of share that confers pre-emption rights and so guarantees them the opportunity to invest further and avoid dilution, there is no guarantee that when it comes to it they will have the cash to do so. In fact, I suspect there’s a good chance that if they are inexperienced they will have no idea that they are going to be asked to put up a multiple of their original investment in order to preserve their position in subsequent fundraising rounds. If their original investment was £100, this probably doesn’t matter. If it was £5,000, it probably does.

 

The point is that when investing in growing companies, both failure and success come with costs attached. The risk is that some of those inexperienced retail investors that are fortunate enough to back a winning proposition are destined to suffer the frustration of getting it right but being unable to afford the price of maintaining their position. And that’s without even considering the question of what is supposed to happen when a retail investor wants to take up their rights in a subsequent, large fundraising round but in order to do so would have to commit more than 10% of their investable assets.

 

In equity crowdfunding, losing money when a company fails is far from the only risk that retail investors face – it’s just the most obvious one.

 

 

This article also appears by arrangement on the Finance Innovation Lab blog. My thanks to Chris Hewett for publishing it.

Disclosure: I own shares in the equity crowdfunding platform SyndicateRoom, which does not cater for 'restricted retail' investors.