Want To In­vest In A Crowd­fund­ing Deal? 7 Tips For Do­ing It Right

ForbesWeekly - - NEWS - BY LAURA SHIN, CON­TRIB­U­TOR

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.”

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