Be ready with the tools you need to analyze crowdfunding investments and startups.
Until this year, only wealthy individuals have been allowed to invest in equity crowdfunding investments. These ‘accredited’ investors already had access to the world of private equity and small business start-up investing so the world of crowdfunding investments really wasn’t anything new.
These investors have jumped into equity crowdfunding as a new way of diversifying their investments and finding that next big idea that will net them triple-digit returns. The popularity of crowdfunding investments has already surged among accredited investors and new rules open equity crowdfunding to everyone.
Thanks to new rules this year, anyone can now invest in crowdfunding investments. Rules passed in May allow companies to raise up to $1 million a year from any investor.
Still not sure if crowdfunding investments are right for your portfolio? Check out an earlier post explaining why equity crowdfunding investing is the next wave. Consider Peter Thiel’s $500,000 investment in Facebook as the first outside investor in 2004. By the time the company went public in 2012 that investment was worth nearly $1.7 billion.
Learning how to Value Equity Crowdfunding Investments
While equity crowdfunding investments are a relatively new opportunity, it’s really no different than valuing start-up companies. Venture capital firms and angel investors have been doing this for as long as anyone can remember and the process is pretty well set.
Before you get started valuing crowdfunding investments, understand what you are really getting with equity crowdfunding by reading this earlier post. Investing in start-up and early-stage companies is not for the faint-at-heart investor. Typically, half of your investments may return less money than you invested or nothing at all.
The company may need additional funding in the future, which will probably dilute your ownership share. We talked about understanding the funding cycle and needs of a startup company in this post. These negatives aside, angel investors and venture capital firms typically get an average of 20% or higher returns on their investments.
You don’t need to be a full-time investment analyst but you will need to have a basic understanding of the financial statements provided by crowdfunding investments. It’s a good idea to know what you’re looking at even if you have a team helping you analyze the project.
Start with the basics below and watch for some of the red flags and warning signs when looking over financial statements provided by start-ups and crowdfunding investments.
A full analysis of the potential in crowdfunding investments should include a review of management experience, general economic outlook and competition within the company’s industry. Just as crowdfunding projects should enlist the help of a team, it is also a good idea for investors to seek out the help of others with experience in analyzing early-stage companies.
Finding good investment crowdfunding projects starts with knowing where to look. Check out my review of the best crowdfunding platforms for equity investors.
Analyzing Crowdfunding Investments: The Income Statement
The income statement is the most important document within the project package and sometimes the only financial statement provided by the project creators. The statement is a table of the sales, expenses, interest on debt, taxes and special circumstances that account for a company’s earnings. As a potential investor in the project, you are a partial owner of these earnings and so interested in how management plans on producing them.
The income statement provided by start-up companies and crowdfunding investments is called a proforma statement because it is an estimation of the next three to five years’ operations and earnings. Management has the responsibility to estimate these figures in the most truthful way but also has a vested interest in showing the project in the most favorable light possible.
Because the income statement is an estimate of future sales and expenses, there are many assumptions that management must make…and that is where your analysis comes in.
Revenues – It all starts here and this is likely the most difficult to estimate. Management should provide guidance on the size of the potential market to which it will sell as well as what kind of market share it thinks it can take from competitors. As with many of the income statement line items, your first stop should be the income statement of competitors. Any company with publicly-listed shares must provide an income statement in its annual and quarterly filings, and it is usually easily accessible on the company’s web page under Investor Relations. You might try looking at both the current annual filing and the first filings the company published to get an idea of how financial operations changed over the life of the company.
- Does management think it can take an unrealistically large share of the market? How much competition is there for the product?
- How fast does management think it can increase sales every year? While smaller and newer companies tend to grow sales faster than larger companies, management’s estimate should not differ too much from the growth rate of competitors without good justification.
- Is the estimate for sales realistic given the general economy and the stage of the business cycle over the next five years? While management may not be fraudulently estimate sales, it may be unrealistically using a best case scenario based on perfect economic conditions.
- Within your analysis, it is generally best to develop three estimates for where you think revenue might actually end up. A best case scenario that is still realistic, a base case scenario that is most likely compared to competitors and the economy, and a worst case scenario that represents the least you think possible.
Expenses – are also a potential source of manipulation or poor estimation and must be thoroughly analyzed. Be wary of the project that lumps expenses together into broad categories like Selling, General & Administrative. This may be an acceptable level of presentation for billion dollar public companies with years of reporting but it is a big warning sign for small startups. You should look for expenses to be broken down to the smallest detail possible.
- Marketing expenses should generally agree with the rate of sales growth. A company looking to break into a competitive market and grow sales will need to spend on advertising. If sales are estimated to grow at double-digits while marketing expenses barely budge, the company better have a solid plan. You will also want to check the percentage of marketing dollars to sales. Does the company expect to generate billions in sales with a marketing budget of a couple million? Is this realistic compared to the marketing budget and sales for competitors?
- Staffing costs will be high relative to sales in the first years but taper off when the company builds sales momentum. Is the company in a labor-intensive industry or can a few people manage the whole firm?
- Depreciation is the expense taken on the normal wear and tear of equipment. If the company is capital-intensive (i.e. requires a lot of machinery, computers or other equipment) then depreciation could be a significant part of the income statement. The idea is that the company takes a charge for every year that equipment is used and so the reduction in the useful life of the equipment is matched with the revenue it produces. This depreciation reduces earnings but must be accounted for because eventually machinery will need to be replaced. A company that does not account for depreciation is artificially boosting its earnings and misleading investors.
- Expenses for professional fees should be closely scrutinized. Management must disclose any conflicts of interest within the notes to the financial statement. Often with small and startup companies, professional fees will be paid to people with some form of relationship to the company or management. Is management paying exorbitant fees to the cousin of one of its directors? Is one of the company directors also a professional collecting fees from the company?
- Management travel and perks – lavish travel expenses and other perks are often used as compensation when the company does not want to show a large annual salary.
- Also included in expenses may be insurance, office supplies, utilities, rental expense and a number of industry-specific costs. Pay close attention to the expenses that are listed in competitor financial filings but not in the project’s statement.
- All expenses should be compared to sales, for the absolute level of the expense relative to sales and the growth rate in the cost. Some growth in costs should follow closely with sales growth while others may not grow as fast.
Interest Expense – This may not be a factor if the company has no debt and does not plan on raising funds through loans. If they do have debt or plan on raising funds, it is extremely important since your claim on the company’s assets and earnings will take a back seat to any creditors in a bankruptcy. Even if no interest expense is listed, make sure investors are not responsible for overly generous loan agreements with founders or management.
Taxes –Most startup companies will likely have losses in the first few years and not have a tax responsibility. A failure to account for taxes even after years of growing profits is not correct either though. Make sure management is correctly estimating potential taxes.
Net Income – This is what it all comes down to as an investor. Your investment entitles you to a proportionate share of these earnings. Of course, management will likely decide to reinvest these earnings into growing the business but eventually you will see your return. Earnings should be shown in a per share amount, according to the number of shares issued by the company. Pay attention to the diluted share count which includes stock options and gifts to management and related parties.
Equity Crowdfunding Investments: Helpful Ratios
Margins – these represent the percentage of sales at certain levels of the income statement. Margins are the defining measures of profitability and are a great check against management estimates. A great product and a strong management team may be able to produce margins well above competitors but you should question estimated margins that escape the realm of reality.
- Gross margin – this is the amount left over after sales minus the cost of supplies (cost of goods sold) then divided by sales. It is the affect of the cost of materials on the company’s profitability. If this margin is much higher than that of competitors’ it may be a sign of inferior materials used in production or of poor management estimation. Smaller companies may not be able to get discounts from suppliers and may have a lower gross margin.
- Operating margin – this is the amount left over after all operating expenses then divided by sales. It is one of the best measures of profitability because it shows the operational efficiency of the company without the effect of debt leverage. A lot of the analysis on the company’s operating margin comes down to each expense line item. Operating margins will likely be lower for newer companies until they learn how to efficiently use resources and cut costs.
- Net margin – this is the net income or earnings reported divided by sales. Beyond the operating margin, it includes the effect of debt through interest expense and taxes on profitability. Again, it is important to compare management’s estimate against competitors to check for realistic assumptions.
Analyzing crowdfunding investments is a lot of work and not everyone is up to it. For easier ways to invest, check out my three favorite ways to invest $1,000 now.
Valuing Equity Crowdfunding Investments
Measuring the price per share against another metric like sales or book value is common in stock valuation but not quite as common in startup financing because of issues like ownership dilution and lack of earnings. More common in valuation are two basic calculations called net present value (NPV) and internal rate of return (IRR). Both measure basically the same thing but display the results differently.
This is where it might get a little technical. Sorry. If you are planning on putting tens of thousands or even more to your crowdfunding investments, it pays to spend a little time to learn financial analysis.
NPV is the present value of the investment, discounting cash flows by your required annual return. A dollar received five years from now is worth less than today’s dollar because of the debasing effect of inflation. Your required interest rate for a project depends on its riskiness and your own return needs to meet your financial goals. The NPV is the cumulative present value of all the investment’s cash flows. If the NPV is negative, it means that the cash inflows (cash back to you) were less than the cash outflows (cash you paid in) after discounting to present value. You decline to invest in negative NPV projects because, according to the calculation, the project will not meet your hurdle for rate of return.
IRR measures all the cash flows of a project, inflows and outflows, and calculates a rate of return where the NPV is exactly zero. If you make your NVP calculation and it comes out to be exactly zero, meaning discounted cash inflows exactly match cash outflows then that is your IRR as well.
There are two important things to remember about IRR. First, if there are multiple periods of cash outflows then there will be multiple IRRs and the measure may not be usable. Also, the IRR assumes that you can reinvest each year’s cash inflow at that interest rate, an assumption that is normally not true. For these reasons, NPV is often the preferred measure of return.
I have pasted an example below but you will likely need to read up on the subject a little to get the hang of it.
Most spreadsheet programs like Microsoft Excel or calculators will crunch the numbers for you. You input the cost of the investment, either on a company-wide or an individual basis, in year zero and then the expected cash flows in each subsequent year. If the company is expecting to start paying a dividend in year three then you would add that expected cash flow in that year. Since most startups do not pay any kind of cash flow for many years, usually the only cash flow is on the investor’s exit. This is either through a sale of the company or by cashing out the investor’s position.
- In the example below, you invest $600 in a project (year 0).
- You require a return of at least 10% annually on your investments.
- The project is expected to pay nothing until the third year when a $250 dividend is expected.
- You expect a dividend of $500 in year four and then expect to cash out of the investment for $1,200 in the fifth year.
The PV factor is just a running percentage discounted by your required interest rate. The PV of cash flows is the cash flows multiplied by the PV factor and the cumulative PV is just the addition of all the cash flow present values.
Since the project’s net present value is a positive $619 then the project meets your interest rate requirement and you might consider investing. The IRR is 31%, assuming that you can reinvest the proceeds in year three and four and earn that same rate.
Net present value will not tell you if one project is better than another unless you keep increasing the required interest rate until one project’s NPV is negative. This is the reason some people use IRR also to compare projects.
Holding crowdfunding investments is a great way to diversify your wealth and not have to worry about a stock market crash setting you back to zero. This kind of alternative asset including crowdfunding, private equity and hedge funds shouldn’t be more than about 15% of your wealth but can really add return and help to minimize risk.
There are libraries worth of books written on investment analysis and you will need more than what is written here to fully analyze equity crowdfunding investments. If you are doing all the analysis yourself, I highly recommend going to your nearest library and checking out the curriculum books for the first level Chartered Financial Analyst (CFA) exam. Some of the curriculum will not be relevant but it will guide you through basic economic analysis and how to read a company’s financial statements. It may seem like a long task but it will be worth it if you plan on investing your money based on your own analysis.