Equity crowdfunding investing is about understanding the risks to a company and the potential for high returns. Learn how to assess startup investing risks and you will make money!
Investing in startup companies and equity crowdfunding deals is risky. Investors face huge swings in portfolio value, dilution of investment and the risk of total loss in any one company.
And that doesn’t even include the startup investing risks in each individual equity crowdfunding deal!
Before you can manage the larger picture risks in startup investing, you need to avoid the deals that have no possibility of success by understanding specific risks to each company.
For those investors that can manage both sets of risks, a whole new world of investing awaits. It’s an opportunity to diversify your net wealth and book double-digit returns well above those found in the stock market.
This post is part of our how-to series on equity crowdfunding investing. We’ve covered nearly every aspect of investing in the new asset class from market research to valuing startups. The final piece of the puzzle is recognizing the startup investing risks in each crowdfunding offer.
Many of the risks to a company’s success are going to be similar across early-stage investing. Companies have to manage a changing economic landscape and regulatory oversight. Other startup risks will be more specific to the company and its industry.
The biggest factor in your success as an equity crowdfunding investor, and the major theme in this series, will be your ability to weed out the deals with the least potential for returns. Rationally analyzing the risks to a company will be one of your best tools.
Macro-level Equity Crowdfunding Risks
There is always the risk that the business cycle will turn and the country will fall into a recession. It’s so persistent that it is almost not worth worrying about because of the uncertainty around forecasts.
Early-stage companies are going to be hit by a recession and bankruptcies trend higher but the time horizon for startup-investing is so long that most companies have to contend with an economic gap at some point before they provide investors with an exit.
While you shouldn’t try to ‘time’ these economic recessions perfectly, there are a couple of measures I like to take to minimize my risk of investing just before a recession.
- Using data from the Federal Reserve Economic Data on employment and lending can help see if the economy is already towards the end of a cycle or still has a few years to run. Business cycles and bull markets don’t die of old age but employment that has been growing for years means higher payroll prices could be coming, reducing profits and leading to cost cutting.
- Investing in very early-stage companies during a recession or the first years of an economic rebound means those companies should have quite a few years to grow. If the economy has already been growing for several years, I start investing in more mature companies that already have the financial power to withstand a downturn.
- Pay closer attention to the industry in which the company operates when investing in startup deals ahead of a potential soft spot in the economy. Companies in an industry tied to discretionary spending like fashion or travel may see their revenue fall dramatically when businesses and consumers pull back.
Another higher-level startup investing risk is that of regulatory oversight in the company’s industry.
- Does the government regulate the industry as in utilities or does it still impose quite a few standards as in transportation?
- Are there government subsidies supporting the industry that might cause problems if they are retracted as in alternative energy?
- What does the regulatory environment look like in other countries? This may seem unimportant but state sponsored steel companies in China have almost destroyed the U.S. industry with import dumping. Make sure you research the trend in imports and exports for the startup’s industry.
Many of these deal risks can be found by looking through annual statements of publicly-traded competitors. The SEC requires that a company list out potential risks for investors. The section is usually fairly vague on the actual risks but is a good source of the themes and factors.
Company-Specific Startup Investing Risks
Understanding the company-specific risks in an equity crowdfunding deal are much more important and can help you avoid some of the worst investments. These risks range from potential problems with management to the company’s business model.
The biggest risks around a startup usually involve the entrepreneurs or the management team. Success in entrepreneurship is much less about the idea and much more about execution. A poor management team can kill even the best product idea so you need to spend some time analyzing management’s ability to make the company work. We covered how to make sure management doesn’t destroy your crowdfunding investment along with a helpful checklist in a previous article.
- What is management’s experience in the industry? Have they worked close enough to customers to know their needs or have they been in management their entire lives?
- What is management’s experience in startups and growing a company? The entrepreneurs don’t necessarily need a long list of companies they’ve founded but it helps to have worked at smaller places to understand how to make a startup competitive and profitable.
- What is management’s control over the startup? Are they open to sharing control or is it just one founder that wants to run the place with an iron fist? A strong leader is one thing but what happens to the company if that leader moves on?
- Has management brought on advisors and implemented any suggested changes? The support of another investment fund both through funding and advisory is a huge validation of a startup company. Not only does it bring in good leadership but the investors will be pushing for an exit.
You will also need to pay close attention to competitive and industry-level risks in each crowdfunding deal. There are always going to be risks for startups competing in an industry. Your job is to recognize the risks that can be managed by the startup and those that might mean failure for the company. A lot of these are going to come up in your market research process for equity crowdfunding.
- Who are the startup’s primary suppliers for materials? Can they be replaced quickly and cheaply? Depending on just one supplier means a startup may have to pay higher prices and could see business grind to a halt if that supplier gets into trouble.
- Who are the company’s primary buyers? Do they sell to one or a few buyers or is it an open market of customers? The same risks exist here as with suppliers. If one buyer accounts for most of the company’s sales and decides to push for a lower cost, how much lower can the startup go before profitability is lost?
- What is pricing competition like in the startup’s industry? Is the company planning on competing on a lowest-cost basis or on quality? How have competitors reacted in the past when a new company enters the market? Look through any industry news over the past couple of years about price promotions, discounts or seasonal sales. The idea is to find out how frequently and how harshly the industry competes on price and what kind of leeway the startup has between costs and price.
How to Manage Crowdfunding Deal Risks
There are two ways to manage risks when you are analyzing individual equity crowdfunding deals.
One of the core concepts of investing is the trade-off between risk and return. Investors demand a higher potential return when risk is higher and nowhere is this more evident than in startup investing. You might be perfectly happy earning 1.5% a year on risk-free Treasury Bonds but you better get more out of your equity crowdfunding deals to compensate for the potential for a total loss.
The problem with assessing risk and return is that it is subjective and impossible to really quantify. I’ve spent more than five years working for venture capital investors and analyzing deals. The one common theme is that no two deals are alike and each company involves different risks.
That said, you can always set some rules for your early-stage investments when it comes to returns. I don’t invest in any deal without the potential for at least a 20% annualized return. We looked last week at three ways to value startup investing deals and calculate the potential for returns. That minimum return requirement would be on a company that has a very high likelihood of providing an investor exit soon and some serious competitive advantages in its industry.
For most startup investing deals involving more risk, I generally want to see the potential for a return of 5-times my investment over five years. That would work out to about a 38% annualized return or even a 25% return if it takes seven years for the company to provide an exit. For companies facing yet more risk than average, I would just increase the potential return needed.
Of course, you’ll never be able to predict the actual return on an investment but reaching a good level of certainty in your valuation and the potential for a high payoff gives you more leeway if things don’t work out as well as you thought.
The second way to assess and manage risk in your crowdfunding deals is just as a way of avoiding the riskiest investments. You’re probably tired of me quoting the fact that more than half of startup investing deals bust or pay out less than the original investment but it is a very real fact and an important consideration. Just avoiding a few of the worst deals so that this group amounts to only 40% of your portfolio can mean a huge jump in overall returns.
Angel investing averages returns of around 25% annually but sees 55% of deals go bad. If you invest $500 in 30 companies, that means losing up to $8,250 in those bad investments. To make a 25% annual return on your portfolio, you would need those remaining companies to provide an average 47% annual return over a five-year period. That’s a high mark to set even for the most successful startups.
Reduce the amount of bad investments to 40% of the total and the picture is entirely different. You’ve only lost up to $6,000 on bad deals and need the remaining startups to average a 38% return over five years to reach your 25% portfolio return.
Avoid the worst equity crowdfunding investments through a careful analysis of the risks to the company and you will make a ton of money!
I hate when analysts say that startup investing is more art than science. It’s a cop-out and an excuse to keep individual investors from getting into the high-return asset class. You’ll get better at assessing equity crowdfunding risks as you look at more deals but there is a process and it isn’t just analyst intuition. Learn how to manage startup investing risks and avoid the worst deals and you will be well on your way to making money as a crowdfunding investor.