Last month the Securities and Exchange Commission (SEC) in the United States released a proposal that paves the way for “equity crowdfunding”.
Unlike existing crowd-funding platforms such as Kickstarter and Selfstarter, who are only permitted to pre-sell products to raise funds, this form of crowd-funding will allow start-ups to raise capital by selling shares online directly to the public, cutting out the involvement of investment banks and stock exchanges.
Using crowdfunding to raise equity has great potential to address the current capital shortages facing many young and emerging Australian start-ups.
Existing channels through which these companies can be funded have proved inadequate. And it’s given rise to a “capital gap” when it comes to financing innovation in the Australian economy. While equity crowdfunding is not the silver bullet, it can go some way to plugging this gap.
Potential equity crowdfunders should be under no allusions in regard to the riskiness of early stage investing. But then why should we expect them to fill this gap when professional investors and more conventional capital sources have failed to do so?
What crowdfunding has shown us is there is a willingness to tolerate investment risk when the end product solves a significant problem for the investor, or holds some other intangible or non-monetary value.
It is well documented in the academic literature that certain investors are willing to pay higher prices (or bear more risk) when they receive or create unique synergies from ownership. We often see established corporations make strategic investments into startups when it could bring synergistic gains to their own business.
Equity crowdfunding applies this concept to the individual investor. And compared to existing crowdfunding, it offers more upside to investors who at present benefit solely from owning a new product at a discounted price.
Australia’s success rate in funding and commercialising innovation lags behind most other advanced economies. Addressing the lack of funding for start-ups is critical because it is these firms that drive the economic transformation needed to respond to new challenges and requirements of a dynamic global economy.
Australian startups have traditionally been forced to rely on three main avenues to raise equity capital.
The first avenue is a public listing. Unlike the Nasdaq exchange in the US, Australia does not have a secondary stock exchange that caters for young firms.
In the past, young firms listing on the ASX have been burnt by a lack of investor interest and an inability to evaluate their long-term prospects. Take Australian biotech CogState whose price halved in the first few months of trade despite being a world leader in its sector. Such listings are not likely to take place again in the near future.
Publicly listing is also expensive. Investment banks take around 7% cut of the issue proceeds. This cost is often dwarfed however, by the discounted share price at which IPO firms sell relative to their first traded price on the exchange. Despite Twitter’s recent stock market debut being hailed by the media as “stunning” and “spectacular” in reference to its 73% climb above its offer price, this is in fact yet another enormous cost of publicly listing borne by Twitter’s entrepreneurs.
Imagine someone bought half of your business today and then sold it tomorrow for 73% more to someone else. How would you feel? You might be scratching your head asking why you paid the investment bankers so handsomely for advising you to sell at this price. Cutting investment banks out of the picture through equity crowd-funding makes a lot of sense for start-ups that can hardly afford these costs.
The second avenue of funding is venture capital. Only a minute trickle of the billions of dollars locked up in superannuation funds in Australia has made its way to venture capital funding vehicles, with fund managers claiming the returns have not been good enough.
As a result, only a handful of venture capital funds have been raised in the last 5 years. The lack of availability of venture money is not the only problem. Entrepreneurs are often reluctant to take it because of the restrictive conditions attached.
Finally, many startups rely on internal funds such as personal savings and loans from “family and friends” who invest, until the business can sustain itself. Many recent Australian success stories have emerged solely from this type of financing such as Envato and Atlassion. But not all firms have this luxury. Some startups require large amounts of capital and need it fast as they compete in industries where capturing users by getting products to market first is essential.
The ability of equity crowdfunding to circumvent many of the above limitations by tapping a new pool of willing investors has the potential release a significantly larger amount of much needed capital to fund Australian innovation.