Home Wealth Investment Here’s everything you need to know about equity crowdfunding

Here’s everything you need to know about equity crowdfunding

Inside the new world of start-up investment.

Your Money contributor

2018 was a game changer for equity crowdfunding (Source: iStock/AndreyPopov)

Editor’s note: This article contains information only. It is not intended as general or personal advice. Your Money recommends seeking professional advice specific to your personal circumstances.

Have you heard about equity crowdfunding but are unsure what it is, how it works or how to go about it?

Essentially, equity crowdfunding lets start-ups and small businesses raise much-needed capital to get things off the ground while giving everyday Australians the chance to invest in early-stage companies, even with a small amount of money.

It does this in a similar way to traditional crowdfunding, whereby someone looks to fund their project by asking a lot of people to contribute a small amount, usually through an online platform.

The difference is that you’ll actually get something tangible in return – a small piece of their company. That means as an investor you’ll be able to share in any success they have.

In this sense, your transaction is a bit like buying shares in a listed company. It’s just that you’ll be buying into start-ups, sometimes even before they’ve made any revenue.

And as only around one in 10 start-ups tends to succeed, this kind of investing comes with a lot more risk.

The rise of equity crowdfunding

Equity crowdfunding was first introduced into Australia in 2017 but it was only available to unlisted public companies – companies with more than 50 non-employee shareholders not listed on the stock exchange.

That changed in September 2018, when the Commonwealth government introduced new regulations that opened equity crowdfunding up to proprietary companies, the structure preferred by most small businesses.

Now essentially any company can use equity crowdfunding so long as it meets certain eligibility criteria, such as having at least two directors, preparing financial and director’s reports, and agreeing to have financial reports audited once the business raises more than $3 million.

They also must go through a licensed equity crowdfunding platform, such as Equitise, Venture Crowd, Birchal and OnMarket.

Meanwhile, the pool of potential investors has been broadened, with new criteria allowing investors that earn less than $250,000 a year or with assets of less than $2.5 million to invest up to $10,000 a year in a company through equity crowdfunding.

“Up until now, early-stage start-ups could only raise equity from capital from investors who met a high net worth test,” explains Lachlan McKnight, CEO and founder of online law firm, LegalVision.

“Equity crowdfunding has broadened the potential investor base. It remains to be seen how much of an effect this will have on the ecosystem.”

“The real question is whether everyday Australian investors actually want to invest in start-ups.”

How has it been received by investors?

So far, there have been some positive signs Australian investors may be keen, so long as it’s the right kind of business and it goes about raising capital the right way.

At least that’s what Eric Wilson, CEO and founder of neobank Xinja believes after he successfully led the business through a capital raise using equity crowdfunding platform, Equitise.

Wilson says he was surprised by just how popular Xinja’s crowdfunding capital raise turned out to be. The company initially aimed to raise $500,000 but it passed this mark within 18 hours.

Within a week it had raised $1 million and by the time it closed, 11 weeks later, it had raised more than $2.4million – close to five times what Wilson and his team had originally hoped for.

“It was pretty humbling to have ordinary Australians from all walks of life investing their hard earned money in us,” Wilson explains. “It really focuses the mind and made us more determined than ever to create a new banking experience designed in our customers’ interests.”

What type of business does it suit?

Despite Xinja’s success, McKnight warns that equity crowdfunding isn’t for every business.

He says founders and business owners should be cautious about pulling the trigger until they’ve done their own analysis on what it will mean for the future of their business and their own potential gains.

After all, any money you’ll raise will come at the expense of owning your own company.

“The first question any founder should ask is whether raising equity capital makes any sense at all. If raising a [venture capital] round isn’t going to make sense, then raising an equity crowdfunding round isn’t going to either.”

“The reality is that few start-ups that are in a position to raise a sizeable round from a high-quality VC would choose to go down the equity crowdfunding route.”

He says, for this reason, that equity fundraising tends to suit two types of businesses – “companies that can’t raise capital from a top-tier VC” (of which there are many), or those that are “selling or building a product everyday Australians understand”.

Who’s investing?

While Xinja didn’t fit into this first category (it had already raised capital through traditional forms), it certainly fitted the second insofar as its product – a fully digital bank – was something most investors could get their heads around.

It was also something many people felt passionately about and Wilson says that this helped make it the perfect fit for equity crowdfunding.

“We’ve always wanted our customers to own part of Xinja and share in its success and equity crowdfunding is an opportunity for them to own part of the action,” he says. “We always said we would crowdfund and as soon as it became legally possible, we did.”

It helped that, before raising money, Xinja had an engaged audience of potential investors.

“These were people who had pre-registered so they had been on the journey with us, and it was this community, who already knew Xinja, who responded so well.”

Altogether, 1,222 retail investors bought $2.44 million worth of shares in the company (close to another $260,000 came from sophisticated investors) for an average investment of $1,997.

Of those, the majority were aged between 25 and 34, with 67.6 per cent investing less than $1,000, although 55-64 year-olds invested the most. The overwhelming majority of investors – some 82.4 per cent – were male.

This is broadly in line with a wider analysis of equity crowdfunding investors undertaken by UK-based platform CrowdCube, which at the time had over 500,000 users investing more than £400 million (A$723 million).

It found that the average investor put in £1,482 (A$2,580), that 73 per cent of investors were male and most investors were aged 30-39.

Interestingly, Crowdcube also found that the most popular sector to invest in was food and beverage, followed by consumer goods and consumer internet.

What happens to a company afterward?

McKnight says any founder considering equity fundraising should consider the same issues as any company owner taking on new investors.

“These come in two big buckets: control and dilution. Will the founder remain in control of the company once investors come into the picture? What decisions need to be made by consensus? How much dilution will existing shareholders take once the round comes in?”

However, he says that one advantage for equity funding is that having so many small shareholders could enhance their control over decision making, as it could be difficult for shareholders to organise and vote against any proposal.

“That said, equity crowdfunding platforms such as Venture Crowd only invest in deals led by a professional investor. In these circumstances, it’s likely that the participants in the crowdfunding syndicate will place decision making power in the professional investor’s hands.”

Wilson says that he was concerned having to please 1,200 new investors would mean “a lot of work for a lean start-up”. However, he’s been pleasantly surprised by the role they’ve played so far.

“They’ve become an invaluable part of the Xinja community, contributing ideas and thoughts as to how they want to build the bank, what they think of the app and so on. So far from being a burden, they’ve helped us significantly.”

Tips for investors looking to get into equity crowdfunding

If you’re looking to invest in a start-up through equity crowdfunding, McKnight gives the following advice:

1. Use a good platform: “Of course due diligence is important but when investing small amounts of capital it’s not worth spending lots of time on it. A better approach is to invest through a platform which requires syndicates to be led by a professional investor. That way the lead investor does the due diligence for you. You just need to make a call on whether you think the opportunity makes sense from a market/team/product perspective.”

2. Treat it as high risk: “A start-up is binary; your investment will either fail or will succeed spectacularly. Investors should only invest equity capital into start-ups if they’re prepared to lose it all.”

3. Diversify: “Take a portfolio approach to start-up investing.”

4. Be wary: “With start-up investing, if it sounds too good to be true it probably is. Just be careful and don’t get greedy.”

Tips for companies looking to raise capital

If you’re a start-up founder or small business owner looking to raise capital through equity crowdfunding, Eric Wilson suggests the following:

1. Treat crowdfunding like any other capital raise. “The phrase ‘build it and they will come’ most certainly does NOT apply here. It requires many months of careful community building and letting people know about your business before you ask them for money.”

2. Think of your investors. “Crowdfunding carries a very high moral duty of care. This is money from mums and dads, brothers, sisters, nurses and tradies… real people who will be impacted if you lose their money.

3. Don’t sell, explain. “Crowdfunding investors are smart. A lot of them do a lot of research. Be honest and don’t under any circumstances lie or be obscure. Make sure everyone knows where you might fail and what you can try to do to prevent that.”

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