Crowdfunding start-ups - dumb money or smart move?

By Cole Wilkinson - October 31, 2018

New legislation that extends access to equity crowdfunding platforms increases opportunities for start-ups – but the injection of 'dumb money' holds potential pitfalls for both businesses and unwary investors, according to Pitcher Partners specialist Cole Wilkinson.

For small businesses and start-ups, the announcement in September that new legislation had opened up greater access to equity crowdfunding was welcome news.

While crowd sourced equity funding had been available for more than a year, the new changes mean companies can now access the regime without having to convert to a public company entity – a requirement which had proved a significant barrier to for many small businesses, and for start-ups in particular. 

Mr Wilkinson said the existing crowd sourced equity funding regime had to date not been widely used among the start-up community, apart from some minor activity through some crowd funding platforms.

“One of the reasons behind this is the actual or perceived administration and costs involved, particularly the requirement to convert to a public company,” he said.

“The recent changes will go a reasonable way to alleviate this issue, but I think take up will be very slow in the start-up sector and I have some major concerns for its long-term viability as a funding source for start-ups.”

Successful early stage and scale-up companies were generally seeking more than just money where it came to securing investment – meaning the value proposition offered by the source of funding was a key concern. 

“The terms ‘dumb money’ and ‘smart money’ are used quite frequently in the start-up sector,” said Mr Wilkinson.

“As a general rule, a start-up would prefer to raise money from a sophisticated investor such as a venture capital fund that can also can provide advice and connections, and open doors.

“They also generally have a better understanding of what it means to invest into a start-up company and the rocky road that this sort of business takes on its way to growth. They can be more flexible on investment terms, and assist with future funding rounds or transactions without being an obstacle.”

Mr Wilkinson said the likely outcome was that the cream of the crop would continue raising money via the current network of experienced and sophisticated investors, while those unable to attract this sort of investment could turn to crowd sourced equity funding – or 'dumb money'.

“This potentially leads to a situation where we have cases of B-grade companies raising money from non-sophisticated investors, and these investors likely don’t properly understand the risks involved in these types of businesses," he said.

"As a result, they could end up investing, or essentially gambling, a larger portion of their wealth than would be advisable in such a high-risk sector."

And while the new legislation made it easier for a wider range of businesses to access crowd sourced equity funding, requirements were still somewhat onerous for early stage start-up companies.

“Preparing financial statements and director reports in accordance with accounting standards is still a relatively difficult and costly process for an early stage company that has minimal, if any, internal or external accounting and finance support,” said Mr Wilkinson.

“This is likely to lead to a reasonable portion of equity raised being spent on consultants and the like, including crowd-sourced funding platforms, and not on the intended use of funding growth for the company.

“I’m sure there will be some winners that have gone down the crowd sourced funding route, but my view is that there will be a lot more losers and investors getting burnt along the way.”

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