Equity crowdfunding for start-up entrepreneurs

Enterprise Nation members hardly need to be reminded that starting a business is risky. However, it's a risk that many small investors are prepared to share and contribute towards - sometimes for other reasons than seeking a financial return on their investment.

I have experience of hundreds of pitches from start-up founders who wanted backers to either order their new product or buy a stake in their business. It gives me valuable insight to share with anyone who wants to explore using crowdfunding, and this guide to equity crowdfunding for start-up entrepreneurs answers several common questions.

In this blog, I focus on equity crowdfunding, in which private companies raise funding through attracting investors to become part-owners in the business. A previous blog covered reward-based crowdfunding, in which start-ups seek to generate pre-paid orders for goods. In both cases the principal seems quite straightforward, which is that crowdfunding is all about securing a relatively small level of backing from a lot of people.

Benefits of equity crowdfunding for entrepreneurs

Start-up businesses are turning more and more to a range of alternative finance options for early-stage investment. Equity crowdfunding platforms are website marketplaces that bring together businesses that want investors, and people looking to invest modest amounts in ways that provide better returns than the negligible high street interest rates. As well as raising money there are several other benefits for entrepreneurs.

• It can be good marketing; it gets a business noticed

• Successful backing provides 'proof of concept', helping a business to then get further investment from other sources

• Feedback from 'going public' with ideas and aims helps to refine plans and targets

• It's a virtuous circle in which customers can become investors and investors can become customers - sometimes very valuable ones

• It encourages investors to become brand advocates, climbing 'the loyalty ladder' to give the businesses positive word-of-mouth support

• It is a public event, establishing a confirmed value that early-stage investors clearly agree with

• Investors may choose to back a business where they identify more with its social, ecological or environmental aims than its financial prospects: for many such people the prime reward is the buzz of helping an enterprise they admire to get off the ground

The money people invest through equity crowdfunding is not a loan. It is not repayable. Though a number of crowdfunding platforms, including SyndicateRoom and property-based Downing Crowd, do offer opportunities to raise money through issuing mini-bonds. Bonds have repayment dates and fixed interest rates, which may suit entrepreneurs who want to retain their equity.

Why don't more new businesses use equity crowdfunding?

Crowdfunding isn't easy. When you look at crowdfunding projects hosted on the various platforms they are like icebergs, which show 10% above the waterline. Below the water is a massive amount of unseen work. I have identified seven key elements of crowdfunding projects, and they all have to be executed well to have a real chance of success. Here are three fundamental ones:

• Build a crowd of potential backers, which may have to start months before a crowdfunding project actually goes live on a crowdfunding platform. This requires marketing that includes any amount of activities, techniques, social media and other communication channels

• At least 30% of the financial target should appear in a project within the very first few days of going public, and it requires personal pre-selling by the project leader. It could be an angel investor or a VC. Money arriving quickly creates momentum, and gives confidence to potential backers who may otherwise sit on the fence. Platforms are unlikely to let a crowdfunding project go to a public phase if it has not achieved this level of pre-backing at a private pre-selling stage

• It is vital to communicate a clear vision of what the money will be used for, how it will advance the company's development, how that progress will be measured, and any intentions to run subsequent rounds of fundraising

There is also a quality bar set by crowdfunding platforms. They only earn from successful projects, so they don't want to waste time on weak ones. A business owner might get knocked back several times to improve any part of their project.

The time these matters can take means that turning to crowdfunding only as a last resort, perhaps after exhausting every other option, can make it impossible. Think months ahead so you do not have to rush and take shortcuts, because a business that fails to reach its financial target will receive nothing.

How long does equity crowdfunding take?

After preparation to complete the seven key elements to a good standard, the equity crowdfunding platforms generally agree on around allowing three months, starting with a 'Hidden phase' as shown in this chart created by the Nordic platform Invesdor. The 'Public phase' usually runs for four to six weeks. It's hard for fundraisers to maintain the required intensity level for longer.

What do investors look for?

Think of crowds of investors as hunting in packs to uncover signs of weakness that will cause them to make their investments elsewhere. Any number of potential backers can ask detailed questions through the crowdfunding platform. The answers will be made visible for all potential backers to see and maybe comment on further. Questions will include items such as these:

• What the money raised is going to be spent on and how far it will advance the business's development

• Evidence of a true market opportunity

• Financial statements and projections

• Timetabled KPIs to monitor progress

• Intellectual property, or some other hard-to-copy factor of exclusivity

• Existing or potential competitors

• The management team's abilities and experience

• Strengths and weaknesses of supply and distribution chains

• The impact of any known forthcoming legislation

• Current and future customer interest/sales prospects

• Eventual exit strategy

All the information - not just most of it - has to be prepared in advance and made ready for swift replies. Larger investors may request personal calls or meetings - project leaders have to make sure their schedule allows time for this. Questions can come in at any time of any day. It's full-on 24/7, don't go on holiday!

Potential investors also look for very advantageous tax benefits offered by HMRC. UK income tax payers who invest in businesses registered under EIS (Enterprise Investment Scheme) and SEIS (Seed Enterprise Investment Schemes) are able to claim a refund of up to 50% of their initial investment through tax relief. If a business later fails, investors can claim a further refund. When a business succeeds, investors can shelter returns from Capital Gains Tax. There are also very early-stage SEIS benefits for company directors. They really are worth checking out. Further information is readily available from a number of equity crowdfunding platforms, including Seedrs, Crowdcube and Crowd For Angels.

How much does equity crowdfunding cost?

In the Preparation and Hidden phases of equity crowdfunding, there are costs for preparing documents, maybe intellectual property fees, a video and image library to prepare, and a budget needed for crowd-building and marketing activity in the build up to and then during the public crowdfunding.

If a start-up considers offering its suppliers payment with equity, they need to keep in mind that shares acquired this way are void of EIS and SEIS tax benefits, so will be of less value.

On completion, crowdfunding platforms all charge commission on successful projects, plus sometimes a completion fee, and there will be transaction fees for handling the investors' payments. Build these costs in to the fundraising target. Allow for 10% of the total raised, and check with each platform how much you can bring this down by, and what else they can provide.

How much to ask investors for

Do not expect or attempt to raise all the money you need to fully grow the business in one round of funding. Plan it in stages. As a business grows it commands a higher company valuation, meaning start-ups are able to raise money in subsequent rounds based on higher share prices.

Road builder MacRebur recently ran its third round of equity crowdfunding. In Round 1 its share price was £7. In Round 2 it was £17 and this time each share was valued at £21, marking the company's growth.

The Cheeky Panda, a brand of bamboo-based tissues I talked about in my reward-based crowdfunding blog, valued shares in its first round of equity crowdfunding at £4.26. It offered 10% of the business for £50,000 in 2017, and when they hit target it represented a public statement that "the market" believed the business was worth £500,000.

Then it raised further investments from an angel investor, and institutional backers came in later on. In its second round of equity crowdfunding, each share was £18.25, and it was £36 in round three in 2020.

What support does a crowdfunding adviser provide?

An experienced crowdfunding adviser knows the standards required by the crowdfunding platforms, and can save an entrepreneur time and money from avoiding a series of knockbacks to improve a project. They can also negotiate with the platforms to gain added marketing support and other 'extras'.

When a crowdfunding project team looks for professional support, there are many marketing, PR and video production companies that have added 'crowdfunding' to their list of capabilities and services.

My own experience of some of them has shown patchy competence. Do the ones you might choose really understand the dynamics and nuances of crowdfunding projects? A specialist crowdfunding advisor will be able to tell, and can also fulfil a campaign coordinator role to steer the entire process.

A crowdfunding project has a start date, an end date, and takes a lot of work. If the financial target is not achieved it's all for nothing. Though success can make dreams come true and transform lives forever.

Relevant resources

• How to use crowdfunding for more than raising business finance

• Understanding finance: Angel investors, VCs and crowdfunding

• Eight key metrics for running a successful equity crowdfunding campaign