Institutional investors could help stop overblown crowdfunding valuations

Institutional investment's role in equity crowdfunding
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Luke Davis
CEO
IW Capital
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The UK’s alternative finance industry rocketed last year, with an astounding £3.2bn of loans and investment completed, an increase of 84% on 2014.

Of the sectors encompassed by this rising industry, equity crowdfunding was cited by Nesta as one of the most rapidly expanding models in the space, growing by 295% since 2014.

In a 12-month period, the UK also witnessed an increase in the number of private sector businesses, with 146,000 additional companies since 2014, which saw the total number of SMEs hit a record 5.4m at the start of 2015. At that time, the number of companies employing also increased by 35,000, reflecting a population of SMEs that have continued to scale their operations.

The UK’s business community has scaled almost in tandem with a rising alternative finance industry and this appears to be no coincidence. The rate of expansion has been remarkable, but there is a need for investment providers and platforms to continue to evolve in order to keep pace with these growing companies and maintain alternative finance’s momentum.

What has arisen recently is a tendency for some platforms to inflate valuations in a bid to encourage companies to list on their sites.

Platforms in the UK are now acquiring a greater number of campaigns, with 254,721 companies and individuals turning to the crowd in 2015. What we can take from this is that alternative finance is democratising SME investment and opening doors for more social investors in the UK.

However, what we can also decipher is that the market is getting busier. As with any market that has increased in popularity and seen a greater number of entities enter the space, this has created new challenges and for equity crowdfunding those challenges have seen some platforms compete for new campaigns.

What has arisen recently is a tendency for some platforms to inflate valuations in a bid to encourage companies to list on their sites. As an industry, this is something that we need to be mindful of and implement measures to safeguard companies, investors and the longevity of the platforms themselves.

Inflated valuations could prove to be detrimental in the long-term for investors as they could dilute returns post-exit. And, should these returns prove underwhelming for investors, there’s the risk that they will become hesitant to back similar campaigns or invest in that company again in the future.

To mitigate this, it is the responsibility of crowdfunding platforms to ensure that their due diligence processes are second to none. In addition, one means of ensuring the industry’s duration could be – and some platforms are beginning to adopt this formula already – to take a steer from the debt sector that typically deals with larger scale finance from an institutional source.

Institutional money – and by that I am referring more to hedge funds and family offices etc. – could act as a lead investor and help to catalyse the crowd. In my view, the profile of the crowdfunding investor has changed to an extent where early adopters have now built a portfolio of up to ten companies and are waiting for their returns. Should those returns prove lackluster due to the aforementioned inflated valuations there is the risk of them becoming more reticent in the future. However, a degree of money from a lead investor could act as a stamp of approval and instill confidence in that campaign’s valuation by tapping into our natural herd mentality.

Aside from valuations, another challenge that has arisen for the crowdfunding industry is the acceleration of the companies themselves that initially sought support from the crowd. Those initial startups or fledgling businesses that turned to equity crowdfunding early on are now at risk of outgrowing the initial market that carried them.

Although this is testament to the industry’s impressive legacy of case studies that have gone on to progress, the development of these businesses means they require more money than the crowd can sometimes provide, however they are still too small to be solely backed by institutional means.

For these scaling businesses that are seeking equity crowdfunding opportunities the model applied more widely by debt platforms could be the answer.

For these scaling businesses that are seeking equity crowdfunding opportunities the model applied more widely by debt platforms could be the answer. That injection of institutional funds, or cash from a more sophisticated investor, would by no means threaten to undo the democratisation of crowdfunding; instead, it could work as a lead investor in order to ignite interest in a raise and generate greater volumes of much needed investment for these companies.

Should the equity platforms choose to evolve and follow the example of debt, which is typically used to dealing with far more established companies that have a proven trading history, the businesses seeking investment would need to adapt their expectations and take more factors into consideration.

Preparing to utilise platforms that incorporate larger sums of money from a sophisticated investor could mean that a business would have to be prepared to give away more equity. This is something that we have to address with companies that we take on at IW Capital. Those companies are well-established and some of which would have pursued other routes to finance previously, such as equity crowdfunding.

Giving away larger sums of equity is often part and parcel of growing a company but knowing how to approach that milestone is key. For businesses, avoiding the temptation of being swayed by large valuations is essential.

Therefore, to reduce the risk of just following the highest figure research is paramount – study your potential investment provider thoroughly then study it again. The valuation negotiated by that investment provider could be essential for future successful raises and for keeping your investors satisfied upon exit. It is important to thoroughly research their past case studies and noting similar businesses that have used that platform or provider before.

The degree of communication between the platform and your investors could also be something to take into consideration when aiming for a larger fund raise; conveying progression, success stories and business milestones during the raise and throughout the company’s lifespan could increase appetite for future investment.

Identifying the nature of that platform’s existing investor network could also be a factor in recognising the potential of that provider, as their passion for a product or sector could influence the degree of investment they are willing to part with and again encourage possible repeat investment in the future.

As a growing business, selecting the right investment platform or investment provider is a huge responsibility and not a decision to be taken lightly. If the equity crowdfunding market does continue to evolve and integrate a larger fraction of institutional money, then those scaling companies will have to adapt and may need to prepare to offer a greater proportion of their equity.

For an entrepreneur, seeking the platforms that do incorporate funds from a sophisticated investor alongside the crowd could be a far more scalable means of raising capital and could pave the way for greater sources of support further down the road.

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06th Oct 2016 11:16

From Twitter user @jeffseedrs:

"Waluation is and should be a market pricing exercise, and the more different investors feeding into that, the better!"

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