Send in the Crowd

Equity crowdfunding offers small investors a slice of the pie, but will they take a giant hit?

Back Article Nov 24, 2015 By Steven Yoder

Pauline Marx, 63, had been a pretty conventional investor in stocks and bonds until April 2014. But to her, the rock-bottom interest rates on fixed-income tools like Treasury bills and CDs felt like stuffing money under the mattress.

Then a friend told her about Fundrise, a website that lets investors buy small shares of real estate ventures around the country — an office building in northern Virginia, a multifamily apartment complex in Salt Lake City, a new building at the World Trade Center site. She started snapping up slices of different projects and is now invested in about 15 of them.

And she’s averaging about 10-percent returns annually, outperforming CDs and Treasuries, whose rates run from less than 1 percent to about 4 percent.

Fundrise is one of dozens of new equity crowdfunding sites that have launched in the last three years. In addition to real estate, they specialize in dozens of industries: new technology, consumer goods, specialty startups like app development (AppsFunder.com), and oil and gas exploration (Crudefunders.com). Some of the businesses raising capital on the sites are startups; others are mature small firms looking to expand.

Marx, who lives in Oakland, knows it’s too soon to tell how her Fundrise investments will do in the long term. The same is true for the thousands of other people who are breaking into private-equity investing through crowdfunding sites, which have only a few years’ track record at best.

Equity crowdfunding portals let small investors, for the first time, buy shares of startups that aren’t listed on the stock exchange. Since most startups fail, novice investors could lose a lot of capital fast. But a few launches are wildly successful — the payoffs to investors who guess right will be huge, and the benefits of connecting small investors with entrepreneurs starved for capital could well create ever more Facebooks and Ubers. Now some California legislators have introduced a bill designed to keep this new funding model on track by thwarting fraud and keeping rookie shareholders from smashing their nest eggs.

The Web’s New Finance Frontier

Even for non-investors, equity crowdfunding websites offer a peek at next-generation companies. You can get on CircleUp.com and read about Watershot, a firm that builds underwater camera housings that allow iPhone users to snap photos 200 feet below sea level. Wefunder.com features Parknav, an app that claims to use a smartphone’s locator to predict with up to 95-percent accuracy where you’ll find an open parking spot on the street.

Users buy shares — at Wefunder, for as low as $100 —  of companies they feel will be the next star performers.  

The web has democratized financial markets. First there was online trading, which cut out the brokers. Then there was peer-to-peer lending, which let individual investors make loans directly to mom-and-pop businesses and individual borrowers. Now investors have another option: buying equity in companies that aren’t publicly listed on the stock exchange, an area that formerly was the sole domain of venture capital firms and angel investors.

Proponents say crowdfunding fills a gap: Startups and small businesses need what are often tiny amounts of capital, and investors need better returns. Scott Hauge, president of Small Business California, thinks the sweet spot in business demand for capital is about $250,000 — too little for most venture capital firms to bother.

“I’m such a strong believer in the power of this to actually disrupt how financing is done. The Internet has disintermediated every other industry from retail to health care, so finance is due for a change. Swati Chaturvedi, CEO, Propel(x)

So far, the amount of money cascading into crowdfunding platforms backs up that claim. Massolution, an equity crowdfunding consulting firm, projects that $34 billion will be raised in 2015, up from just $6 billion in 2013.

“I’m such a strong believer in the power of this to actually disrupt how financing is done,” says Swati Chaturvedi, CEO of San Francisco-based Propel(x), which links investors with startups based on new technologies and scientific discoveries. “The Internet has disintermediated every other industry from retail to health care, so finance is due for a change,” she says.

High-Risk, Illiquid Investments

Until now, the 2012 federal law allowing equity crowdfunding has been mostly restricted to those who can afford to lose money — that means accredited investors, people with a net worth of at least $1 million or annual incomes of $200,000 and up.

That restriction is about to change. As of this fall, the U.S. Securities and Exchange Commission is past-due to release rules for everyone else. The rules will go into effect early next year, says Matthew Milner, an industry analyst at Crowdability.

That’s good and bad news. Novice buyers might go all-in on a street parking app or underwater camera equipment. The demand seems obvious, so how can they fail? But the odds are they will. Most startups go under. They run out of cash, novice leaders make bad choices, a strong competitor emerges. A 2012 Harvard Business School researcher who looked at more than 2000 startups found that about 75 percent didn’t return their investors’ capital.

It’s impossible to say how equity crowdfunding’s returns will do against traditional markets. Rory Eakin, co-founder and COO of CircleUp, says that for the sector as a whole it’s too early to tell, pointing out “these are high-risk, long-term illiquid investments.” On its site, Wefunder invites investors to think of crowdfunding shares as “socially good lottery tickets.”

All of that poses too great a risk for most financial planners. A dozen called for this story either didn’t respond, hadn’t heard of crowdfunded equities or don’t put their clients into alternative asset classes. “If an investment doesn’t have at least a 3-year track record, we won’t even give it a look in efforts to protect our investors,” says David Waldrop, certified financial planner and owner of Bridgeview Capital Advisors in El Dorado Hills, a registered investment advisor.

The chance that a wave of Madoff-scale frauds and investor bankruptcies could sour people on the sector has consumer groups and California small businesses concerned. The federal rules will allow unaccredited investors with annual incomes or a net worth above $100,000 to invest up to 10 percent of that income or net worth per year. That means over time, losses could wipe out someone of modest means. So Hauge’s Small Business California and others are backing state legislation to cap the total crowdfunding investment for the unaccredited at $5,000 or 10 percent of their yearly net worth, whichever is less.

But Hauge’s group wants more than to protect potential investors. It also wants to empower entrepreneurs to sell shares on their own. Under the federal rules, startups can’t put up shares for sale directly through their own websites — they have to pay a platform like Wefunder or CircleUp to list them. The bill that Small Business California supports would allow a business to list its offering on its own website after the deal is reviewed by the state’s Department of Business Oversight. Assembly Bill 722, which would amend the state’s Corporations Code, failed this year, but Hauge says it will be back in 2016.

Forget Your Intuition

The negatives aside, some startup investors do well against the stock market. In a 2007 study of more than 500 angel investors who sank money into early-stage startups, the average return per startup within 3.5 years was three times higher than the amount invested. Fundrise CEO Ben Miller says that the hundred or so deals his company has done have returned average annual yields of 13.5 percent. Eakin says that in CircleUp’s 3-year history, startups that have raised capital through the platform have grown 90 percent per year on average.

But Eakin is quick to stress the “average” part of that metric. That’s important — most startups don’t return their investors’ money. In the 2007 study, more than half the startups that angels bet on returned less than what the investors put in. A tiny group, 7 percent of them, returned more than 10  times what their investors put in, making up for the losers.

So investors who make money in the private-equity market follow a set of rules. “You have to know what you’re doing,” says Crowdability’s Milner. “You’ve got to be sure that you’re not doing it by intuition. You’ve got to follow the statistics.”

That means first educating yourself about best practices in crowd investing, he says. A number of crowdfunding platforms offer tools and information, sort of a “Crowd-Investing 101.” Crowdability itself offers a mix of free and paid content —  tutorial documents and videos for novice crowdfunding investors and tools that let investors check out individual startups in more detail.

There’s also wide consensus that crowdfunding investors need to diversify by betting a little on many startups instead of putting all of their dollars behind just one. There are several ways to build a portfolio, says Bill Clark, CEO of San Francisco- and Texas-based MicroVentures.com. You can pick a mix of early- and late-stage companies or buy shares of companies from a diverse range of industries. As for target numbers, Milner says you should invest in several dozen startups, and 50 – 100 is best.

Many experts also stress the importance of due diligence. That includes checking out the track record of the crowdfunding platform itself and assessing whether it discloses the startups’ key fundamentals, says Kelly Rodriques of San Francisco-based 

PENSCO, an alternative asset custodian that helps investors put retirement dollars into alternatives like real estate and private equity. For individual startups, due diligence means checking how much experience the leaders have running a business, whether they’ve done a successful beta launch, and whether they’ve attracted other venture capital or angel investors, he adds.

Another option is to follow the pros — venture capitalists and angels with good batting averages who pick winners in the private-equity market, says Milner. Sites like AngelList.com let smaller investors buy into deals set up by experienced angel investors, paying them up to 30 percent of any profit that results.

Most importantly, if buyers do explore crowd investing, they should keep that part of their portfolio to no more than 3 to 5 percent of total assets invested, says Roseville investment advisor Kimberly Foss of Empyrion Wealth Management. And they should assume that their money will be locked up for five to seven years, she adds.

Chaturvedi says that if investors use crowdfunding the right way, its impact on how capital is raised will be “massive.” That already seems to be happening — the $34 billion projected to be raised in crowdfunding this year could, for the first time, be more than what comes in through traditional venture capital.

Time will tell whether private-equity crowdfunding will evolve in a way that reassures or wards off new investors. If it succeeds, it could present a nice problem for startups raising money: too many options. 

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