London, 10 December 2014

An investor’s guide to equity crowdfunding success

Equity crowdfunding is the fastest growing form of alternative finance, offering crowd investors the chance to invest alongside City professionals and access early stage growth opportunities previously available only to an elite of private equity or venture capital investors.

Now, however, millions of ordinary investors can benefit by being allowed to invest sums of as little as £100 to help start-ups, early stage growth companies and even those already eyeing a flotation on the stock market.

The combination of small minimum investments and easy access via crowdfunding platforms means it is easy for investors to build up a diverse portfolio of investments, which is the key to maximising chances of success.

Investing in early stage equities involves risk, including loss of capital, illiquidity, lack of dividends and dilution and should only be done as part of a diversified portfolio.  Investors should read InvestingZone’s full risk warning before making an investment.

To help investors understand and manage their risk, InvestingZone, the equity crowdfunding platform, has issued some guidance for investors to aid them in making an informed choice and avoiding some of the less obvious pitfalls of investing in private companies.

Jean Miller, CEO of InvestingZone, says that there are a number of key questions that investors need to ask before committing any capital to this asset class.

“Most people understand that early stage companies are risky, but few people realise that if you don’t check for some of the key terms and conditions which may be in the fine print of the shareholders’ agreement, you could end up investing in a successful company but still receive little or no return. It’s these type of unfair or even dubious contractual terms that we’re trying to draw everybody’s attention to, because it’s in nobody’s interests for investors to get a raw deal.”

 

InvestingZone’s key questions to ask before committing

How do you know if you’re paying fair value?

"Assessing what a company is worth is a very tricky business and there is no precise formula," says Miller. "Much depends on whether the company is entering a growth market, a saturated market or even a shrinking market. Clearly a company entering a rapidly growing market would attract a higher valuation. Experienced investors will always scrutinize the company’s management because it doesn’t matter how good an idea it is if the team aren’t up to much so can’t capitalise on it.

“If a company is looking for investment armed only with an idea but no track record, no revenue and no profit, it is clearly more risky that one that is up and running – the investors can get sucked in by an attractive pitch or the backing of a celebrity figure. In general, avoid companies that are relying in celebrities to help draw investments.

"Another key rule is to look at whether the directors have invested any money themselves. You want to see them putting some of their own cash in as ‘risk capital’ at the same valuation as the crowd investors. This is an important test – Dyson put his own house on the line to raise capital when he was starting his vacuum business – that shows real conviction and ambition.”

Miller suggests if you have absolutely no experience of investing in an early stage projects, start by investing in companies operating in an industry that you know something about. "It might be the industry you work in or friends and family have some knowledge of. This will give you a better understanding of whether the company has a chance of success, whether its business model is sound and whether the valuation seems fair.”

 

Preserving the value of your money

Many investors don’t understand that most early stage companies will need several rounds of fund-raisings, and that the one you are looking at on a crowdfunding site might be the first round of many. 

"More fund raisings can have a severe diluting effect on your investment because it means the company will issue more shares to more investors. If you don’t have pre-emption rights with your shares, a common omission on crowdfunding platforms, you may well find that other investors are given first option to buy the newly issued shares and you may not get the opportunity to participate.

"That means that the value of your holding could reduce. To preserve the value of your investment you should be prepared to invest top up sums, so think about holding back some funds to invest at a later stage.”

 

Where other investors may be getting a poor deal

Many sites don’t have enough information for investors to make an informed choice, or don’t adequately explain the risks. Share issues take place without telling investors that they don’t have pre-emption rights, or don’t explain the implications of the lack of pre-emption rights (i.e. you can be excluded from further rounds of capital raisings so you cannot buy more shares, but new investors can). 

"This is a terrible situation because if you invest without knowing these basics you may end up with a virtually worthless holding even if the company is a roaring success, simply because you didn’t know you had to invest more money to stop your investment becoming diluted. What we want to see are higher standards for transparency and education on crowdfunding sites so that people understand the nature of equity investing and don’t get exploited by professional investors who have more expertise.”

 

The importance of voting rights

"This cannot be overstated," says Miller. "Many shares being offered don’t have voting rights or if held through nominee accounts won’t have voting rights other than collectively by the assigned nominee.. That means that if a company hasn’t defined an exit strategy and the shares are illiquid, as many early stage shares are, then you will have no way of influencing how you will get your money out." 

"Without a vote to force the company to push on for an Initial Public Offering (IPO) or sell up so people can realise their gains, you may never see the profits that you are due."

 

Tracking your investment

Some crowdfunding platforms have forums where, in theory, you have contact with companies in which you have invested, but if management are not particularly diligent, you may just not hear from them.

"It’s essential in my view to be able to keep track of your investments just like you can with a stock market listed investment," says Miller.

"On InvestingZone, we actively encourage all companies to give regular updates of revenue, gross and net profit and a summary of achievements and business updates. This allows us and investors to keep track of whether company is floundering or succeeding, enabling you to “take the temperature” of your holdings to assess their progress."

“In a nutshell, we press for too much rather than too little information. As an investor you can always choose to ignore management information, but if you don’t get the information in the first place, you may never know the consequences until it is too late for you to do anything”.

 

Check the tax reliefs - they are incredibly generous

About 95% of companies that list on equity crowdfunding sites are eligible for some form of tax relief, usually in the form of the Enterprise Investment Scheme (EIS) or Seed Enterprise Investment Scheme (SEIS)

Investments under the SEIS attract a 50% income tax credit, no matter what your income tax rate is. That means that, come the end of the tax year, you can deduct 50% of your investment from your tax liability. If you are a PAYE employee, then you can simply state your investment and relief on your tax return and it will be refunded to you by HMRC. The maximum you can invest in an SEIS scheme is £150,000 in any one tax year. 

EIS investments award a 30% income tax relief, so that 30% of your investment can be reclaimed at the end of the tax year. Up to £1m can be invested in an EIS scheme in any one tax year.

One point to remember is that any tax refunds cannot exceed your tax liability. So if you had an income tax bill, whether through self-employed work or PAYE, of £25,000, the maximum refund you could receive under either EIS or SEIS is £25,000. You cannot reclaim more tax than you owe. 

 

Capital gains tax 

In addition, shares in unquoted companies are free from capital gains tax if you hold on to the shares for three years or more. Any gains you realise within that time can be reinvested in another EIS or SEIS scheme, which defers any CGT liability and means that you are effectively receiving combined tax relief of up to 78% - 50% income tax credit and 28% CGT relief.

 

Loss relief

Additionally, even if the company in which they have invested goes under, investors can qualify for loss relief, which is calculated at your marginal tax rate. So if you invested £10,000 into an EIS qualifying company which then folded, you would receive up to 50% of the investment back (£5,000) through a tax credit, and up to a further 40% of the remaining £5,000 loss – equating to £2,000. So in a worst case scenario you could still recoup up to £7,000 of a £10,000 investment even if the company went bust. 

Of course, your tax treatment depends on your own personal circumstances and may be subject to change in future.

 

-Ends-

Notes to editors

The report published by Nesta and University of Cambridge ‘Understanding Alternative Finance: The UK Alternative Finance Industry Report 2014’ can be found here.

For more details on Investingzone please visit the website:

https://www.investingzone.com/

For further details contact:

Jean Miller, InvestingZone (info@investingzone.com)

Nick Gardner at Cicero Group on 07453 721 803