The two biggest risks in investing through crowdfunding are precisely what differentiate these securities’ issuers from stock market issuers: the risk associated with the start-up’s unproven business model and liquidity risk. These are summarized in the Risk Warning.
Liquidity risk means that although these shares are tradable, and Investors can sell them to anyone through a simple sales contract, they do not have an organized market like the stock exchange, making them difficult to sell.
The business risk should be considered at least from the following aspects:
- Team: Assessing the founders and team of the Campaign Owner, their experiences, genuine commitment, reputation, and work capacity.
- Corporate Governance, Culture: What kind of corporate culture is being established, and are employee commitment and loyalty being fostered? For example, is there an employee stock option program?
- Vision, Strategy: This is about where the founders want to take the Campaign Owner company in a 5-10 year timeframe and how.
- Mission on Sustainability: Dealing with environmental consciousness and intentions to improve the world.
- Business Model: Assessing the risks of the Campaign Owner’s ability to generate profits.
- Market Size: The size and dynamics of the target market also determine the company’s development and growth opportunities.
- Advocacy Ability: Assessing the Campaign Owner’s business advocacy capabilities necessary for success in the given market.
- Novelty, Disruptiveness: If the Campaign Owner introduces something completely new to the market, do they have the capital and capacity for evangelization, i.e., generating demand for the new, and can they reach from early adopters to the mass market where real capital can be made?
- Exit Strategy: Showing the timeframe and type of exit the founder considers feasible and the expected return level.
Crowdfunding campaigns represent an additional significant filter compared to businesses raising capital in other ways. During the campaign, on the forum, users’ questions can provide further information about the business (crowd diligence).
Thanks to these factors, there have been very few cases of fraud in the history of equity-based crowdfunding in Europe, dating from the launch of the UK’s biggest platforms, Seedrs and Crowdcube in 2011. Of Seedrs’ 750 successful campaigns or Conda’s 115 campaigns in Austria, not a single scandal has occurred to date. The World Bank explains this by stating that crowd diligence is stronger than due diligence. When interested investors spontaneously ask everyday questions and the quality of the Campaign Owner’s responses creates uncertainty, the campaign does not even commence. However, the biggest danger might not be fraud but the failure of the business model. Many analyses on the internet explain why businesses fail, with the most common reason being the inability to realize the sales plan within the available funded period (referred to as the ‘runway’ and measured in months). (In pre-financing campaigns, the most common problem is that the promised product is not completed on time or to the required quality, or not completed at all, and the supporters suffer the consequences, but actual fraud – especially considering the number of campaigns – is very rare.)
Common causes of failure:
– The most common is that the company fails to achieve the growth for which it raised capital. Since its operations are not yet proven, as it is a recent start-up, this is quite frequent. Bankruptcy is also not rare. Diversification, i.e., spreading investable capital over multiple investments, can protect against these.
– Management errors.
– Fraud: Rarely, but unfortunately, it can occur that the Campaign Owner spends the capital on something other than what it was raised for, or worse, for personal use. This can be sensed from the quarterly reports or their absence. The Campaign Owner can face criminal prosecution if there’s a strong suspicion of fraud.