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Jul 22, 2015

The Equity Crowdfunding Experience in the UK and Sweden: Implications for Angels

I pass on a recent Angels Insights Blog post of the Angel Capital Association.  The question of allowing non-accredited investors (less than $150,000 annual income or net worth excluding residence less than $1 million) to make investments in non-public companies is being actively debated.  The SEC is considering loosening its rules to allow non-accredited investors.  This change is often called “equity crowdfunding”.  Current crowdfunding approaches are generally pre-purchases in which the person providing money expects to receive a product or service.

Seventeen states and the District of Columbia now allow non-accredited investors to invest in startups located in their state. As more states follow suit, it is useful to look at data detailing other countries’ experiences. Both the UK and Sweden have experimented with “equity crowdfunding” for non-accredited investors for a number of years now. Their experiences so far have been interesting, as have the implications for the UK and Swedish angel communities.

A 2014 report estimated that equity crowdfunding grew by 201% in the UK in 2013-2014, with an average amount raised of £199,095. Thirty-eight percent of investors were professional or high net worth individuals, who tended to have a larger average portfolio size (£8,000). For retail investors the average amount was only £4000.

A key lesson from the UK relates to information provided by equity crowdfunding platforms. A study conducted by the UK Financial Conduct Authority noted that the material on some of the platforms was misleading, especially in terms of how shares would be treated in the event of a buyout. The platforms implied equal treatment when in fact they would be diluted in the event of a VC round. This issue will become more important as crowdfunding grows. In order to make crowdfunded investments more appealing to later investors, an increasing number of deals in Europe have pre-negotiated clauses specifying that crowdfunders will be bought out at a set price in a later funding round.

Interestingly almost 95% of the funded deals were eligible for the country’s angel tax credit programs, providing significant income tax relief and no capital gains tax on stock held more than three years.

Although tax credits have proved useful in stimulating angel investing in the US, it is unlikely that they would be able to be used concurrently with crowd investments. As seen below, some states require a minimum investment well above the average crowdfunded amount.  Others are open only to accredited investors or have almost impossible filing requirements for the business. This difficulty could be exacerbated when the SEC finalizes rules for Title III of the JOBS Act, allowing interstate investment along with in-state programs.  For instance, the business is required to file investor details with the state tax authority.  Since only some investors would be in-state, this quickly becomes burdensome.  States also require different holding periods for equity, which would mean the business would have to keep track of which investors were allowed to sell and which were required to hold. Of course, a federal angel tax credit could quickly alleviate many of these issues.

Reasons Why Current State Tax Credits Could Not be Used for Crowdfunded Investments

1.  Required minimum investment too large for most crowdfunders:  Arizona, Connecticut, Maryland, Michigan, Minnesota, Nebraska, Utah
2.  Required holding period: Georgia, Hawaii, Illinois, Iowa, Louisiana, Maine, Maryland, Minnesota,  Nebraska, New York, North Carolina, North Dakota, Ohio, Utah, Vermont, Virginia, West Virginia, Wisconsin

3.  Preclusive filing requirements on part of business (and for investor when application requires substantial details about the business):
Arkansas, Colorado, Kansas, Maine, Maryland, New Jersey, North Carolina, West Virginia, Wisconsin

4.  Filing requirements that may not be worth the  administrative costs if only a few in-state investors  could take advantage of it:
Georgia, Illinois, Indiana, Iowa, Nebraska, New York, Rhode Island, South Carolina

5.  Accredited investor specified:
Georgia, Louisiana, Minnesota, Kansas, Kentucky, Nebraska, New Mexico, South Carolina. Wisconsin

6.  Application fee for investor: Maine New Jersey

7.  Requires investment in VC fund, University or angel group:  Iowa, Michigan, Oregon

Sweden’s equity platform, FundedByMe, has been around for a number of years. Its market is estimated at between 385 and 450 million EUR per year, about the same size as the formal Swedish venture capital market. As with the UK tax sweeteners, a number of organizations offer added incentives. For instance, the Internet Infrastructure Foundation .SE, tops up the amount a crowdfunding entrepreneur receives to 100% if he/she manages to raise 50% or more of the requested amount on the FundedByMe platform. Despite this, research shows that only 17% of equity investors are repeat investors, suggesting that equity crowdfunding is not becoming the investment mechanism of choice for many Swedes. Entrepreneurs have also expressed concern about having a large number of individuals with equity in their companies and the difficulty of coming to consensus on big decisions. Others were concerned about “tracking down and convincing lots of individuals to sell if they tried to sell the company later.” IT entrepreneurs in particular preferred angels who often “better understand” complex IT business plans.

Equity crowdfunding has a number of potential benefits for startups, including the ability to test and build a market and access to a greater pool of investors. Unfortunately, it also has potential costs:  reputation effects if campaign goals are not met; IP exposure; donor exhaustion; and time spent “working the crowd”. The up-front costs are not small either. Over and above the required accountant fees, UK platforms in 2013 charged between 5 and 12%, often with a further 3-5% processing fee. Certain platforms such as Seedrs are taking steps to address the costs, standardize offerings and educate retail investors about all risks. On others they will remain a significant factor. These costs suggest that non-accredited equity crowdfunding is not the answer for every startup.

As it becomes more popular, reviewing other countries’ experiences can help work out where and how the mechanism is best leveraged by firms and angels. Here’s hoping American policy makers can learn from these experiences and adapt programs to maximize their impact here.