The trouble with crowdfunding

You’re no one in the world of food & drink startups if you haven’t amassed a loyal army of shareholders willing to part with their cash for a piece of your company. Turning to the crowd for capital to fuel early stage growth is practically a rite of passage for young brands.

Since its tentative first steps in 2011, equity crowdfunding has become a mainstream source of funding. Over 900 companies (many from food & drink) have raised almost £500m from thousands of investors in the past six years with the lion’s share committed since 2014, according to alternative finance analyst AltFi Data.

“Crowdfunding has become a lot more mainstream. It’s made the transformative step from the route of last resort to a genuine financing source of choice for many businesses,” says Luke Lang, co-founder of Crowdcube, the biggest crowdfunding platform.

So with businesses no longer reliant on banks, is crowdfunding here to stay? What’s the success rate for crowd-funded startups in food and drink? And is there adequate protection for punters or do the sceptics have a point?

The most successful exponent of crowdfunding is BrewDog, whose iconoclastic image has been perfectly complemented by its use of this alternative channel to raise £26m, culminating in the sale of a minority stake to US private equity earlier this year valuing the punk brewer at £1bn and giving its crowdfunding shareholders returns of up to 2,800% - on paper at least, if not in cold, hard cash. And fellow craft brewer Camden Town had a hugely successful exit too (see box below).

But worrying cracks have started to appear in the foundations - and the authorities are investigating them. Ahead of a regulatory review from the Financial Conduct Authority due in July, its initial findings in December found it was difficult for investors to understand the risks and returns of crowdfunding, that marketing material was sometimes unclear and misleading, and some firms did not manage risks and conflicts of interest properly.

And then there’s the failure rate. Data from analysts at Beauhurst shows just 1% of the 930 companies to raise money so far have provided an exit for investors, while 10% are now dead, with another 1% effectively zombies. This compares with a 10% exit rate and a 7% death rate for businesses backed by VC and PE in the same time period (although the majority of these are less risky investments).

On the other hand, it’s early days: most of the crowdfunders have only raised their funds since 2014 so haven’t had time to prove themselves - or burn through the cash - yet. And a report by AltFi says crowdfunded businesses have actually performed “impressively”, with an average annual paper return of 8.55p for every £1 invested - with a high proportion remaining active.

But the failures create quite a stink. Claims management firm Rebus raised £800,000 on Crowdcube in 2015, but after it collapsed in 2016 it emerged the business failed to inform investors of its precarious financial position in the pitch. Crowdcube admitted it was not aware Rebus had hired insolvency firm Resolve in 2014 to advise it on cashflow issues and promised to beef up its due diligence.

A few months later Solar Cloth Company proved an even bigger failure, burning through the £1m it raised on Crowdcube in less than 18 months.

It’s a similar story this year at cycling clothing start-up Vulpine which, as The Times reported, launched a £750,000 Crowdcube campaign even as it was teetering on a cliff edge. The pitch was pulled before hitting its target. Days later, it was in the hands of administrators.

Food and drink has not been immune to controversy either. In March The Grocer revealed that gluten-free food maker Feel Free, which supplied the multiples and indies, had gone bust after raising more than £370,000 in two Crowdcube pitches in 2013 and 2015.

The administrator’s report was damning. It emerged that in its fundraising prospectus, valuing the business at £2m, and forecasting sales of £7m by the end of 2017, owners Sally and Stuart Allister had failed to tell investors that Feel Free had collapsed before, in 2012, owing creditors £400,000, and had made nothing but losses since it returned.

Crowdcube admitted it was unaware of Feel Free’s past failings but promised the situation couldn’t re-occur due to improvements in due diligence.

It is not the only example in food and drink – Lick Frozen Yoghurt also entered liquidation around the same time as Feel Free leaving 293 investors almost £300,000 out of pocket – but it certainly the more egregious so far.

Not surprisingly such failures are raising more than a few eyebrows.

Rotten

“Crowdcube don’t know a rotten apple when they see one,” says Rob Murray Brown, author of blogsite The Truth About Equity Crowdfunding and founder of ECF Solutions, a consultancy for businesses using crowdfunding and investors. “Very few ‘entrepreneurs’ on this site seem to have a clue how to start and grow a business. It is an incredible waste of investor cash and businesses’ energy. Not to mention the loss to HMRC in tax reliefs and collapsed business debts. It certainly is no help to UK Inc to have half-baked, poorly planned businesses getting access to what has been fairly easy money up till now.”

Fair? Lang argues the failures are down to the normal cost of doing business and points out that investing in any start-up is inherently risky. “We’re totally confident with all businesses that list on Crowdcube that we do the appropriate and necessary due diligence. We have a team of finance professionals and we have been doing this for six years. But we are keen to always be improving, and investor protection is a top priority.”

At Seedrs, which has raised more than £220m from over 500 deals (though not all of them have been crowd funded), chief investment officer Tom Davies claims it is more rigorous than others. “We decided to make our potential customers’ journeys harder to benefit our investors. We will lose potential customers on the way as they go to other platforms where it is easier, but that was a commercial decision we made.”

“It is no help to the UK Inc to have half-baked, poorly planned businesses getting access to what has been fairly easy money”

Charlie Thuillier, MD at ice cream brand Oppo, which has raised £800,000 in three campaigns on Seedrs, believes the due diligence process is “absolutely more than thorough enough”. “We have written three pitches and every single statement is verified and checked for accuracy,” he says. “If I say we are in 3,000 retailers, they want proof. If I say we have a certain director on board, they want proof.” And all the brands The Grocer spoke to - using both Seedrs and Crowdcube - confirm that readying a pitch to go live is an exhausting process.

Wildly optimistic

Due diligence is by no means the only area of concern in crowdfunding, though, with eyewatering valuations a constant source of criticism.

Murray Brown, one of crowdfunding - and Crowdcube’s - harshest critics, says “projections are always far too optimistic and companies always underestimate what it will cost to get to where they say they’re going. You go to Crowdcube and it is like entering Disneyland.”

Chris Silverwood, MD at Corpfin Capital, which runs Investor Bank, a group of 75 high net worth individuals investing in post-seed, pre-private equity businesses, adds: “The normal metrics of investing don’t exist. You very rarely see a sensible percentage of equity given away. A private individual investing £1m would want to triple their money over a three to five-year period. If you look at valuations of the crowd there is no way you will triple your cash as the businesses would have to sell at such a ridiculous multiple.”

Valuations in the food & drink space are certainly quite rich in some cases. Fast-growing Scottish brewer Innis & Gunn was valued at £50m after an oversubscribed fundraising round in late 2016, despite making a loss on sales of £12m, according to 2015 accounts.

And Crowdcube darling Cauli Rice, which has raised more than £3m in four funding rounds in two-and-a-half years, was valued at £10m, despite losses of almost £1m in 2016, and was £1.4m short of its £2.9m sales projection in one pitch. The business is, however, stocked in an impressive 2,800 stores across the major multiples, and founder Gem Misa - an early adopter of crowdfunding, who first used the crowd in 2012 for her salad dressing brand Righteous - explained to investors that forecasts fell short due to phasing issues around the introduction of listings. However, a November 2016 investor update for the Righteous business seen by The Grocer reveals the brand admitted to shareholders that major delistings of its salad dressings had “significantly” reduced the valuation of the business.

However, Lang points out, Camden Town was widely derided for being over-valued and six months later was bought by AB InBev for £85m, delivering 3x return to investors.  “It is very easy to criticise valuations but they are highly subjective and even professionals can get them wrong,” he says. “Ultimately a company is valued at the price people are willing to buy the shares at, and over 54% of the investment via the platform comes from high net worth and sophisticated investors.”

Nonetheless Murray Brown warns forecasts wildly miss the mark a high percentage of the time.

After tracking 395 companies funded through Crowdcube and comparing their profitability in the latest financial year with projections, he discovered a £175m shortfall. Of the 200 sets of accounts available, 187 (or 93.5%) fell short, with an average miss of £930,000. Of the 13 companies that hit or exceeded expectations, Murray Brown says half only did so because they failed to secure further funding so plans had to be put on hold and losses were narrower than they would have been. “Companies have promised the earth but delivered absolutely nothing,” he says. “No one is regulating this, even the platforms, which just have a small sign saying they are not liable for projections. The more glamorous the projections the better the valuations and the less equity you have to give away. Entrepreneurs always believe their company is going to be the next success.”

Lang hits back: “Projections are always clearly marked as not being an indication of future performance. Entrepreneurs, by their very nature, tend to be optimistic and looking to grow quickly. The notion that investors are being misled is completely false.”

Questions have also been raised over whether the big successes of crowdfunding (see box) actually delivered value for crowdfunding shareholders.

BrewDog sold a 22% stake to US PE firm TSG in April for £213m, valuing the business at an enterprise value of £1bn. Founders James Watt and Martin Dickie split £100m between them, while retaining majority control. But the 50,000-plus Equity Punks, who have ploughed an astonishing £26m into the business since 2009, were limited to selling up to 15% of their shares, capped at 40 shares, a maximum return of £527, no matter what round of investment the shareholders came in at.

Murray Brown says the shareholders are left holding massive risks with none of the reward. “It didn’t ring punk to me,” says Brown.

Silverwood adds this is what happens when dealing with “uneducated capital. Professional investors would never allow it, they would demand the same deal as management.”

BrewDog points out investors in the earliest funding round have seen an increase in value of 2,765%, with those who invested in 2016 sitting on an impressive 177% rise. And to be fair to the brewer, more than 90% of shareholders agreed to the temporary removal of their pre-exemption rights to allow the deal to go ahead.

“We also offered investors the chance to retain 100% of their shares, and celebrate their investment with a free six-pack of a new beer,” Watts says. “It was pretty humbling to see that the number of people who retained their shares and opted into the beer offer outnumbered those who sold their shares by more than five to one. Only 3% of investors wanted to take any money out, and with up to 2,800% return on investment, this was a very modest uptake, proving their commitment and the expectations for the future of BrewDog.”

“Crowdfunding has enabled a whole new generation of food businesses to exist and, more than that, start to compete with the big boys”

He adds: “Crowdfunding is not just about raising money, it’s about community. For us, we have built an army of Equity Punk investors who drive our business forward and ensure we’re growing in the right way. They care about what we do, they rave about us to their friends and they tell us when they want to see us do things differently.

“We’ve come a long way in 10 years and at the heart of that has been our Equity Punk shareholders. They’re our biggest advocates, as well as our harshest critics, and it’s ace to see that they are along with us for this crazy ride.”

Buyer beware

And critics shouldn’t drown out the many positives of crowdfunding, Lang insists. He says more than 140 UK food and drink businesses have raised money on Crowdcube, with £72m invested in the sector.

“The impact we have had on the sector has been phenomenal,” he says. “Those millions of pounds raised have helped to create and safeguard hundreds of jobs, grow exports and provide access to funding not otherwise available.”

Thuillier agrees crowdfunding has been a force for good. “It democratises investing and the potential to start up a food company. Crowdfunding has enabled a whole new generation of food businesses to exist, and, more than that, start to compete with the big boys. The multinationals have armies of merchandisers, I have my crowd. They have paid reach, I have investor word of mouth. They have advisory boards, I have 1,200 investors on the end of the phone.

“Goliath is now big and unwieldy, rather than big and powerful. Nimble with low overheads and seriously rapid innovation is the name of the game. Crowdfunding enables that.”

Even some of the industry’s harshest critics don’t want to see tighter regulation. Seasoned dealmaker Shaun Browne, MD at US investment bank Houlihan Lokey, argues the principle of ‘buyer beware’ should rule and any problems will be dealt with by natural market forces once the initial excitement generated by the relatively new medium ebbs away.

But he also warns “when people start to realise that most investors lose money because of poor management, and these companies can promise anything they like, crowdfunding may well die.”