U.K. Shows the Way for Amateur Venture Capitalists

Ultra-risky equity crowdfunding gaining traction, U.S. following suit

LONDON—A few years ago James Manning, a Brit who runs a cleaning company, decided to get into the movie business.

The 50-year-old went online and bought a stake in cinema-technology startup Kinopto Ltd., which was selling shares via a website. But Kinopto soon folded and Mr. Manning lost his money. “It was always going to be a high-risk investment,” says Mr. Manning, who put several thousand dollars into the venture.

For Kinopto’s co-founder Danny Jeremiah, however, raising money online was a no-brainer. It “was embarrassingly easy,” he says. “We went down the path of least resistance.”

The U.K. has led the way opening up a new ultra-risky market in which fledgling companies pitch shares to amateur investors online. The country “is now the best place for equity crowdfunding in the world,” says Kieran Garvey, the policy program manager at the Cambridge Centre for Alternative Finance, which benchmarks such projects across the globe.

Buying shares in unlisted companies is a long-shot bet: Few if any of these companies will ever have a public offering that will allow investors to cash out at a hefty profit. The main hope for many investors is that the company is eventually sold. Financial reporting is thin, and the U.K.’s regulator has expressed concern that amateurs aren’t suited to do the kind of financial sleuthing a venture capitalist can.

So far, out of 367 U.K. companies that have raised equity between 2011 and the first half of 2015 via equity crowdfunding, only one has made a profit for investors, according to Altfi Data, which tracks the alternative finance sector. Since then, Camden Town Brewery became the second company set to make money for investors, after agreeing to sell to a rival brewer. ​

Still, U.K.-based investors have snapped up stakes in companies making everything from flying cars to burritos and musicals.

The U.S. is following the U.K.’s lead, with the Securities and Exchange Commission set to allow armchair investors to get in on an act long reserved for “accredited investors”—broadly those with a net worth of over $1 million or who earn at least $200,000 a year. Other countries remain wary. Germany eased disclosure rules for small businesses looking for funding but caps the total investment at €10,000 ($10,900) a person. In Italy individuals can only invest €500 at a time or €1,000 over a year.

In the U.K. the rules are more relaxed. Retail investors must certify they won’t invest more than 10% of their portfolios, excluding housing, pensions and life assurance, on crowdfunded companies. Websites make investors pass a multiple-choice test to show a basic understanding of the risks involved.

The U.K. equity crowdfunding market is small but growing rapidly, roughly tripling between 2013 and 2014, according to the Cambridge Centre for Alternative Finance, helped by generous tax breaks for investors. Proponents see it as an important way for small companies—many of them starved for credit as European banks pare lending—to access funds. It also allows investors to access investments they wouldn’t have been able to before.

Tax breaks are a major incentive. The U.K. offers 30% tax relief on investments up to £1 million ($1.49 million) and allows investors to offset any losses they incur against their income.

Critics say it opens the path for companies with inflated valuations to hawk equity to uninformed investors. One in five companies that raised funds via crowdfunding between 2011 and 2013 is no longer in business, according to Altfi.

Many of the companies that raised money are still growing. “It’s going to take another year or two or three to get a feel of how well it is working,” says Luke Lang, co-founder Crowdcube, the U.K.’s largest equity crowdfunding platform. Mr. Lang says the current failure rate is better than expected. Several companies that sourced cash online via Crowdcube have gone on to raise funds at higher valuations, he says.

ENLARGE

Chilango last year asked customers to invest in its ‘burrito bond.’ PHOTO: RENEE LIGHTNER/THE WALL STREET JOURNAL

Investors in Britain aren’t just hunting for the next Uber Technologies Inc. or Facebook Inc.Hungry customers at Chilango, a U.K. chain of Mexican restaurants, were recently handed leaflets promoting a share sale along with their burritos. Chilango raised £3.4 million this month selling equity to investors on Crowdcube. The equity raise came after Chilango loaded up on more than £2 million of debt last year via a “burrito bond” also pitched to customers.

“What better people to own your company than those that support it?” says Chilango co-founder Eric Partaker.

A lack of transparency has made judging success of such capital raises hard. Most of the crowdfunding websites don’t provide regular information on how companies that raised money are holding up.

It can also be unclear how much traction a pitch actually has. For instance, Crowdcube says that a theater musical, called “The Water Babies,” raised £1 million on its website in 2013. However £800,000 of the total had already been lined up offline from other investors, says Peter Shaw, one of the show’s producers. (After some negative reviews Water Babies Musical UK Ltd. went into liquidation earlier this year.)

So far around 90% of U.K. companies that raised funds via Crowdcube have missed their projected financial targets, estimates Rob Murray Brown, who tracks crowdfunding investments on a blog called “The Truth About Equity Crowdfunding.”

Phil Murray, a teacher, made money from a sale of an equity crowdfunded company​ earlier this year. He invested in electronic car rental company E-Car Club which sold to a competitor .

Mr. Murray, who has invested around £80,000 in about 25 small companies via online platforms, also saw another bet go sour. “I don’t think you can ever predict what the outcome will be,” he says. Most people investing via these websites “have no idea what they are doing,” he adds.

Earlier this year the Financial Conduct Authority, the U.K.’s regulator, said it was concerned that the majority of the people placing funds on the sites had no venture-capital investment experience.

In the U.K., investors tend to be men who have disposable income, says Jeff Lynn, chief executive of Seedrs, an equity crowdfunding platform based in London. The peak investment time on Seedrs is at 11 a.m. on Monday mornings, he says, suggesting that investors are looking for an exciting distraction at work.

Mr. Manning was at work when he decided to invest in Kinopto. The company provided technology that allowed schools, town halls and other public spaces to turn into “pop up” cinemas. Kinopto raised £35,000 from 23 investors in a week, selling a 15% stake in the business via Crowdcube. Mr. Manning, an entrepreneur who has invested in seven crowdfunded businesses online, became the company’s biggest external shareholder.

The business was well received but struggled to make money, says Mr. Jeremiah, Kinopto’s co-founder. “We realized that the market was there, but paying for it was not,” he says. Kinopto was dissolved this summer.

Despite the setback, Mr. Manning says he was impressed by Mr. Jeremiah. Mr. Manning is hopeful his other crowdfunded investments will come good. “I will be happy if I get my money back,” he says.

Source: WSJ