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Crowdfunders: Second-rate investors?

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There are two types of business investors in the UK. The first is the traditional wealthy professional investors – those who make a living investing in companies and (hopefully) getting their investment back many times over when that firm goes public or is brought up. 

The second is the casual investor. You and I. Anyone who has ever dumped £50 into a Crowdcube campaign or lent a friend £200 to help get their new business off the ground.

Although the number of professional investors in the UK has remained relatively constant, the number of casual investors is exploding.

The rise of crowdfunding websites like Seedrs and Crowdcube has hugely democratised the investment process. It makes raising money easier for businesses, and it makes investing easier for the general public. It’s justifiably being heralded as the future of business funding.

While the crowdfunding movement is all about democratising the investment process and levelling the playing field, it still has a way to go. In fact, the playing field is still far from level.

Anyone can now invest in a company through a crowdfunding platform, but the best deals (and the fattest returns) are still reserved for the pinstriped investor caste, and many lay-investors may not realise they’re getting a bum deal.

Arriving at a company valuation

The key to determining if an investment is worthwhile is the company valuation.

A simple method to value a business – and one used by most investors – is combining historic profits and a “multiplier”. A multiplier is a numeric representation of your business’ current and potential performance, based loosely on how much possible return an investor might see.

For example, I sold my first startup, Pure360, in 2008. The sale value was £3.9m, based on a previous year’s net profit of £480,000 and an 8x multiple. Now, 8x is quite a big multiple, justified by a subscription-based business model which guaranteed strong, recurring revenue.

If it were a business where customers had a close working relationship with a senior member of staff (and hence weren’t tied to the business itself) – a legal practice or traditional accountancy firm, for instance – you could expect a multiple of around 1x. Similarly businesses that get most of their income from a handful of large contracts, paid upon completion, are seen as riskier by investors.

Most sophisticated investors will look for a multiple in the 3-4x range. This means the company has enough potential to provide a good return, but is still young enough that they can invest at a reasonable valuation.

Investor inequality

Given what I’ve just told you, you might be surprised to learn that many companies crowdfunding for equity apply multiples of 20x, 30x or more to their profits or revenues when settling on a valuation to raise money against. Despite these obviously-inflated numbers, many enthusiastic amateur investors jump aboard.

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