Equity crowdfunding: risks for partners

Equity crowdfunding has emerged as an innovative tool for financing startups and SMEs, offering private investors the chance to become partners in emerging companies with a simple and accessible process. This financing model is particularly advantageous for companies, which can raise capital without going through traditional channels, and for investors, who have the opportunity to participate in the growth of promising companies at an early stage and even with small amounts of money.

However, like any investment, equity crowdfunding involves risks, both for those entering as new shareholders and for those who are already part of the corporate structure and must manage the entry of new investors. Lack of liquidity, possible loss of capital, and corporate governance risks are some of the critical issues to consider.

In this article, we will look in detail at the main risks to members investing in equity crowdfunding and those that may arise for pre-existing members with the entry of new investors. Finally, we will look at some strategies to mitigate them and protect one's investment.

Becoming an equity crowdfunding partner: risks

Investing in a startup or SME through equity crowdfunding means becoming a partner in the company. It is an affordable and easy investment, but not without risk, as all investments are. A good crowdfunding campaign is also one that transparently communicates all aspects of the investment, including the implications in terms of rights, duties and risks.

I new members Should be aware of the following risks:

• Loss of invested capital

The main risk for new equity partners is the possibility of total or partial loss of invested capital, which is common to any financial investment. Startups and small businesses, moreover, are high-risk businesses by their very nature, especially when their business is innovative. But that is precisely why they are also high-potential.

If the company does not meet its goals or, in the worst case, fails, investors could lose all of their invested capital.

• Low liquidity

Another typical risk of crowdfunding for new members is the illiquidity of the investment. Unlike publicly traded equity investments, the Shares in a startup funded through equity crowdfunding are not easily transferable or saleable. Investors may find it difficult to find a buyer for their shares or to exit the investment unless there are additional liquidity events, such as an acquisition or IPO. This illiquidity may limit the investor's ability to recover capital in case of financial need.

Crowdfunding platforms are beginning to develop systems to improve liquidity, such as secondary marketplaces for buying and selling shares. An electronic bulletin board system for this purpose has also been suggested as part of the European regulation for crowdfunding service providers. Inquiring about these possibilities can give investors a clear view of future exit arrangements.

• Lack of transparency and information asymmetry

Transparency is another possible concern for new partners. Often, the information available about a startup can be incomplete or difficult to interpret. Communications and official documentation are often not designed for nonprofessional investors, so they are difficult to access and understand. There is, in addition, an inevitable disparity in access to information between small investors and those within the company or large investors.

This translates into difficulties in assessing the potential of the investment, the performance of the company, the fulfillment of promises made during the crowdfunding campaign, the desirability of a exit advantageous, but also in fully understanding their own equity crowdfunding membership rights.

Finally, we need to clear the field of a unfounded fear that some would-be equity crowdfunding investors sometimes manifest: partners who enter the corporate structure through an equity crowdfunding campaign participate in the company only with their own capital and do not acquire any legal responsibility for the company's activities. In case of bankruptcy or litigation involving the company, crowd partners only lose capital.

Other risks exist only if a crowd shareholder enters into private agreements with the company to take on managerial, operational, or leadership roles in the company.

Acquiring partners with equity crowdfunding: risks for founders

While equity crowdfunding offers new funding opportunities for companies, it is also important that the original shareholders, such as the company's founders and any early investors, include the Potential risks from the entry of new partners. 

I new investors can bring fresh capital, contacts, and expertise, but the dynamics of governance and ownership within the company may change, presenting some challenges to be addressed. 

• Capital dilution: entry of new members and reduction of ownership percentage

One of the most immediate risks for existing members is capital dilution. When a company decides to raising funds through equity crowdfunding, the entry of new shareholders leads to an increase in the total number of shares issued, reducing the percentage ownership of current shareholders. This can affect not only the value of shares in percentage terms, but also the weight of individual shareholders in the shareholders' meeting. 

• Fragmentation of governance

The entry of new investors may influence the decision-making structure of the company, especially if special rights are granted to new shareholders. Some investors, in this situation, may require the presence of a representative on the board of directors, changing the decision-making balance. If clear rules for participation in meetings are not established, the decision-making process may become more complex and less agile.

However, this situation is necessary. Existing members can work to establish governance clauses that protect their rights, such as equity shares of different kinds (e.g., class A shares with multiple voting rights). A collaborative approach can turn new partners into strategic allies, bringing expertise and networks that can strengthen the company.

• Change in business strategy: new members with different goals

Another risk is the potential change in corporate strategy. New partners may have different goals and approaches than existing partners, which could lead to divergence in the company's strategic vision. 

• Increased administrative burden and transparency

The creation of a crowded membership that also consists of "lay" investors, i.e., those unrelated to the company's business, imposes a series of extra administrative activities to comply with regulations and maintain a relationship of transparency and direct communication with new shareholders. Only then do the latter become a real asset to the company.

However, there are software programs that greatly simplify the management of new members and professional figures who deal specifically with these activities.

More than actual risks, in fact, these are the fears - only partly legitimate - of many businesses approaching equity crowdfunding. In theory, these are real risks, but in practice they represent issues that anyone who wants to do equity crowdfunding needs to address BEFORE preparing a campaign, adopting expedients and protective strategies that are now the norm and that allow Clearly distinguish the rights and decision-making weight of the original members from those of the multitude of crowd members: we talked about it in theArticle on how not to lose governance in equity crowdfunding and we will discuss this in the next paragraphs.

The most sensitive issues concern the possible entry of partners who are important in terms of the size of the capital injection or their professional or business role, and who may require broader rights than ordinary investors. For these types of partners, an ad hoc contractual arrangement may be considered.

Risk mitigation strategies for equity crowdfunding

Equity crowdfunding presents, as we have seen, potential risks for both new and existing members. However, there are easy practical strategies that can be put in place to mitigate these risks and maximize opportunities.

For new members:

• Due diligence: verification of the company and the investment project.

For new partners, one of the most important steps is to conduct thorough due diligence. This means carefully assessing the company in which you plan to invest, examining its business model, financial strength, management team and growth projections, financial history, and any previous rounds of financing. Reviewing this information helps you make more informed decisions and identify potential risks associated with the investment.

• Importance of the Reading and understanding of investment documents

It is crucial that new members read and understand all investment documents, including terms and conditions, exit clauses, and member rights provisions. These documents provide key information about performance expectations, equity and voting rights and liquidation arrangements, any buyback clauses, liquidation preference clauses, or shareholder agreements that limit the rights of small investors, giving investors clarity about their financial commitment.

• Strategies of portfolio diversification

Another effective strategy is portfolio diversification. Investing in multiple startups, rather than concentrating investments in a single company, and also investing in financial instruments other than crowdfunding and other than stocks reduces overall risk. In this way, even if one investment fails, the potential gains from the other investments can offset any losses.

• Plan of exit

Finally, it is essential that new members have a plan for exit or know the eventual plan of exit proposed by the company. Before investing, they should examine possible liquidity patterns and opportunities to sell shares, either at specific events (such as acquisitions or IPOs) or through secondary markets, if available. Having a clear view of how and when one might divest from the investment is crucial for informed capital management and for mitigating poor investment liquidity.

For original members:

• Definition of governance clauses: specific limits to protect the rights of founders and their decision-making power

Existing shareholders can protect their interests by establishing governance clauses that clearly outline rights and responsibilities within the company. These clauses can set specific limits regarding strategic decisions and ensure that founders retain control over key issues.

• Use of shares of category A and B

The implementation of a different quota structure (e.g., Category A shares with voting rights and category B shares without voting rights) is another useful strategy for existing members. This distinction should be included in the corporate charter. This approach allows founders to retain greater influence over business decisions, despite the entry of new partners with significant investments. In most cases, equity crowdfunding campaigns do NOT sell voting shares.

Restrictions on the transfer of shares can also be introduced: for example, provide pre-emption clauses to prevent the entry of unwanted shareholders.

• Compaction of new members

To more nimbly manage the new, crowded membership, it is possible to bring all equity investors together within a special purpose vehicle, which will represent a single partner for the crowdfunding company and act as a single point of contact on behalf of all the new partners, or to construct a trustee mandate or other legal entities for the same purpose. This avoids an overcrowded cap table, which complicates logistical and administrative management and creates distrust in potential future institutional investors.

• Limits to representation on the board of directors

Establishing limits on investor representation on the board is another useful preventive measure. Establishing a maximum number of board members who can be elected by new shareholders ensures that existing shareholders retain a relevant voice in strategic decisions, preventing power from becoming overly concentrated in the hands of new investors.

• Dilution planning: accurately calculate the level of equity dilution to ensure that the founders retain a significant share of ownership.

It is critical for existing partners to plan for equity dilution strategically. Carefully calculating the level of dilution one is willing to undertake and negotiating terms that allow founders to retain a significant share of ownership can be crucial to protect not only invested capital but also control over the future direction of the company. There are numerous anti-dilution clauses that can be adopted in corporate bylaws: some covenants may provide mechanisms to protect shareholders from dilution in the event of future capital increases.

Conclusions

We can therefore state one thing about theequity crowdfunding: risks entails, no doubt, but they are rarely the ones that entrepreneurs and investors are most concerned about, as partners. I risks to members are part of the investment and financing game and can be considered ordinary to be tackled as an essential first task, the indispensable basics to know in order to participate in the game.