Equity crowdfunding investing has the potential to open up a whole new world for investors, but what are you really getting?
The Securities & Exchange Commission approved the rules for equity crowdfunding investing last weeks, opening the market for a huge flood of projects and crowdfunding investors. That makes it the perfect time to revisit an old post to look at one of the biggest risks in equity crowdfunding investing.
Crowdfunding may have started as a way to fund creative projects and non-profit ideas but it could be ready to evolve into one of the key steps to starting a business. Just a year after passage of Title II of the JOBS Act saw a total of 534 small biz owners successfully meet their equity crowdfunding campaign goals to raise money for their businesses. More than $200 million in equity crowdfunding investing capital was raised, averaging a little over $400k per company.
What’s special about equity crowdfunding investing is that instead of going to an investment bank or a group of wealthy investors, these companies raised money from regular investors. With crowdfunding investing, investors have direct access to invest in start-up companies and the potential for huge profits.
If you're not sure what crowdfunding is or what it means to investors and small business, check out this free crowd funding webinar.
With passage of Title III of the JOBS Act, equity crowdfunding investing has opened to millions of investors across the country. Before Title III, only accredited investors, those with a net worth of at least a million or a minimum annual income, could invest in equity crowdfunding projects.
Accredited investors make up less than 5% of American households. Passage of Title III will open the market up to more than 58 million households and expand the available pool of investors by almost ten times.
Despite the new opportunity in equity crowdfunding investing, this new investment vehicle isn’t without its risks.
The concept of small business investment will be new to many investors and investing in a start-up company is not like investing in stocks. Understanding ownership in start-up investing will go a long way in not getting burned or seeing your investment diluted away.
Equity crowdfunding investing has been a boom for real estate developers. I talked to the co-founder of Fundrise recently about real estate crowdfunding investing and some ways even non-accredited investors can participate.
Ownership in Equity Crowdfunding Investing
Unlike rewards-based crowdfunding, in equity crowdfunding investing you are buying an ownership percentage in a company when you invest in an equity crowdfunding project. The measurement of that percentage ownership and what happens to it in the future is one of the most important but neglected concepts in equity crowdfund investing.
Important because that percentage ownership entitles you to a percentage of the cash flows from the company, whether through dividends or when the company is sold. The idea isn’t well understood though because investors usually fail to read the fine print of company regulatory filings to understand what will happen to their percentage of the company later down the road.
When a project gets listed on one of the crowdfunding platforms for equity investing, it is seeking funds by selling ownership in the company. For this it will issue shares, some of which will be sold to investors and some of which will remain with current owners as their remaining share of the company. Equity crowdfunding projects are required to register with the Securities & Exchange Commission (SEC) before taking on investors. They are required to list a number of things including:
- Target amount of funds, deadline and progress updates through the life of the offering
- Share price and methodology to determine price
- Description of ownership and capital structure, including detail on terms of securities and those of previously sold securities. Detail on shareholder rights and dilution of shares
The problem is that startups often need multiple rounds of financing throughout the company’s lifespan. The initial equity crowdfunding investing round may just get the business up and running. If the company wants to enter new markets in later years, it may need more money and may need another round of financing. For this new stage of fundraising, it may need to issue yet more shares.
For example: If it issued one million shares previously, those shares were entitled to 100% of the company’s profits. Now if it issues another million shares, then the initial owners of the million shares are only entitled to 50% of the company’s profits because there are two million shares issued in total.
Besides issuing more shares through financing, companies can also grant shares to management as compensation. These stock options and awards have the same effect of diluting current shareholders. Of course, the idea is that through subsequent rounds of funding or by rewarding good management the company will grow and even a smaller percentage ownership will be worth more.
If you are still not convinced of the importance of understanding ownership, a good example can be found in the movie, The Social Network, about the rise of Facebook. Eduardo Saverin co-founded Facebook with Mark Zuckerburg when the site was launched in 2004. Saverin owned 30% of the company for his initial funding but the company issued 24 million new shares of stock in 2005. This caused Saverin’s stake to be a smaller percentage of the new share count…much less. After the dilution, Saverin owned less than one percent of the company.
As I write this, that 30% stake in Facebook would be worth nearly $60 billion against a 1% stake worth about $2 billion. Get the picture?
With that second round of funding, Facebook was able to get to where it is today. That’s a positive for earlier investors but the issue of ownership dilution is a constant risk.
Do you really get a vote in equity crowdfunding investing?
When you buy stock in a company, you get a vote whenever the company has a shareholder’s meeting to decide important issues.
Unless you are a large percentage owner of the company, large enough to have a seat on the Board of Directors, then there is often not much you can do about share dilutions or management stock awards. You are allowed to cast a vote if one is held and can rally other share owners to vote one way or another but founders often maintain a controlling share and control the vote.
For this reason, you absolutely must read through the crowdfunding project’s regulatory filing and understand your rights as a shareholder. You may even seek legal counsel or an investment group knowledgeable on the matter. Multiple rounds of financing and ownership dilution may be unavoidable, and may even be a good thing, but you need to understand how and when the company is expecting to dilute your ownership.
Ownership in equity crowdfunding investing projects will likely be a little different than normal stock investing. First, crowdfunding projects are usually much more personal and offer a sense of community. Even the larger crowdfunding projects usually have less than a few thousand investors as opposed to the millions of shareholders in some of the largest publicly-traded companies.
You are also more likely to be able to invest enough to have a significant stake in equity crowdfunding investing than you would a multi-billion dollar company. All of this works in your favor should the company seek to raise more funds through another share issue.
- Understand that your investment entitles you to a percentage ownership in the company but that percentage owned may change
- Read regulatory filings for the projects in which you want to invest and look for future cash needs and possible dilutions
- Seek out other investors in the project. You may wish to form an alliance to argue against dilutions or other future events at shareholder meetings
Why Equity Crowdfunding Investing could be the Next Big Thing
So with all the risks, why would anyone want to put their hard-earned money to equity crowdfunding investing?
I covered the question in a recent post on why equity crowdfunding investment could be the next big thing. Investing in start-ups is nothing new and wealthy investors have been able to realize strong returns through careful analysis of projects.
Research at Willamette University studied more than 1,200 investments over a 15-year period. While more than half (55%) of the investments ended up failing, angel investors in the projects realized an overall return of 260% on their investment.
The opening of equity crowdfunding investing to the general investing public isn’t without risk but then no investment is without a level of risk. Investors trade the safety of bonds for higher returns in stocks. In equity crowdfunding investing, you trade the relative safety of long-established companies for the potential of even higher returns in start-ups.
Make sure you know the risks and always diversify your total investment across many different projects. Holding less 5% of your start-up investing money in any single company means a few failures will eat away at your returns. Check out an earlier post on how to analyze investment crowdfunding projects.