Stakeholder Relations: Top 5 Equity Crowdfunding Trust Barriers

Early stage companies now have a whole new way of raising vast sums of money for their ventures. Crowdfunding is the newest vehicle for financing anything from a cause to a business. To date, most crowdfunding has been for charitable causes, such as the famous ALS Ice Bucket Challenge that raised $88.5 million. Recently, businesses have adopted rewards-based crowdfunding campaigns, the most notable being Pebble Time Smartwatch that raised $20.3 million in discounted pre-orders. However, equity (including debt) crowdfunding, which is the newest form of crowdfunding, promises to be the most significant. Barely two years old, early, high profile success already has Neil Young’s PonoMusic Player raising $4 million in total financing, even after having turned away millions of dollars from investors who failed to satisfy regulatory requirements; on the heels of already having raised $6.2 million from a pre-order rewards-based crowdfunding campaign.

It is the people who were turned away, the same category of individuals who, to date, have been funding cause and rewards campaigns at ten times the value of the largest equity crowdfunding campaigns, who will be the key to unlocking the full potential of this new digital medium for business investment. It is these non-accredited investors, namely ordinary people like you and me, those not deemed to be high net worth individuals, who hold the keys to the ultimate promise of equity crowdfunding. They will be the game-changers that fuel future new business creation. They are also the people who are currently barred from investing through equity crowdfunding in most jurisdictions around the world. This is about to change, as newly proposed regulations, most notably in the U.S. Jobs Act, are going to give the rest of us an opportunity to also participate in this super-high-returns asset class.

Major change, such as this, will be disruptive for all concerned, from issuers, to investors, to all traditional intermediaries that facilitate the early stage venture investment process. Change is difficult, fraught with well-founded fears, as well as inevitable misconceptions that foster resistance. Despite the promise, issuers and their chosen crowdfunding portals will need to adopt innovative new ways to overcome significant barriers inhibiting investor acceptance. Many so-called, early adopters are bound to experience remorse and rouse public indignation before norms and common understandings are established. Already, a high profile example has emerged from the Oculus Rift (virtual reality headset) rewards crowdfunding campaign that provided a preview of the implications of unmet expectations, when “crowdfunders” expressed public outrage over a perceived betrayal of trust upon hearing of the company’s sale to Facebook for $2 billion, because their “donated” funds would no longer be needed (fueled by underlying remorse that they had not had an opportunity to invest in company’s shares instead). Equity crowdfunding initiatives must be diligent not to fall into similar expectation traps.

Sophisticated investors, such as angel investors and venture capitalists will also need to adapt to the new realities of equity crowdfunding that threaten to disrupt established business models and open opportunities for new ways to create value. Portal-supporting ecosystems of 3rd party services providers (e.g. lawyers, accountants, consultants, technologies, marketing, governance, compliance, insurance, derivatives, secondary markets, etc.), regulators and broker/dealers will need to evolve to support simplified, low cost, volume-based transaction flows.

More than ever, issuers’ stakeholder relations practitioners will become a critical success factor. In addition to traditional investor relations, which deals primarily with matters of corporate governance, corporate social responsibility, and shareholder management and communications, for crowdfunding, stakeholder relations becomes event-based; more akin to an initial public offering than steady-state relationship management. Crowdfunding demands new, high standards for stakeholder “engagement” that progresses investors through the entire transaction lifecycle (discovery and evaluation, negotiation and fulfillment, commitment, settlement and compliance, and exit), helping smooth all friction that could impede capital (or debt) deal flow. The most significant areas of abrasion reside with the novel aspects of equity crowdfunding:

1. Limited Liquidity

By definition, unlike publicly listed companies, private companies cannot easily sell their shares on secondary markets. That means investors in private companies can neither buy nor sell their shares without involving the issuer. Private equity investors are therefore considerably more committed to their investments than those holding publicly listed shares that trade on a stock market. To mitigate their liquidity risk, equity investors typically get very close to the business and its owners.

In most cases, start-up investors are the founders themselves, together with their families and friends. Founders are held to account through their strong personal and community ties. Subsequent rounds of financing come from increasingly distant circles of trust. These include angel investors who establish close relationships with the founders of the business, followed by sophisticated venture capitalists who rely both on familiarity with the founders and management, and the critical success criteria for the business and their investment.  The latter pay particular attention to how they will realize their return on investment (their exit strategy), either by selling their shares to an acquiring company, or by taking the company public.

By contrast, crowdfunding investors primarily fund angel rounds, with limited ability to know the founders. Although digitally intermediated crowdfunding opens new opportunities for enhancing stakeholder relations effectiveness, it also introduces special challenges, since they also need to bridge the requisite investor-to-founder familiarity gaps that could otherwise give suitors cold feet when contemplating the reality of being locked into prenuptials that largely preclude them from initiating future divorce proceedings - namely selling their shares.

2. Novice Crowdfunding Investors

Accredited investors are accustomed to relying on investment dealers to provide professional investment advice. However the Exempt Market Dealers, who once played an advisory role and now run the neutral and transparent equity crowdfunding portals, can no longer advise their former clients. In crowdfunding, even sophisticated investors will need to learn new, non-traditional ways of assessing their investment options, which could retard the investment transaction process even for those who are most qualified to invest.

For the first time, non-accredited investors, those deemed less capable of making informed investment decisions, will also have access to these early stage investment opportunities (already available in some provinces under the Offering Memorandum Exemption), although likely with some protective restrictions. However, their prior investment experience, if any, would likely only have been with publicly traded shares, which they could sell, at will.

Stakeholder relations will need to find new ways of connecting both classes of investors with resources that appropriately help each navigate new crowdfunding-related risks and provide mechanisms to render any residual uncertainties acceptable (e.g. escrow, insurance, guarantees, warranties, derivatives, etc.)

3. Empowered Digital Crowds

Social-media savvy, online investors are likely to have non-traditional investment expectations. They are accustomed to having bidirectional communication with decision-makers via direct, online channels of communication, such as blogs and social networks, and are likely to have elevated expectations for issuer responsiveness. They also feel entitled to reinforce their views by mobilizing similarly minded activist “crowds” to drive change by creating collectives and aggregations that amplify their voice. Digital crowds also tend to trust and rely on the opinions and support of like individuals, more than traditional so-called “experts”.

These new dynamics have implications beyond issuer-investor relations that include cultivating healthy engagement among critical stakeholders themselves, including investors, opinion leaders, and the influential portal ecosystem of services providers.

4. Shotgun Deals

Traditional private equity investors have some control over the investment agenda, timing their investment commitments to coincide with their confidence and comfort thresholds. In other words, they take their time to build trust in the company before finalizing the deal. Similarly, public company shareholders choose when to buy and sell their shares based on individually selected criteria, such as personal preferences and market conditions.

Crowdfunding takes away much of that ability to time investment decisions, since crowdfunding campaigns typically run within time-limited, 30 to 60 day windows of opportunity. Stakeholder relations will need to adjust their engagement strategies to satisfy the needs of diverse investors in order to maximize participation.

5. Ambiguous Shareholder Rights

Experienced private equity investors rely on established practices for post-investment decision-making. Typically, if they hold a significant stake in the company, they are entitled to a seat on the board of directors, or at least can influence the selection of board members. Unaccredited investors, by contrast, might only be accustomed to exercising their proxy voting rights in publicly listed companies, with marginal, if any, influence over director selection, but they can always sell their shares if they become unhappy with corporate decision-making.

Decision-making at early-stage private companies usually resides with the founders alone, with some influence from founder-selected family and friends board members. Their corporate governance practices tend to be less well defined, if not non-existent, and therefore generally unknown to shareholders. While all have equally locked-in investments, only majority shareholders have the power to force management to initiate a liquidity event, which tend usually to be the founders themselves. Equity crowdfunding inherently attracts larger numbers of less-empowered, minority shareholders, therefore mitigating their liquidity risk will become a major consideration.

Post-campaign, the new capital stockholders (as distinct from secondary market shareholders) are likely to feel a unique sense of company entitlement. This poses an added challenge for issuers, of how to optimize their investors’ participation in company decision-making.

Before equity crowdfunding can realize its promise, portals will need to develop new, crowdfunding-optimized corporate governance standards for issuers and introduce other means of protecting shareholders from becoming disillusioned with their investment. Stakeholders relations needs to play a proactive role in engaging with the crowdfunding community and helping portals devise effective and practical trust enabling practices, such as promoting the proliferation of secondary markets (e.g. TMX and Aequitas). Particivesting (participatory investing) that establishes equitable decision-making rights for its capital stockholders will be critical for equity crowdfunding success, and promises to ultimately become its distinguishing quality.

Author: Alex Todd, Principal at Trust 2 Pay, delivers game-changing insights to FinTech ventures.