Wednesday, 14 March 2018

Is this is why companies on Crowdcube believe it is their right to mislead investors?



We had a very enlightening chat with a business founder who had used Crowdcube to raise capital but had so far failed to get even close to its projections. 


His explanation was honest. Simply put, it is impossible to create sensible projections. So all businesses therefore produce overly optimistic projections. Everyone knows this. Therefore everyone allows for around a 50% reduction on net revenues when they look at them. The point was also made that it's impossible for businesses to know what costs and revenues will be even 12 months out, so trying is pointless. 

Added to that, he stated that the only sensible way to value new businesses was to look at further funding rounds where the value of the company will be dictated by the amount people are willing to pay for shares. 

We dont agree with either.

It maybe a fact that all the projections we see on Crowdcube are hopelessly optimistic but we believe there is a positive reason for this. Its done to attract investment. If any of the investors believed that these projections were out by 50%, they wouldnt invest at the value which is set by the very same projections. We know this because if you look at the queries on valuations on Crowdcube, they are all answered by pointing directly to the figures in the projections. If everyone agrees the figures are nonsense then so is valuation. Unless investors really are fools, they would only invest at a halved valuation. Its not a conclusion you can escape - people still invest. QED they believe the projections are in the right ball park. Most of then are not on the same planet. 

Regarding the company health check - we also disagree with this. How many times have we seen companies returning for second third and fourth rounds at increased valuations only for the company to go bust. There are quotable examples where the administrator's report states the company had been in trouble well before the funding rounds and yet the upward valuations indicated the opposite. These valuations are entirely subjective and investors have mixed motivations for reinvesting. Many believe that just a little more will bring about the outcome they dream of -  a healthy ROI. Otherwise known as the Gamblers Curse - once on the ride it is difficult to jump off. These dreams are initiated and encouraged by founders emails to shareholders giving them often highly misleading information. These emails are not regulated and do not go via the platforms. So they are legal lies. They can get away with whatever they like and often do. 

There is a fundamental problem with UKplc being littered with companies that have accessed ECf  funding based on these types of projections. It encourages them to over trade in a vain attempt to meet their aspirations - taking on crippling fixed costs that will if unfunded in subsequent rounds, bring the business to its knees. As down rounds are not really the thing on ECf platforms, these next rounds simply exacerbate the problem by raising the value - thereby satisfying everyone that the business is being successful. Given a more gradual climb many of these companies could become part of a healthy UK SME structure. 

All the while all of this mess creation is being paid for in part by the Goverment's S/EIS tax reliefs. What we need is a system where all directors of limited liability companies have to pass a knowledge based test or S/EIS is not available. This, backed by much more stringent assessment of the handling of the company's affairs on administration, would certainly help. After all you wouldnt want someone on the roads without a license.

It was certainly interesting and worrying in equal measure to hear this opinion from the horses mouth.


16 comments:

  1. Rob - a question please

    You have stated "founders emails to shareholders giving them often highly misleading information. These emails are not regulated and do not go via the platforms."

    I've had some companies update via email and others via email message but via the platform - would this second form be "regulated" due to being via the platform?

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    1. Depends if the ones via the platfrom are just letter boxing or if they get read before they forwarded. Knowing CC it seems unlikely they check them - once a company is funded they tend to get well out of the way.

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  2. So what do you propose for better valuations? I've spoken to companies before about this, and they've taken my advice to change the valuation and then completed.

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    1. Massive topic. Too large for this forum but we know that the current'system' is failing so we need a new one.

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    2. Not really. Valuations are ultimately set by the market. Caveat emptor always applies, but some emptors use more caveats than others. It's not a "system" as such, but the market will learn over time where valuations are reasonable based on the level of risk (in track record and information presented). I think we're just about there on the latest pitches. Yes there'll be a lot of failures from the previous pitches where companies, platforms and investors were finding their feet, but it's a new market, so it's obvious that only the smartest will make the early profits. It's great that the government have subsidised the early years, but I don't think EIS will last much longer. Maybe another five years...

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    3. Terry - our evidence - ie the study of all the actual Crowdcube campaigns that have been valued and completed, doesnt share your optimism. In fact rather the opposite. The more desperate Crowdcube become to have more completions, so they can pay their £8m plus annual bills, the higher the valuations appear to become. Do you have any evidence or are you just working on sense of smell? Your idea that vauations are set by the market is fine in a text book but it simply isnt the case in ECF. If you had looked at 1000 plus campaigns over the last 3 years you would know that. Valuations are set by a mix of the platform and the company and presented to the market. A few and it is a very small few, lower their valuations in a last desperate attempt to get over the line. Why would the Government remove EIS if,as they beleive, it is being a massive hep to SME funding? Its so easy for them and they dont have to pay a penny for it. Agreed its a new market where levels need to be found, but there is little sign that platforms are heeding any of the warnings. Crowdcube were only a week ago advising the Government on how to regulate/help ECF.

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    4. ps I think the mistake you make is to assume this is a market, when its not. The current system is like a shop, not a market, where fixed prices are the valuations and there is very little if any haggling. If a system was possible where it could become a market ie valuations were really set by the investors, then that could be interesting. Although that would assume a certain knowledge base on the part of the investors which we havent seen on Crowdcube.

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    5. PPS - of course you also have to remember that we have been saying this for 7 years or since Crowdcube launched in 2011. We dont remember any other people agreeing with us for the first 4 years of that.

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    6. Ah - I think you have misunderstood my use of the term "market". I meant it in the way you have used it in your comment "presented to the market" rather in the context of being able to haggle. I appreciate that haggling is minimal, though as I say, not non-existent. My point was that if people don't like the valuation, they don't have to invest, and if more and more pitches don't fund, then of course it is in everyone's interest to lower them in future. Again, previous evidence doesn't matter until the level is found, but there's no reason it can't be found, unless people don't like a valuation but invest anyway, which I think did happen in the past but will now happen less.

      Not sure what you mean by EIS not costing the govt a penny...?

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    7. Fair point but i dont agree - valuations are still heading north and people are still investing.

      EIS doesnt cost the Gov a penny - its a mechanism for reducing the income tax people pay so its not a up front cost to Gov - ie they dont have a budget for it. As they completely fail to regulate how you (as a company or as a claimer) claim it or are allowed to access it, it incurrs no or very little admin overhead.

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    8. I agree with Terry.
      Entrepreneurs are surely too optimistic in their projections, however they are projections and as long as they are marked as such, investors should use their own judgement. If I think the valuation of a new startup is too high, I can just not invest. Nobody is forcing retail investors to put money in ECF, nor is a necessary component of a balance portfolio.

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    9. I think the miss the point. Being optimistic is one thing and can be allowed for. But how do you allow for a 3 year projection where Y1 Rev is £100k Y2 is £500k and Y3 is £2m. Valuation is based on Y3. But in reality the business does Y1 80k Y2 170k and Y3 250k - having also taken new investment in Y3 just to stay in business. We are not looking at just missed projections we are looking at consistently 300% to 1000% missed numbers. Id love to know just how you as an investor allow for this?

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  3. All fair comment. I'd be interested to know what proportion of the crowd even go as far as to look at the projections though. I suspect a lot of investments on crowdcube are made on a whim, perhaps after watching one of the slick promotional videos. I reckon a lot of investors think that if they diversify sufficiently their bound to invest in a few good businesses.

    There's little doubt there is potential for this house of cards to come crashing down but equally purely on the law of averages there's bound to be a few ECF businesses that go on to make it biggish. Whether those will offset the substantial number of failures seems unlikely.

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    1. Investors at under £100 yes but those investing more do do some reading. Typically half decent campaigns will send out 300 plus PDs so someone must be reading them.

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  4. I always read the packs in detail, but tend to ignore the numbers for all these reasons. I give them a cursory glance to see where the valuation may have come from, but it's likely that the valuation comes from other factors anyway (or just thin air). If it looks like a great idea with a good team, that's more important to me, unless it looks grossly overvalued. I always have the conversation in person though - never just on the site. No losers yet!

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  5. I don't think there is enough focus on the risks which exist for any new pitch - any questions asked are on the basis of the valuations but there is little discussion on risks. I agree that it's not a market and that its a fixed price take it or leave it. The overall regulation is probably too light touch and not sure how well that is understood.

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