Want To Invest In A Crowdfunding Deal? 7 Tips For Doing It Right
Now, practically anyone can become a small-time venture capitalist.
New rules implemented under Title III of the JOBS Act give those earning less than $100,000 a year or people with a net worth lower than that the opportunity to invest in small businesses and startups.
This could be enticing to many investors. Ryan Feit, chief executive of SeedInvest, a platform that vets and lists such crowdfunding offerings, says, “Overall, the returns, especially for startups, have been better than people think.” Cambridge Associates finds that its U.S. venture capital index outperformed other indexes over most time periods, with it sporting a 24% return over 25 years, compared to 10% for the S&P 500.
He also adds that pensions and endowments have been diversifying by adding private investments alongside stocks and bonds. Noting that Yale’s endowment allocates 16% of its portfolio to venture capital, he says it is significant “that the largest institutional investors allocate a portion of their portfolio outside of the stock market.”
But if you find the opportunity appealing, go in with your eyes wide open.
“This is a high-risk asset class,” says Wayne Mulligan, cofounder of Crowdability, an aggregator of offerings on top crowdfunding sites, which offers Crowdability IQ, a ninepoint rating of crowdfunding opportunities. “Most startups, whether they’re VC-funded, bootstrapped or just raised angel money, will go out of business, period. I mean, most VCs lose money on 60% to 70% of their investments, and these guys are supposed to be the best investors in the space. Investors that approach these types of investments and think they can cherry pick one, two or three companies and one of them is going to turn it into Uber—that’s just not going to be the case. Those people are likely going to lose their money.”
By way of comparison, according to the Australian Small Scale Offerings Board, only 49% of startups that were listed on the platform in 2013 still survive today.
Assuming you’re in the game to make rather than squander money, follow these tips to up your chances of bringing in some dough.
1. Limit your exposure. Those interested in investing in crowdfunding opportunities should restrict all their speculative investments to no more than 5% of their portfolio, particularly for those with net worth lower than $1 million or incomes lower than $100,000, recommends Allan Moskowitz, an El Cerrito, California-based certified financial planner. Investors with more money to spare could increase the limit of their speculative investments, perhaps up to 10%.
And only bet money that you are 100% completely willing to lose. “Investment money needs to be extra money,” says says Darryl Steinhause, partner at law firm DLA Piper. “It can’t be money that you need to live on next year. It’s got to be money you have the ability to lose and it doesn’t disrupt your life.”
2. Invest money you won’t need for at least five years. The three ways you’ll make money are if the company goes public (increasingly unlikely these days, as more companies choose to stay private longer), if the company is acquired (far more likely) and if you sell your shares on the secondary market. But even to sell on the secondary market, you have to hold the asset for at least a year, and it’s not yet clear how active secondary exchanges will be.
“There’s going to be very little liquidity, so unlike investing in a public stock where you can trade your shares the next day if you change your mind, when you’re investing in a private company, you’re holding on for the long-term, until an acquisition or an [initial public offering] occurs,” says Feit.
Observing that the typical hold period for early-stage private equity is three to five years, Mulligan’s cofounder Matthew Milner says, “If you don’t have at least five years and maybe more to be conservative, you shouldn’t be investing in this asset class.”
3. Diversify. Mulligan recommends that investors not bet all their crowdfunding money on one investment. “If you go into this and you understand that the majority of these investments are going to fail, maybe one or two will work out, you could allocate a portion of your portfolio to this … and diversify that portion over 20, 30, 40, hundreds of investments over the course of several years,” he says.
4. Vet the platform. You want to avoid platforms that act
merely as listing services and aim for one that either is or works with a broker-dealer. Search for portals that are more selective, so the offerings are the cream of the crop. SeedInvest, for instance, selects only 1% of applicants. To find the best opportunities, research the experience of the team behind the platform. What kind of background do they have in investing in private companies? How well are companies that have previously been funded through the platform doing?
Assess how long the portal will be around. Since your money will be locked up for at least five years, ask yourself, “Will they really be there in two years if there’s a problem with the deal?” says Steinhause, who recommends using a site with venture backing, “so if something goes wrong, it can afford to help you.”
Then find out how well it conducts its due diligence on companies. Determine what the platform requires by way of documentation. Audited financials? Third-party valuations? Does it talk with the company’s customers and other investors? For a real estate deal, does it require that the company offer indemnity or liability to investors if they fail to follow through on their procedures? Don’t be afraid to ask the platform for the questionnaires it had the company fill out, the backup documents, the notes of interviews the marketplace had with the company’s lawyers and bankers, etc.
Look for a portal that will help you solve anything that goes awry. Learn if and how your money is protected. Is it put in a bank? In escrow? “The platform and portal should have affirmative policies and procedures with some liability insurance and indemnity to the investors that we have reviewed all the documents and information and we believe the investment is reasonable,” says Bryan Mick, president of Omaha-based Mick Law, which performs due diligence for broker-dealers. “Someone should have to sign off on that and put their name on it.”
5. Vet the company.
Then, of course, research the company you might invest in. “The Internet has a lot of information. If you’re investing with a company or individual, do your own due diligence on that person,” says Steinhause.
Crowdability’s Milner and Mulligan suggest that you know the founder’s background and whether or not they have direct experience in the industry. Look for a team balanced between technical and business backgrounds, which correlate with higher success rates. Despite the success stories of college dropouts Bill Gates and Mark Zuckerberg, opt for startups with college-educated founders, since research shows that their ventures are less likely to fail. Also, favor companies with three founders, which have been shown to grow three-and-ahalf times more quickly than those with single founders—an important consideration since many startups run out of money before they can take off.
6. Understand the business model.
Play the role of VC. “There’s a correlation between hours of research and success,” says Milner.
Determine whether the industry, such as tech, has a higher survival rate than those of others, such as manufacturing. See if the company’s other investors have been backed by professional venture money.
“Read the disclosure or offering memorandum, because you need to understand the investment and not just look at the number that says, ‘Hey, I’m going to get the 25% return,’” says Steinhause. “You need to look at how the company is trying to get that return.”
Dive into the nitty-gritty details. Don’t be afraid to ask questions about how things work. “If you look at a real estate deal, who is analyzing the Phase I environmental report?” says Mick. “Who’s analyzing the engineering report to make sure the capital reserves that are funded as part of the offering are sufficient to replace the roof in four years? For an oil and gas deal, who’s looking at the actual reserves under the ground? Who’s doing the economics on the costs it takes to get it out of the ground, pay taxes and severance and transport it to the refinery 300 miles away?”
7. Understand the investment terms.
Don’t overpay. “If you’re looking at a company that has two guys, no product, no revenues, and they’re saying they’re already worth $15-20 million and want you to invest at that valuation, it will be tough for you to make money,” says Milner.
Even if you invest early on, you could overpay. “M&A is the highest possible successful outcome, and those usually occur below $100 million,” says Mulligan. “It’s not like everybody’s getting bought out like Instagram for $1 billion. So if you’re investing in a company that seems to be doing well, but you’re paying a $50 million valuation, statistically speaking, that company is not going to get bought for $1 billion. Even if they get acquired, you could still lose money.”
Also, know whether you have preferred or common stock. If you own common stock and someone else has preferred at the same valuation, if the company is bought at a break-even price, the preferred shareholders will get their money back first, and you may not receive anything.
Find out who’s doing the pre-money and post-money valuations—is there a third-party firm that gives their opinion? Who’s calculating the fully-diluted share ownership? What limitations are there on management issuing themselves stock and options? Who negotiates for you if there’s a future round of financing that could dilute your shares?
Whatever you do, don’t be cavalier about these investments. “Understand the basics,” says Milner, “because there are so many weird, unusual points that come up when you invest in a private company that people haven’t come [across] when they’ve invested in public markets.”