Protecting yourself from the downside of crowd sourced funding For business and investors By Jeffrey Luckins on 14/09/18 - Mins to read: 4 minutes The Australian Federal Parliament recently passed an amended 2017 Equity Crowdfunding legislation, granting Small-to Medium Enterprises (SMEs) relatively inexpensive and timely access to capital markets, rather than debt funding from banks; extended payment terms from creditors, or investment from related parties and syndicates of investors. This legislation recognises the importance of providing the right conditions and alternative avenues for the ‘engine rooms of our economy’ to flourish. The SME sector should enjoy the positives that crowdsourcing will bring them – opening access to capital markets, with less red tape than listed public companies on securities exchanges, like the ASX. Furthermore, it gives investors the opportunity to invest in SMEs and gain direct access to businesses, which have solely been the domain of entrepreneurs and successful family-owned businesses. Yet, while it may seem like a panacea for private businesses in Australia and a seemingly wonderful opportunity for investors; there are pitfalls and risks from this type of funding, especially where there is a lack of experience in capital markets. Here’s how to protect yourself from the downside of crowd-sourced funding. For Small-to-medium enterprises While this legislation broadens the base of sources of finance to operate and expand business operations, the risk profile of SMEs which seek to raise crowd funded investment will certainly increase, and without the SME actioning appropriate safeguards, they could be the subject of litigation in a worst-case scenario. Why so? With fewer resources and more elementary governance structures in place, there is a greater likelihood that smaller entities may mismanage the raising of such capital or make forward-looking statements which they can’t support (or which prove to be false). This creates the potential for class action from new investors claiming to have been misled at the time of the fund raising. Moreover, without appropriate advice and support in these capital raising endeavours, the short-term gains of crowd sourcing may result in a dilution of their ownership in the enterprise – or worse still, selling equity too cheaply (and therefore realising a lower capital gain). SMEs must not lose sight of the costs of capital raising. Where debt funding may seem harder and more expensive in the short term; if owners maintain their funding operations from debt- maintaining their equity holding intact – in the longer term by maintaining their equity base they potentially can maximise the return on their investment by selling this equity later at far greater value. The key for SMEs, is to mitigate the risks by planning ahead, and in the first instance consider: Governance: bring experienced people to the business. Consider appointing experienced independent directors to the board including a chairman with a track record of raising capital. Financial managers: most SMEs will have a financial controller in place, but with crowd funding and business expansion occurring they need to consider whether to upgrade to a more strategic and experienced Chief Financial Officer role. Continuous disclosure: implement systems to address continuous disclosure requirements to keep the investors and market informed on a timely basis, consider appointing an experienced external company secretary on an, as need basis. Share registry: given the complexity of managing an investor base, having a professional share registry provider is a relatively low cost and sensible solution. Internal control systems: implement systems which minimise the potential for inaccurate financial reporting, consider having audited financial reports available, including an interim report every six months. Legal advice: seek out lawyers with capital markets experience. Investment and business strategy: have a longer-term investment and business strategy in place, such that any crowd funding monies raised are done so with the longer-term objectives of the business in mind. If crowd funding is to be sought after, SMEs need to do so in accordance with a clear plan for growth or exit, to maximise the value of the raisings and minimise the potential for class actions from disgruntled investors. For Investors Investors also need to carefully assess the risk profiles of these businesses and assess how a crowd funding investment is an appropriate decision in their own investment portfolio. By way of example, the emergence of crypto currencies in the past few years has also provided investors with a new category of investment, but like with crypto currencies, investors have similar issues to consider: Accounts disclosure and assurance: What assurance is available on the financial stability and performance of the investment? Typically, crowd funding does not require general purpose financial reports in accordance with international (or Australian) accounting standards and even if financial information is produced, is there audit assurance issued over it? Size: Size does matter. If a company is too small to IPO, but wants to raise capital from the market, the potential for fraud and error may be higher than in a listed public company. There is no doubt that the smaller the entity being invested in, the higher the risk of the investment, and the return which should be expected. But you need to ask yourself: is this investment in this SME a risk worth taking? Dividends: Are investors really expecting yield or are they investing for growth? What does the dividend policy of the SME look like and has it had a history of paying out profits to the owners previously or re-investing those profits? Key Management Personnel: How are they remunerated and what is being done to lock the best managers into the business? In a listed public company, all this information is disclosed, but in SMEs this information may be much harder to extract. Exit strategy: Does crowd funding provide the investor with the opportunity to sell their investment in an open market? Knowing how to exit the investment should be understood before committing funds. Investment in crowd funded SMEs comes at a much higher risk than a listed public company for which there are regulations, governance requirements, disclosures and much tighter controls over directors and management. If the SME is crowd funding you need to ask why? Have banks decided against lending to them and if so, what were the reasons? The buyer should be aware and should have realistic expectations before investing in a company which provides only very limited disclosure and assurance over its business.