Equity Crowdfunding – 5 Prerequisites for Follow-Up Financing

Equity crowdfunding and crowdfunding have become a global trend. More and more startups are choosing to be financed by the crowd. In most cases, equity crowdfunding is only the first step toward growth. The maxim for venture capital is: “Post-financing is pre-financing.” Usually, follow-up financing is necessary to enable further growth such as internationalization.

Follow-up financing is also important to crowd investors, since the startup they invested in at an early stage may fail without sufficient capital in later stages. What does an equity crowdfunding contract need to entail to be ideally suited for follow-up financing? While there are several factors to consider, here are a few basic conditions that must be included.

No shareholder participation rights

During a successful equity crowdfunding campaign, several hundred micro investors participate in a startup. With such a large number of investors, it is unreasonable for each to have the right to influence the startup’s business operations. Otherwise, the startup would be unable to take action and no venture capitalist would invest.

All major equity crowdfunding platforms, Companisto included, therefore only involve investors economically. This means that investors benefit from the startup’s revenue and exit proceeds like full-fledged shareholders, however, they do not receive co-determination rights.

Naturally, investors can communicate with the startups directly on the platform to express suggestions and critique. Startups like to respond to these comments since this enriching exchange with the investors is one of the reasons why startups opt for equity crowdfunding.

Dilution of participation

Follow-up financing usually brings in additional investors as new shareholders. This means that the participation rate of existing shareholders is slightly reduced, which is called dilution. The dilution of existing shareholders, including equity crowdfunding investors, is not only common in venture capital, it is also an absolute prerequisite for follow-up financing. This affects not only equity crowdfunding investors, but also the founders, business angels, and VCs. Follow-up financing would not be possible without dilution.

Protection of confidential information

Knowledge is both power and a competitive advantage. Startups and venture capital societies all know this, which is why it is of utmost importance to prevent the publication of the startup’s confidential information.

A basic prerequisite for follow-up financing, therefore, is making sure that micro investors do not spread confidential information. A VC will not invest in a startup that regularly leaks confidential information relevant to competition to the public (and potential competitors).

Therefore, startups must pay attention to reporting requirements demanded by platform operators while selecting the right equity crowdfunding platform. The leading platforms may differ greatly in this respect. As a member of the Bundesverband Crowdfunding e.V., for example, Companisto has committed to implement specified reporting guidelines. While reports include figures on financial planning, the publishing of additional KPIs and internal financial or business secrets is optional.

Contract duration must be long enough

Equity crowdfunding capital is timed capital. Just like VCs, equity crowdfunding investors want their money returned at some point. The venture capital industry generally follows the principle of “first in, last out.” This means that the capital invested first will be the last to flow back out of the company.

The reason for this is simple: VCs want to prevent money from flowing out of a company before it has reached an exit. The invested capital should be completely available for the company’s growth until its exit. Only upon reaching the exit should the money flow back from the startup to the investors.

Startups, therefore, need to make sure that the participation contracts have a sufficient duration when they select an equity crowdfunding platform. VCs reckon with around 3-7 years until an exit. Participation contracts, therefore, should only be terminable by micro investors after 8 years at the earliest, in order for these contracts to be compatible with follow-up financing. This is also an advantage for investors, as it is better to participate in profits for 8 years than, for example, for 5 years.

Companisto has created ideal conditions with its lifetime participation.  The participation agreements no longer terminate the Companists' participation in the company after the minimum term has expired. This gives Companists the choice to participate in the startup’s profits and potential company sale (exit) for a lifetime. Both parties, startups, and Companists, thus work toward an exit together.

The investor thus does not run the risk of not being able to participate in the sale of a company because his or her participation ended before the exit. Furthermore, his or her investment does not terminate after eight years anymore. This is advantageous for the startup because it can only calculate its cash outflow before an exit by the sum of the invested capital plus fixed interest. This predictability is very valuable for the startup and subsequent investors.

Investor Pooling

If the previously mentioned points are provided for, it is not necessary to adjust equity crowdfunding participation agreements with crowd investors for follow-up financing rounds with VCs. However, not all follow-up financing is designed the same way. Therefore, the possibility that the participation agreements must be adjusted for specific arrangements cannot be excluded. If the contract duration is too short or the reporting requirements are too strict, the agreements will almost certainly have to be changed.

VCs will not deal with hundreds of investors individually to negotiate contract changes. On one hand, there are next to no investment cases in which this kind of effort would be worthwhile for investors. On the other hand, even if one made the effort, the likelihood of not reaching an agreement with individual investors is great.

Conclusion

Follow-up financing for startups that were financed through equity crowdfunding is simple as long as one follows the rules of the venture capital industry. Equity crowdfunding should be seen as an addition to and rather than as competition against financing from VCs. There are cases in which a startup needs both equity crowdfunding as well as VC funds in order to be successful. For this reason, it is important not only for the startups but also for the investors to invest through an equity crowdfunding platform that is set up for VC follow-up financing. After all, an investment promises to be especially successful if the startup has the chance to receive follow-up financing.

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