Convertible Loans as a Band-Aid Solution to the Valuation Problem in Equity Crowdfunding

100 dollar bill band aid money

What’s happening: the industry wants equity

It’s ironic that crowdfunding makes it possible to set up companies that otherwise never would’ve come into existence, only to ruin them later by postponing the valuation issues that any start up will have to solve sooner or later. Might the positive start of crowdfunding come to a halt due to unsavoury developments, convertible Crowd Fans Audience Trafficloans specifically, within the equity-crowdfunding branch?

The good news first: crowdfunding continues to grow, especially equity crowdfunding is catching up. From the beginning of this year, equity crowdfunding has seen a delayed but sharp increase compared to the other forms of crowdfunding (donations, rewards, loans). A development that is projected to continue along with the funding volumes in this niche. The fact that (somewhat) complicated capital forms are being adopted means that entrepreneurs and investors are ‘reading up’ and that the industry is maturing. Reason for some platforms take their chances and claim they’re offering equity crowdfunding: without solving the valuation issue.

The sweet and sour of equity crowdfunding

During the last decades, Europe has been heavily hooked on bank loans much like the U.S. was in the ‘80’s. Since the financial downturn (and now its projected upturn) entrepreneurs have had to develop some creative financial income streams, one of them being crowdfunding.

Equity vs DebtEquity crowdfunding is a specific type of income generation that a lot of people have never learnt to control or deal with sufficiently. They’re simply not educated in this field, which explains why peer-to-peer lending has seen a major increase in the beginning of the crowdfunding era whereas equity has been a slow starter: people don’t understand so people don’t use it.

Now that equity is increasingly being adopted by investors and entrepreneurs, more platforms are eager to claim that they offer equity-crowdfunding. But the problem they run into is valuation. It’s hard to valuate a company that (often) hardly exists. And in contrary to traditional entrepreneur- investor settings, there is no discussion on how much a company is worth because.

The crowd often receives a certain valuation as a ‘take-it-or-leave-it’-offer, and investing means you agree with the valuation. Some platforms like CrowdCube offer the opportunity to ask for a “Alternative Offer” but 99% of the equity platforms isn’t that well developed. On top of that, even when the crowd does discuss a company’s worth, they often lack the knowledge to create a factual, calculated value.

So what do platforms like ReturnOnChange, Fundable, Seedrs or the Dutch platform Wekomenerwel (“We’ll-get-there”) do: they offer convertible debt as a way to delay the valuation issue.

Why are convertible loans bad for the crowdfunding industry?

Mark Suster, a two-times entrepreneur turned VC, has written extensively about the pros and cons of convertible debt in the traditional setting (not crowdfunding), explaining the difficulties in this form of equity instrument.

For those not informed, a convertible loan is a loan you get from a (potentially) future investor with oftentimes a very low interest rate, because the creditor belies that at a later stage he’ll be able to acquire part of the company for a relatively low price.

What’s so great about convertible loans?

If you don’t know exactly how equity investing works or what it might mean for your company (which unfortunately is the case more than we’d all like to admit) let alone cracking your head over a reasonable valuation, convertible loans sound pretty good. It’s a loan against fairly low interest rates. And when the creditor in a later stage becomes shareholder, he often doesn’t own voting rights.

The only catch: you don’t know what price you’re selling your company for, you’ll decide that later. I understand that in specific cases a convertible debt seems a good decision to make, especially for start-ups who often can’t (or don’t want to) spend a lot of time and money on the legal requirements of setting up the entry of a (direct) investor in the company (which is an invalid point in equity crowdfunding if you have the right legal structure). But in comparison you’d never agree to buy a car, put down a certain amount of money on forehand and find out later that you should’ve paid much less considering the milage. You’d run the risk of a scam.

Within the crowdfunding industry the tendency has arisen to do exactly that: expose your company to bad deal. The risks include not being able to pay back the loan or develop crucial parts of your company because you have a loan, unreasonable and/or unnecessary dilution and even losing control of the company. And all because we don’t want bust our balls over a valuation.Discounted Cash Flow Valuation Firm Value

Valuation is unfamiliar, complicated and expensive and it belongs in the financial department according to many starting entrepreneurs, not in the product/marketing department of which most start-ups are made up of. That still doesn’t mean taking up a loan now and hoping for the best (which is what convertible loans often seem to come down to), is how we should develop equity-crowdfunding. Convertible loans in the crowdfunding area are used as an excuse to delay the valuation problem: not to solve it.

The answer to the valuation problem? Do a valuation.

Which is very strange, considering a solution is already at hand. There are several alternatives at hand besides going to your accountant.

One example is EquityNet’s Calculator, extensively described in this article, which aims to create a quick scan valuation allowing the entrepreneur to have valuation within a few minutes straight into your e-mail inbox.

Stack of Coins MoneyAnother example that was started as a side project by SmartAsset, is Startup Economics. Though the tool is great for getting insight in the relation between raised funding amounts and share prices, for starting entrepreneurs it might be a little too much too soon, asking questions “the maximum pre-money valuation at which the notes may convert into equity”. It’s great to ‘play’ around with the figures and see the immediate feedback so that you can quickly get a grip on what is what in terms of numbers.

Another option is Equidam which has developed an entire company around online valuation. You won’t be done in two minutes, but based on a combination of your quantitative and qualitative input and five valuation methods; you’ll receive a 20-page report (paid) or the first free pages including your valuation for free.

These might not be the only solutions, but for now, they’re the best online start-up valuation methods I’ve seen. It offers an objective basis for supporting you valuation and for a lot of entrepreneurs (if the data is realistic) it’s a wake-up call as well as a good bottom-line for the valuation discussion. The DCF with DG, DF with multiples, Scorecard Method, Checklist Method and the VC method are all included and the report covers 20 pages of data and explanation to back up the start-up’s value.

Like I’ve argued before, the crowdfunding field can learn a lot of things from the traditional capital markets, with convertible loans as a beautiful example. Crowdfunding platforms should take responsibility for the products they help to sell and actively work towards a qualitative solution for valuation instead of adopting a ‘head-in-the-sand’-attitude. Instead of polluting the feeble and merely developed crowdfunding market with exotic investment vehicles that often don’t work in a traditional setting either, let’s focus on creating a real solution: a decent valuation method for start-ups.

(Editors Note:  Symbid holds a small equity position in Equidam)

_________________

Ludwine DekkerLudwine Dekker has been coaching entrepreneurs in executing their digital fund raising for three years. As a digital marketing specialist, she specializes in entrepreneurship, technology and fund-raising. As a campaign manager at Symbid she strategically manages the entrepreneur’s campaigns and requirements, organizes pitch events, frequently writes for several platforms, and gives workshops.  You may follow Ludwine on Twitter @Luudwine

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  • Kathrin77

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  • I’m not sure how much of what I’m about to say applies to equity crowdfunding outside the United States.

    I think your article and the article it references neglect to take into account one of the primary benefits of convertibles: the ability to delay complex negotiations around deal terms. Using convertible equity instead of convertible debt eliminates all of the debt concerns. I would agree with you that valuation caps can be a huge problem for convertibles, and there’s no perfect solution (caps, no caps, and graduated discounts all trade one set of problems for another). But I’m skeptical that tools for valuations can ever work with preferred stock, because it boils down to one key question. Valuation of what? Pre-money valuation for preferred stock isn’t as simple as coming up with a valuation for the company, because a company valuation is almost certainly going to be a valuation of common stock. Preferred stock itself is an exotic instrument, and far more complex than convertible equity. And it’s the terms of the preferred stock that determine the pre-money valuation for that series of preferred in relation to the valuation of the common stock. Variables like liquidation preferences, board seats, control provisions, anti-dilution protection, pay-to-play requirements, pro-rata rights, drag along rights, and voting rights all have an impact on the valuation for the purposes of preferred stock. A major advantage of convertibles is that it leaves both the valuation AND the negotiations of those terms until a later date when experienced professionals are involved.

    The only way around exotics for crowdfunding would be to issue shares of common stock. You could definitely do this with inexpensive or free valuation tools, but you lose many of the advantages of preferred stock. Not only does it complicate matters with things like the IRS and employee stock option grants, but you lose all the provisions of preferred stock designed to protect investors. If a company was to later raise money from angel investors or venture capital, you can assume with certainty that those investors would be getting preferred stock or something that would convert into preferred stock. You would then have the perverted situation of the earliest investors taking the most risk yet getting a far worse deal than later investors taking less risk.

    I definitely agree that platforms need to take responsibility for the offerings on their platforms and work to solve these issues, I don’t know that valuation tools and common stock are the solution.

    • Ludwine

      Thanks a lot for your comments: it’s good to see your interest in this subject and the valid issues you address.

      As for the first benefit of delaying the valuation terms and negotiations: within the current crowdfunding industry (in Europe at least), delaying negotiations isn’t a welcome given. The entrepreneur makes sure a Stakeholderagreement is put online when starting the campaign, and if you agree as an investor, you invest, otherwise you don’t. This speeds up the process incredibly and since it often concerns small investors ($60-$1000), the investors wouldn’t have much of say regardless of what the Stakeholderagreement says. Problem is that quite some platforms have no idea how to structure negotiations afterwards, what points to attend to (drag-along rights, pay-to-play, etc are often unknown territory) and since they cannot support in these kinds of information/processes, they chose to delay that problem by offering convertible debt. So while there might be some benefits, in these cases it’s often used as a reprieve/ ‘delay of execution’.

      Regarding your (fair) comments on preferred or common stock: the tendency of the industry and platforms offering equity specifically is to offer common stock, not preferred stock as the process and claim on the usual benefits is a long and difficult process that many platforms are not equipped to cater for. The larger investors who do demand a piece of preferred stock, often contact the entrepreneur outside of the campaign and make a separate Agreement, that often asks the large investor to invest at least Amount X in the current campaign. Of every (small) investor would claim preferred stock accustomed to their own benefits, the crowdfunding/shareholderagreement would become so endlessly
      complicated that crowdfunding would become the same ‘drag’ that it currently is when attracting a ‘normal’ Angel/investor. I’m not saying that we shouldn’t aim to streamline that process and make it available to the crowd, but currently the industry isn’t that far developed yet and we should aim to get a grip on the basics.

      I think you make some very solid statements, however, for me the most important argument that, for the time being, is an answer to most of your points, is that the crowdfunding industry simply isn’t as far developed yet. Exactly the reasons why we should take it easy with things like preferred vs common stock, convertible debt vs convertible equity. My advice would be to keep things as simple as possible and work towards a solution for each of the current problems (like the valuation of a company) one
      problem at the time, instead of introducing band-aid solutions that’ll only
      create problems in the long run because most crowdfunding platforms aren’t equipped enough to deal with the complex consequences.

      • Not sure why my previous comment was suddenly converted to a guest post, but…

        You raise a very interesting point about how far along the crowdfunding industry is with understanding and developing equity structures. Of course, one possible solution is equity crowdfunding portals that do understand the complex issues and remain involved throughout the process. I understand, though, that may be aspirational and the industry may not be that far along. That’s a factor I honestly hadn’t considered. So thanks for shifting my thinking!

        I’m involved with a co-founding a platform in the States that’s working through trying to simplify and standardize the process, but I admit as a former lawyer my thought process can be a little skewed towards the wonky. Our concern isn’t really the complexity or our ability to remain involved in the process and simplify it for both sides, but rather the tradeoffs and what the long-term impact is going to be for crowdfunders as the investments mature.

        I still think there are reasons to consider convertibles (especially convertible equity) as more than a band-aid solution, and reasons to consider the impact of preferred stock versus common stock, if a portal is equity to wade through those issues. As you said, portals should take responsibility for the interactions they are enabling.

        But your points are very well taken.

        • Ludwine

          I definitly agree with you that there must be cases where CD can be a beneficial option, but those cases are very specific I expect and tailered towards specific needs of the investor and entrepreneur, and not towards SME’s and the crowd in general. So I assume (but perhaps I’m wrong here and future developments will correct my thinking) there are either a lot companies that won’t get the tailored result they need, or a lot of crowd-investors that don’t properly understand what they’re investing in.

          In any case, thanks for your critical take on my article, it made me rethink my arguments quite thoroughly.

  • Edit: I’m not sure how much of what I’m about to say applies to equity crowdfunding outside the United States.

    I think your article and the article it references neglect to take into account one of the primary benefits of convertibles: the ability to delay complex negotiations around deal terms. Using convertible equity instead of convertible debt eliminates all of the debt concerns. I would agree with you that valuation caps can be a huge problem for convertibles, and there’s no perfect solution (caps, no caps, and graduated discounts all trade one set of problems for another). But I’m skeptical that tools for valuations can ever work with preferred stock, because it boils down to one key question. Valuation of what? Pre-money valuation for preferred stock isn’t as simple as coming up with a valuation for the company, because a company valuation is almost certainly going to be a valuation of common stock. Preferred stock itself is an exotic instrument, and far more complex than convertible equity. And it’s the terms of the preferred stock that determine the pre-money valuation for that series of preferred in relation to the valuation of the common stock. Variables like liquidation preferences, board seats, control provisions, anti-dilution protection, pay-to-play requirements, pro-rata rights, drag along rights, and voting rights all have an impact on the valuation for the purposes of preferred stock. A major advantage of convertibles is that it leaves both the valuation AND the negotiations of those terms until a later date when experienced professionals are involved.

    The only way around exotics for crowdfunding would be to issue shares of common stock. You could definitely do this with inexpensive or free valuation tools, but you lose many of the advantages of preferred stock. Not only does it complicate matters with things like the IRS and employee stock option grants, but you lose all the provisions of preferred stock designed to protect investors. If a company was to later raise money from angel investors or venture capital, you can assume with certainty that those investors would be getting preferred stock or something that would convert into preferred stock. You would then have the perverted situation of the earliest investors taking the most risk yet getting a far worse deal than later investors taking less risk.

    I definitely agree that platforms need to take responsibility for the offerings on their platforms and work to solve these issues, I don’t know that valuation tools and common stock are the solution.