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

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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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