Investors crowd in to fill the equity gap for start-ups

Few countries have more reason than Britain to be wary of unlisted equity investment. The 18th century South Sea bubble is part of national folklore. Investors are weaned on the folly of speculating in ventures that promise to pursue an "undertaking of great advantage, no one to know what it is". Yet recent years have seen the rekindling of the long-dormant embers of early-stage investment. Alongside the growth of institutional venture capital - a trend that has nurtured the UK's expanding technology scene - there has been an upsurge in equity crowdfunding.

While still far from mature, interest is growing fast. Retail investors put £84m into crowdfunded ventures last year, up from £3.5m two years before, according to Nesta, an innovation charity. There are now around 30 online platforms catering to those brave souls who wish to chance their arm on unlisted shares.

This is a pared down service. Most sites provide little more than an explanation of the businesses seeking capital, some biographical information on the founders and a set of financial projections. While platforms have an interest in vetting promoters if they wish to flourish as marketplaces, how closely they have looked will only become clear when the first cohort of ventures matures.

There are reasons to celebrate the growth of crowdfunding. There are few options beyond bank loans for young companies trying to raise less than £1m. Many entrepreneurial businesses get becalmed in the so-called "equity gap".

Whether crowdfunding will deliver satisfactory returns to investors is more open to question. Just as with the speculators of Change Alley, many neophyte punters seem to rely on the "wisdom of crowds" in deciding where to place their bets. Money is thrown at consumer-facing businesses or those associated with well-known businessmen. Investors place too much credence on slick videos, in which promoters peddle their wares.

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Valuations matter because of the nature of early-stage investing. The attrition rate is extremely high: many crowdfunding websites make clear that up to 90 per cent of start ups pitching for funds will fail. The only way to make money is to assemble a portfolio of businesses, hoping that one or two of them do fantastically well. Pay too much up front, however, and even the wins may not offset the duds.

Buying shares at high multiples is not the only way that investors limit their chances. They don't always pay sufficient attention to the legal terms, snapping up shares with weak rights, including the ability to be sidelined by insiders and heavily diluted in later rounds of fundraising.

<>"The first big scandal in this area will come not when someone loses a lot of money in a failed business, but when someone has invested in a great business deal but the contract wasn't properly structured and they don't make any money," says Jeff Lynn, chief executive of Seedrs, a large UK crowdfunding platform.

After the South Sea Bubble, lawmakers clamped down and the joint-stock company was outlawed for 150 years. Modern day regulators are more willing to live and let live. In any case, there is little scope for the heavy hand. The average size of a crowdfunding deal is £200,000 and the mean investment size just £1,599. Weighed down with rules, the industry would wither.

Change can only come from within. Aside from better education and decent vetting, a simple few tweaks might protect investors. Platforms should make sure it is easy to build diverse portfolios and manage them. More of them should group punters together under common ownership structures both to maximise their leverage and to facilitate post deal oversight. Investee companies should be obliged only to sell securities that have no worse rights than any other investor.

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