Crowdfunding - Invest like a Venture Capitalist
Did you ever see a company and think - wow that is an incredible business, I wish I was a part of it? I certainly have and unfortunately the only ways to be a part of it was by working there or investing in it.
Getting a job at a fast growing company doing amazing things is hard enough. But being able to invest early in the company journey is even more difficult.
Funding potentially groundbreaking companies is usually reserved for the ultra wealthy or for venture capitalists. That is until crowdfunding came along opening the door to average investors.
In this post I am going to explain what crowdfunding is and educate you on how you can use it effectively.
What is crowdfunding?
All projects need cash. From a personal project to starting a company to change the world. In the past you had limited options to get funding.
You could go to the dark side and get a loan from a bank. You could ask friends, family and investors for cash. Or you could bootstrap by saving pennies or maxing out credit cards. All that changed when a new option called crowdfunding arrived.
The definition of crowdfunding is:
"the activity or process of raising money from a large number of people, typically through a website, as for a project or small business."
This ability to tap a large group of people to fund a project was a giant leap forward. It gave every project the potential to raise cash when needed.
How Crowdfunding Started (aka Reg CF)
Before 2016 investing in private corporations was only open to accredited investors. The US government set this restriction under the assumption they were protecting everyday people.
How nice of them!
That all changed when the SEC enacted Title III of the US JOBS Act. Title III became known as Regulation Crowdfunding or Reg CF. Reg CF relaxed the accredited investor rule. That allowed more people to invest in private companies, you can check out the details from the SEC here.
Rules of Reg CF
The most up to date rules for Reg CF is a 400 page whopper! You can find it here. For this post I am only going to touch on what many view as the most important points.
Entrepreneurs can raise up to $5 Million via Reg CF in a 12 month period from non-accredited investors. This is a big step up from the previous maximum of $1.07 Million.
Accredited investors have no limits on the amount they can invest in private companies.
Non-accredited investors have a 12 month limit on how much they can invest. The allowable amount is based on annual income or net worth.
Here are the current limits:
Crowdfunding SPV (Special Purpose Vehicle)
Both entrepreneurs and investors know a messy cap table can be a problem.
Because of this the SEC allowed a new type of SPV called a "Crowdfunding Vehicle". The benefit of having this new SPV is that it creates a single line item on a cap table, making administration easy.
Testing the Waters
Entrepreneurs can now also gauge if there is potential investor interest before starting the Reg CF process. This is a massive time saver for the entrepreneur. If they "test the waters" and see minimal interest, they can focus on other avenues for funding.
"Demo Days" and Similar Events Exempt
Entrepreneurs can take part in certain events without fearing that the SEC will say they are soliciting investment.
These include meetings sponsored by:
- higher education institutions (college /university)
- state or local government
- nonprofit organization
- angel investor group, incubator or accelerator
The Many Flavors of Crowdfunding
Securities / Equity Crowdfunding
Private companies and startups need cash resources in order to grow. Crowdfunding bridges the gap between the company raising money from VCs and individual investors.
Individuals invest in the company. They then receive stock, future shares or another security issued by the company. Before crowdfunding, it was nearly impossible for individual investors to invest in private companies.
Peer to Peer Lending
Peer to Peer lending crowdfunding allows one to get a loan directly from other people. This removes banks and other middlemen from the process.
Prosper is one of the popular players offering access to this asset class.
Real estate crowdfunding allows one to invest in real estate projects, construction loans, corporate & residential developments, and even farmland! Investors take part in real estate investing without having to find the project, manage it, etc.
Pre Purchase of Products
Product crowdfunding is when one prepays for a product to come to life. One can think of this as pre funding the building of a product. Products may even tie a "reward" to your early purchase.
Example: pay $200 now and you will receive the product which will retail for $500. You may also be one of the first to get the product!
If you are a watch and/or tech nerd you probably remember the Pebble Watch. It was an early SmartWatch and still reigns as one of the top buyer funded products ever.
The Pros & Cons of Investing via Crowdfunding
Just like with every investing strategy one has to consider it’s Pros & Cons. I am going to lay them out and provide a framework for evaluating opportunities.
Easy Access to Opportunities
Before crowdfunding investing in private companies was hard. You had to be an accredited investor and had to hunt and network to find potential opportunities.
With crowdfunding many of the steps are gone. The crowdfunding platform finds the opportunities, does due diligence and presents the opportunity.
What would take investors weeks and months to complete is now done for you. All available at the click of a mouse button.
Small Dollar Buy In
Crowdfunding allows you to invest in smaller dollar amounts. Some opportunities will take on investors starting with as little as $10. That low buy in price is a far cry from what is usually expected.
Most non-crowdfunding opportunities have substantially higher minimum buy-ins, generally starting at $10-25k or more.
Low dollar buy-in coupled with easy access allows you to diversify with little effort.
Diversification is not only beneficial for public company portfolios. But it is also one of the top strategies when investing in early stage private companies.
AngelList (which is not a crowdfunding portal) has done research supporting an index investing approach for early stage companies (details here).
Support Your Passion or Theories
Everyone has a passion around a certain industry or technology. To be a part of those passions you need to either start a company in that space or join one. With crowdfunding you can now participate as an investor.
Potential to Hit Investment Home Runs
Because you are investing in a company early in its life. You have the potential to be investing in something that can change the world and grow incredibly. It is not unheard of for an early investor to net 10x or more on their investment!
Lack of Company Track Record
Roughly 99% of startups, and early stage companies fail.
Mature companies have a track record of revenue and income. With a young company you are only investing in their idea and the potential successful execution of that idea. Because of the high failure rate a likely outcome is losing all of your investment.
The only sure way to see a return on your investment is by a company “liquidity event”. That means an acquisition and/or public listing. In both cases the event needs to happen at a higher valuation than when you bought, otherwise you will take a haircut on your investment.
Liquidity events can happen anytime but a realistic window is 5 - 10 years from investment day.
Lack of Voting Rights
Generally speaking when you make an investment in a crowdfunded company. You will not get voting rights. This means you will have zero say on how the company grows or evolves. You are only along for the ride.
Because crowdfunded companies are young, there is a limited set of financial and operational data. That means determining a valuation is a near impossible task. What usually happens is the company founder or lead investor in the round sets the valuation for the fundraise.
The lack of reliable data for valuations leads to two potential problems:
- When you can finally sell your investment it could be at a lower value than you paid
- Investments offered on a crowdfunding site may be at worse deal terms than those offered to other investors
Limited Information Rights
You are not granted access to company information.
Some entrepreneurs will send out monthly investor updates but those are not required. In fact, entrepreneurs can pick and choose the investors that get updates. As a crowdfunding investor there is a high probability you will be in the dark about the ongoing operations of the company.
Crowdfunding portals are a business so they charge fees to both the companies seeking funding and investors. These can include listings fees, setup fees, carried interest, annual service fees, closing fees on real estate, and more. All fees will be a drag on your potential investment return.
Crowdfunding Investing Framework
Now that we know the pros and cons of investing via crowdfunding in companies. I’m going to attempt to lay out a framework that can help you pick your investments.
Step 1 - Figure out what to bet on
First you need to decide which assets you plan to invest in. If you have a particular passion or knowledge set, lean in to that. You might understand a certain technology very well. Or you work in the industry the company is trying to change.
Use your specific set of skills and knowledge to help you frame why this company or opportunity can be successful.
Step 2 - How to Use Your Chip Stack
Any great poker player will tell you that your chip stack is your life. If you blow all your chips on one hand. FIN.
Consider NOT placing a large percentage of your total net worth in early stage companies. A conservative starting place would be 5% or less.
Here’s an example using a more conservative 2%:
$100,000 net worth gives you $2000 max for early stage investing.
From there you can consider investing that capital into several companies. For example, $2000 max for early stage investing with $100 in to 20 deals.
You can build up from there. Or as the players say - chip up!
Step 3a - Find Opportunities, Decide, Deploy
Start looking at deals. Do your own research and read the due diligence notes the crowdfunding portal provides. The idea is to form a future vision and opinion on why this opportunity might provide a beneficial long term outcome.
Professional venture capitalists will look at thousands of deals each year and may only fund 1-2% of them. You will find this exciting but be methodical in your research.
Step 3b - Deal Memos and Fantasy Investing
A great way to learn is by writing deal memo's about deals you looked at, invested in or passed on. Write out why you think this deal is good, bad or indifferent. Over time track to see how your views played out in real life.
You can also use deal memos as a way to become a “fantasy investor”. If you write memos and follow the companies as they grow. You will start to find your own method and thesis about how to invest in private companies. All without investing a dollar until you are ready!
Step 4 - Portfolio Management
Once you have put your investing chips to work. Keep playing the game, continue to look at new deals and writing deal memos.
Usually year 2 of investing is when you start to see action in your portfolio. Companies will flame out or start looking for their next round of funding.
The companies that flamed out will need to be replaced by new opportunities for your portfolio. If you have been doing the constant work of Step 3 you should have no problem filling in your empty roster spots.
Companies in your portfolio looking for growth funding may be on to something. Write a new deal memo as if they are a new opportunity. If you still find them attractive see if you can invest more cash to increase your ownership.
The creation and evolution of crowdfunding has been fantastic for investors. What used to be only available to the rich is now available to more investors in the US.
Start by understanding that you can lose all your investment in crowdfunded assets. Then focus on funding projects and companies that align with your passions and theories of the future.
Remember to go slow and do the homework needed to find the true diamonds. You might find a winner that changes both your financial life and the world.
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