The continued growth of crowdfunding as a popular means of raising finance indicates that it is here to stay. Whilst “crowdfunding” is a general term which describes funds being raised from multiple individuals (whether by issuing debt, equity or rewards and donations, for example), in this article we will be looking only at “crowdfunding” of shares in private companies (equity fundraising) using a mainstream online crowdfunding platform.
It is estimated that in 2018 crowdfunding was involved (typically alongside other private investors) in 22% of all equity investments into high growth British businesses. To put this into context, as recently as 2011 only 8 deals included funding from a crowdfunding site. There are various reasons for this growth, and the ongoing emergence of alternative finance generally. Some obvious examples would be the increasing number of successful exits being achieved by crowdfunded companies, the ongoing desire for wealthy private individuals to pursue tax-efficient investment opportunities, and further investment in crowdfunding platforms by venture capital firms and the crowd itself.
One of the great attractions of crowdfunding through an online platform is that it is generally perceived to be user-friendly. Crowdfunding platforms tend to have very engaged in-house teams who help fundraising companies through the process of issuing equity to investors – usually with relatively accessible, standardised documents. For many start-ups and high-growth companies, the funds raised through the crowd are essential to the continuation of their business, and so there is little appetite to spend hard-earned cash on professional advice to support the raise.
However, professional advisers (primarily lawyers and accountants) can add significant value in supporting a fundraising company through a crowdfunding raise. In many instances it will be cost-effective and proportionate to engage some expert help. Whilst some companies raise funds successfully through a crowdfunding platform without outside help, deciding not to instruct lawyers (even on a lightweight budget) could result in serious problems further down the line, some of which may prove terminal to the lifeblood of the company.
Each board of directors will need to decide on the best approach for their particular company, but here are some scenarios where involving lawyers to assist with a crowdfunding campaign can add value far exceeding the initial cost of the advice.
Choosing your crowdfunding platform
Even at this preliminary stage there are certain differences between crowdfunding platforms that are worth discussing with your legal advisers.
For example, will there be one ‘nominee’ shareholder (managed by the crowdfunding platform) or will each individual member of the crowd be registered as a shareholder of the company? There are benefits to both approaches, but certain crowdfunding platforms tend to favour one over the other – and this might not correspond with your preference.
A shock for many entrepreneurs is the amount of time and effort required to get a crowdfunding campaign over the line – whilst simultaneously trying to drive forward the growth of the business. It is tempting to focus solely on the financial cost of involving lawyers to help with managing and negotiating a crowdfunding raise, but this should always be weighed against the opportunity cost of an entrepreneur being pulled away from the core priority of growing their company.
Due diligence and resolving historical issues
As part of the onboarding process to set up the crowdfunding campaign, a crowdfunding platform will perform due diligence on your company. Depending on the age and progress of the company, responding to due diligence enquiries can be time-consuming and complex – an undertaking with which lawyers are ideally-placed to assist.
Issues will often arise during due diligence which need to be addressed prior to the crowdfunding campaign launching. Typical examples include problems with share capital, commercial contracts and the ownership of intellectual property. Involving lawyers at the outset will help to flag difficulties early, and resolve them swiftly, without causing delays to the crowdfunding campaign and a loss of momentum.
Whilst a crowdfunding platform will often provide assistance with legal documents, it is not providing legal advice to the company, and inevitably, there will be areas where there is an inherent conflict of interest between the company’s/founder’s best interests and those of the crowd.
It is in these key areas – such as the negotiation of warranties, limitations on claims or non-compete covenants from the founders – where independent advice will be hugely valuable; simply because the financial repercussions for the company/its founders of failing to negotiate a fair and reasonable position could be extremely damaging.
As suggested above, the availability of advantageous tax treatment – primarily SEIS (Seed Enterprise Investment Scheme) and EIS (Enterprise Investment Scheme) relief – is one of the primary reasons why crowdfunding has grown so quickly. The majority of crowdfunding opportunities are SEIS/EIS-qualifying, and investors will expect to be eligible for the relevant relief. As we have explored previously, the consequences of losing SEIS/EIS relief can be very severe and great care should be taken to ensure that this only happens where there is a tangible benefit to the parties in doing so.
In broad terms, these reliefs provide three key benefits to investors (in addition to advantageous inheritance tax treatment), which are currently:
Income tax relief of 30% or 50% of the value of the investment (i.e. a reduction to the individual’s tax bill in that year of £3,000 or £5,000 on a £10,000 EIS/SEIS-qualifying investment).
Capital gains tax relief on any gains accrued on the subsequent sale of the shares, with the ability to defer this by investing in another EIS/SEIS-qualifying company.
In the event that the company fails, and a loss is suffered on the investment, loss relief of an equivalent rate to the highest rate of income tax that the individual pays.
The rules relating to SEIS and EIS relief are complex and ever-changing. Whilst crowdfunding platforms will help with certain aspects of compliance (such as issuing the relevant certificates to investors), it is worth obtaining expert advice very early in the life of the company to try to ensure that the proposed structure and growth plans of the business are, and will continue to be, SEIS/EIS-compatible. For example, many companies will apply to HMRC for ‘advance assurance’ that their fundraising will be SEIS/EIS-qualifying, which will typically involve assistance from professional advisors.
Negotiating the shareholders’ agreement and articles of association
Usually, it will be a condition of a successful crowdfunding raise that the company adopt a new set of articles of association and the shareholders of the company enter into a shareholders’ agreement. Typically, these will contain various protections for the crowd, which may include the right to appoint a director or board observer, commercial warranties to be given by the founders, and certain restricted acts which cannot be undertaken without specific shareholder consent.
Crowdfunding platforms tend to offer standard templates which provide a good starting point for negotiations, but sometimes it will be more appropriate to amend these or to use existing documentation. This will be particularly relevant where a company already has angel or institutional investors.
Negotiating shareholders’ agreements and articles of association can be complicated and may challenge even the most experienced investors and entrepreneurs. Even if no other advice is taken, we would always recommend that you ask a lawyer to carry out a red flag review of the proposed documents to highlight potential areas of risk or concern.
Managing the relationship with existing shareholders/investors
Where a company already has a number of existing shareholders and investors, or perhaps is planning to issue shares to investors alongside the crowdfunding raise, quite a bit of relationship management can be required to get the raise over the line.
For example, certain shareholder resolutions will need to be passed to issue new shares and adopt new articles of association, some of which will require the approval of shareholders carrying 75% of the voting rights in the company. This can be a delicate procedure and it can be beneficial to have an experienced legal adviser helping to manage shareholder communications.
Making recommendations and introductions
Over time a growing company will often find that it needs increasing levels of external support – whether from accountants, R&D tax credit specialists or industry experts. It will often be appropriate to explore new, experienced additions to the management team.
Law firms tend to be well-positioned to make these recommendations and introductions and are well-placed to offer an opinion about individuals that will be a good fit for your business – both in terms of skill-set and personal chemistry.
Sorting out post-completion filings and admin
After the crowdfunding raise has been completed, and the funds have been transferred to the company, there will often be a raft of post-completion administration to deal with.
Given that the founders’ primary responsibility is now to deploy the funds effectively and press on with growing the business, it is often sensible to ask lawyers or accountants to deal with updating company registers, submitting Companies House filings and issuing share certificates, where this is not undertaken by the crowdfunding platform itself. In some circumstances these processes can be complicated significantly by the addition of many new shareholders. At this stage, it may be worth considering appointing an external company secretary.
Investors will want to know that the company is being managed properly – and failure to draw together any loose ends can cause real problems with subsequent fundraising efforts.
Supporting post-fundraising growth plans
A successful crowdfunding raise is usually a springboard for various new opportunities and exploits, many of which will require legal assistance. For example, you may be entering into new commercial contracts, introducing new employment contracts, setting up employee share schemes and planning follow-on funding rounds.
As discussed above, there is also the consideration of ensuring that your business plans comply with SEIS/EIS legislation.
Financial promotions and crowdfunding
There is a strict regulatory regime which applies to offering investments (including shares) to the public. Even small fundraises are caught by the legislation, whether or not an online platform is used. This is because when you invite or induce others to engage in an investment activity (for example investing in your company), you fall within what is widely termed ‘the financial promotion regime’.
Whilst the regulation around offering investments to the public and that of financial promotions goes well beyond the scope of this article, it is vital for fundraising companies to grasp that this is a heavily-regulated area, with potential for financial and criminal sanctions if breached. It is also essential to understand that whilst commercial crowdfunding platforms are regulated by the Financial Conduct Authority (FCA), and therefore able to promote their fundraising companies within the parameters prescribed by it, this does not give fundraising companies themselves carte blanche to promote their pitch in whichever way they see fit. This is equally important where the fundraising company is communicating with potential investors outside of the crowdfunding platform, for example via email or social media.
If you have any concerns about financial promotions and crowdfunding, then expert legal advice should be sought at the earliest opportunity.
Next steps: finding a suitable law firm
If you decide that you are going to need some legal assistance with your crowdfunding campaign, the next step is to find a suitable firm. You should check that the firm has sufficient expertise to help you where required, and identify a lawyer you can get on well with and who understands what your company is trying to achieve.
If you are concerned about fees and proportionality, then you should ask your lawyer to quote on a phase-by-phase basis so that you can make an informed decision about those stages of the process with which you most need help.
Michelmores has advised numerous clients raising funds from the crowd, including Mindful Chef (on its campaigns with both Seedrs and Crowdcube) and Velorution. We advised Downing LLP on the launch of Downing Crowd and Triodos, the sustainable bank, on the launch of its own crowdfunding platform.
This article is for general information only and does not, and is not intended to, amount to legal advice and should not be relied upon as such. If you have any questions relating to your particular circumstances, you should seek independent legal advice.