An Investors' Perspective
Investor-led and entrepreneur-led crowdfunding: horses for courses
So, you know the difference between the types of crowdfunding – rewards, donation, lending and equity. Now it’s time to delve a little further and understand the two types of equity crowdfunding being spruiked: investor-led and entrepreneur-led. We introduced this concept a few articles back and there’s good reading elsewhere exploring this topic.
As we’ve alluded to before, investor-led equity crowdfunding could be best described as ‘letting the experts decide’ how startups can be funded. In general, angels or VCs create syndicates, lead the investment and negotiate share terms, and open the deal to the crowd (or, more usually, a majority of accredited investors) to invest alongside the professionals.
The entrepreneur-led equity crowdfunding model, on the other hand, is ‘letting the crowd decide’ which startups should be funded. Generally, these could be categorised as an online market where the entrepreneur chooses their own terms for taking investment and investors have a direct shareholding in the business.
The distinction may be minor, but the implications can be dramatic.
In attempting to assess the implications for investors, we’ve taken a stop light approach to the question. Green signifies a favourable impact, orange poses challenges but can be overcome, whilst red signifies a generally unfavourable event that may require significant time input with no guarantee of a positive outcome. Read on as we compare and contrast the different approaches to leading an equity crowdfunding deal and the implications this has for investors.
Due diligence - the investigation or audit into the business, its financials, management, legals, clients, competitors and market validity - can be an intensive process involving external financial and legal consultants, at a cost. At a minimum, lower level “desktop due diligence” involving reviewing the high level information provided by the entrepreneur, can be time consuming for the investor.
Investor-led crowdfunding would lean towards more in-depth due diligence, provided at a cost to the investor or entrepreneur, while the entrepreneur-led crowdfunding would lean towards desktop due diligence with additional checks focused on potential fraud of the business and / or management team.
Note: due diligence in itself does not improve the prospects of the success of the business.
Investors are likely to receive more favourable investment terms in negotiated investor-led deals, the drawback being that there will generally be costs to the investor, often upfront as well as carried interest on the investment. However, this can be somewhat offset by the lead investor providing more professional investment terms and an ongoing advisory role utilising their expertise.
Entrepreneur-led investment terms as expected are more favourable for the company but are to an extent, self-regulating, as potential investors are unlikely to be attracted to wild valuations and unfavourable share terms. In general though, there are likely to be less investor protections offered in these types of deals as there is minimal negotiation of investment terms prior to the offering.
Investor-led deals is the more expensive option in this regard as there are generally costs every step of the way for the initial due diligence, subsequent negotiation and syndicate creation, which could be in excess of $10,000. Of course, this level of rigour has appeal in providing peace of mind to the investor. Entrepreneur-led deals generally have no upfront costs for the investor but each investor thus conducts most due diligence and research.
There are generally ongoing costs associated with investor-led syndicates including director’s and advisory fees, however this comes with the added advantages of ongoing advice and strategic direction from angels and VCs to the entrepreneur. There are generally no ongoing costs to investors investing in entrepreneur-led deals, but apart from their own advisory committee, if any, there is a heavier reliance on the entrepreneur’s vision and business acumen.
Investor-led deals can be more difficult to access for retail investors as angels and VCs are often presented with private deals. Consequently these deals tend to be less consumer focused – unlike the majority of entrepreneur-led deals – and more intangible in the nature of their business models, e.g. food testing technology or e-commerce backend technology.
In contrast, entrepreneur-led deals open up an array of deals previously unavailable to retail investors and democratising the flow of capital and equity. The major pitfall is that a small percentage of offerings may fail to meet reasonable investment standards which is where the onus falls back on investors to correctly identify a sound investment.
Investor-led deals are generally less transparent as information from entrepreneurs are filtered through the lead investor, with a crowd investor’s financial interest held in units in a syndicate rather than direct shareholdings - although there are exceptions to this. Entrepreneur-led deals offer a direct shareholding in the company and appeal to investors who like direct ownership and control. The downside to this is that there can be additional administration in managing direct shares both for investors and entrepreneurs.
Both the investor-led and entrepreneur-led models provide the investor with a level of control over their initial investment – giving the investor a choice of whether or not to commit to any one particular company – and the ability to build one’s own venture capital portfolio. However, the separation of an investor’s shareholding through an intermediary structure (such as a syndicate) in the investor-led model, generally means that some investment decisions will be made by the Angel or VC on your behalf. In contrast, entrepreneur-led crowdfunding allows investors more say in their dealings with the company, but the cost being that there is additional administration.
Investor-led deals effectively give retail investors the chance to free-ride on the expertise and negotiating skills of experienced investors, saving time and minimising some of the risks associated with less in-depth due diligence. Negotiation time is lengthy however, and opportunities can be missed as a consequence.
In contrast, it is up to the crowd investor the extent of due diligence they require before making the decision on the merits of the offer in entrepreneur-led deals.
Companies taking an investor-led approach can have the added advantages of the VC or angel’s professional networks and subsequently benefit by this expanded experience and potential source of backers. For entrepreneur-led deals, the breadth of possible crowd investors can provide similar benefits, utilising their own networks to assist the startup with industry connections which potentially could improve startups’ prospects.
Clearly there are benefits and drawbacks to each approach and, as part of the capital democratisation process, the onus is placed back upon the investors to make informed decisions that best suit them.
There are also service offerings in entrepreneur-led campaigns that lean towards investor-led style investment and vice versa. There are a myriad of choices as the equity crowdfunding industry develops from its relative infancy, investors will make the decision that suits their investment criteria – from the individual merits of a startup’s campaign to the comfort with either the investor- or entrepreneur-led model. In most cases, investors will choose a startup that appeals, and then determine whether they are comfortable with the terms offered.
As with all things, a smart portfolio is probably going to be composed of diverse elements from both investor- and entrepreneur-led approaches, mixing fun with pragmatism, satisfying both emotional and rational investment needs. In this regard, exciting developments in the equity crowdfunding sector opens considerable pathways for investment opportunity and success. It’s up to the crowd to decide what’s best for themselves and then vote with their mouse click.
As a general note we envisage that equity crowdfunding approaches, we will ultimately meet in the middle as learned experience guides the appropriate balance between investor interests and entrepreneur reward. Similarly, we foresee strong uptake in both investor- and entrepreneur-led approaches with the adoption of each dependent on the particular business proposition.