Judging from the number of businesses which have jumped on its bandwagon to raise capital for growth, it’s clear that crowdfunding is – at the moment – as hot as pulled pork.

This very contemporary method of raising money is touching every industry and every sphere of business, with some estimates suggesting that crowdfunding has now raised in excess of £15bn globally.

The more unusual campaigns for crowdfunding this summer included one that successfully raised enough cash for one student to fund a master’s degree at Oxford, and another that managed to raise $50,000 for a ‘potato salad’, after going viral through social media (the sales collateral, on Kickstarter, included the immortal line “basically I’m just making a potato salad – I haven’t decided what kind yet”).

Novelty and social media stunts aside, crowdfunding is an interesting and viable route for entrepreneurs seeking seed or early stage funding.  It is different from other forms of similar funding, such as an investor angel network, which typically comprises a relatively small number of high net worth individuals who will probably follow their money by taking an active interest.

Crowdfunding typically involves a large number of small investors who are passive and have few rights. They often have a special interest in the company – as customers.  While the scrutiny of businesses has improved, it still lacks the rigour and accountability of most other funding options.

One of the more recognisable platforms for businesses wishing to access this relatively new avenue is Crowdcube, which has so far raised over  £40m in the UK for 150 businesses and has nearly 88,000 registered investors.

Entrepreneurs in industries such as food, drink and leisure have wasted no time in harnessing the new source.  Recent campaigns include Chapel Down Group’s quest to raise more than £4 million for new vines, a winery, a brewery, increased storage and distribution; drinks group Crafted & Distilled’s effort to fund a limited edition small-batch beer; and developer Corryard Holdings £1m fundraising for 20% in a new luxury hotel near Perth, Scotland.  One of the sector’s most famous exponents of crowdfunding is BrewDog, the Scottish brewer and bar operator, which raised more than £4m at the turn of the year (December 2013).

However, this seemingly easy, democratic and virtuous mass-funding circle is not without its flaws.  What perhaps in one sense makes crowdfunding so attractive is also what undermines it – the lack of red tape and rigour – and which we expect will inevitably lead to changes in the rules.

BrewDog’s crowdfunding is one of the most widely reported in the sector, along with Chilango, both excellent offerings with wide customer appeal.  Chilango offered a bond paying 8% interest and two “free” burritos. While Chilango’s prospectus is championed by a range of high-profile industry operators, all commenting on the quality of the offering, the numbers in the prospectus show it had not made any profit at that point.  Whilst no professional investor would consider 8% an appropriate return for this type of unsecured loan, for those individuals with a few pounds in the bank earning no interest this clearly seemed like a risk worth taking.

The confusion arises when individuals don’t invest purely on the basis of the financial merits of the opportunity – in short, when the lines between a fan club and a sound investment opportunity become blurred.  This can lead to ‘retail’ investors – people who are not professional investors, but often first and foremost customers and strong advocates – making poor investments from a financial return standpoint.  Such investors, by and large, do not analyse the value equation before investing.  It means that these individuals often buy at over-inflated valuations that bear no resemblance to the true worth of the enterprise at that point.

If, at the end of 2013, BrewDog had been sold in a competitive process to a private equity group, it is likely to have fetched less than £40 million.  As it was, the business sold shares to the value of £4 million for 3.5% of the business through crowdfunding.  This valued the company at more than £110 million – a multiple of 146 times historic EBITDA.

BrewDog is undoubtedly an exciting business – they topped the 2013 Zolfo Cooper Profit Tracker listing of the fastest-growing businesses in the sector – and may well in time reach or exceed a value of £110 million, but the risk to the credibility of crowdfunding is that they prove an exception.

The reality is that if a typical crowdfunding exercise vastly inflates the value of the business at the point of fundraising then in the midterm this will damage the crowdfunding model as too many investors will lose their money. The key is to make crowdfunding more equitable thereby securing its future.  I fully appreciate many investors enter such a scenario with their eyes wide open, attracted by the generous non-cash incentives that the likes of Chilango and BrewDog offer to would-be investors. These have a material value and in the case of BrewDog included a £10 voucher, a 5% lifetime discount at its bars, as well as first option rights on newly-released beers. Investors also receive two tickets to its annual meeting, which BrewDog promises will be more Scottish music festival than staid AGM.

From an owner-operator perspective, there is another issue that arises from companies using amateur investors to fund the next stage of their expansion. As many readers of M&C Report will testify, growing a business from five units to 20, or from sales of say £5 million to £15 million is, in the leisure sector, just about as tough and challenging as it gets.  It is very easy to lose control of a company at this stage, either financially or operationally – or both. What entrepreneurs get from private equity, which funds the majority of growing companies at this stage in their growth – over and above the expansionary cash – is rigour, rollout nous, contacts, experience and grey hairs.  Bringing experienced investors with a track record in the sector into a growing company delivers a wealth of situational knowledge and gives the business a better chance of fulfilling its potential.

The regulators (the Financial Conduct Authority, or FCA) say on their website that, with crowdfunding “it is very likely you will lose your money”.  For investors with a few hundred pounds to spare this is often a risk they are willing to take for the chance to be part of the next big thing.  However, for owners considering their fundraising options there is a need to determine what you really need to give you and your business the best chance of success.. For investors, the advice is to do your homework – you will then know if you are investing from the heart or the head. 

Paul Hemming is a Partner and Head of Corporate Finance at Zolfo Cooper, the advisory services firm.  Email phemming@zolfocooper.eu