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Avoid the sting in crowdfunding’s tail

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Investors Chronicle | By Rosie Carr | Nov 15, 2013

Sting in a Crowdfunding tail -  Avoid the sting in crowdfunding's tailEvery crowdfunding investor dreams of a Facebook moment. That’s when you wake up to discover that the tiny start-up you backed a few years ago is now going to float for millions or even billions, making you unbelievably rich in the process. But beware of discovering soon afterwards that you’ve fallen into the same trap as unlucky Facebook co-founder Eduardo Saverin whose fate, and subsequent legal battle, are depicted in the movie The Social Network.

What happened to Saverin was that having invested $1,000 (£628.12) for his 30 per cent-plus share in the company he jointly founded with Mark Zuckerberg, his stake was later massively diluted by the issuance of fresh shares to new investors. In fact Saverin's share was watered down to less than 0.5 per cent, while Zuckerberg's share remained exactly the same. Saverin might have had a piece of paper telling him he owned a third of Facebook, but what he didn’t have were pre-emption rights. If he had, those rights would have prevented his original share from being diluted away to almost nothing.

Worryingly for devotees of equity crowdfunding in the UK, the risk of being written out of the picture at any point, including just ahead of a big flotation, is a real one. That's because start-ups will continue to seek new capital as they grow. And as they approach the stage where they look ready for a float, they will attract serious attention from canny venture capitalist backers who will demand preferential terms and will have no qualms about riding roughshod over your dreams. In other words your holdings will be drastically diluted while they walk away with the lion's share of any future float or sale, along with possibly preferential rights to dividends.

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You can protect yourself from the risk by paying attention to the terms on which you are offered shares in a crowdfunded deal, and by securing the best class of share available even if this means investing more. Your holding can still be diluted as additional capital is raised by the company, but what you don't want to happen is new shares being issued in huge numbers with preferential rights to a select few investors.

Seedrs protects investors by using a nominee structure so it remains the representative of the investor and always enters into a subscription agreement (similar to a business angel agreement) with each investee company. This ensures that investors receive professional grade investor protection including anti-dilution and tag-and-drag rights. Jeff Lynn, chief executive at Seedrs, says that while a company's Articles of Association can appear to offer rights to the original shareholders, in fact the articles can be rewritten by shareholders with voting shares. "A subscription agreement is the only real protection," he says.

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