Equity Crowdfinancing Risks & Returns

Published on April 2, 2016

Editor’s Note: To learn more about this topic, we also recommend this webinar.

 

Few opportunities in life can generate personal wealth as profoundly as being a founder or early investor in a startup that achieves grand success.

Reid Hoffman was one of Facebook’s first two outside investors. As an entrepreneur himself, Hoffman had been a founding board member of PayPal and then founded LinkedIn in 2003. He staked $37,500 on Facebook in 2005, when the social network had just moved out of Mark Zuckerberg’s Harvard dorm room to its new headquarters in Silicon Valley, and was valued at $5 million. When Facebook filed its initial public offering (IPO) seven years later, and the company’s value topped $100 billion, Hoffman’s piece of it was worth something like $75 million, giving him roughly a 2,000-times gain over his initial stake.

This is a high-profile example of a spectacularly successful angel investment. The overwhelming majority of angel investments are not so successful; some of them are moderately to very successful, and—this is the sad part—most of them are losses. As you know, the possibility of meteoric growth in the value of startups is accompanied by commensurate risk of sluggish growth or outright failure. That’s why successful angel investors typically buy equity stakes in several startups and, by doing so, diversify the risk and increase the chances of a hitting one out of the park.

The potential rewards of angel investing are not just financial, though. There are also strategic benefits, which may include:

  • Close association with talented developers and inventors, brilliant entrepreneurs, and well-connected directors of the companies.
  • Participation in company management or governance, possibly as a board member, paid consultant, or strategic partner.
  • An up-close, insider look at innovative business models, new products, cutting-edge technology, and proprietary research.
  • The opportunity to invest in future rounds of later-stage angel and venture financing.

In the process of seeking financial returns and strategic benefits, angel investors can also derive social rewards: boosting community development (especially when the investors and issuers represent the same metropolitan area or region), creating new jobs, supporting favorite products and brands, and helping good people make their dreams come true. The rewards and benefits from successful ventures reach far indeed.

Enter at Your Own Risk
The door to angel investing is now open to all investors, thanks to Title III of the Jumpstart Our Business Startups (JOBS) Act of 2012. Title III of the act legalized equity crowdfunding and allowed the participation of tens of millions of non-accredited (average) investors who did not have access to private securities offerings before.

Not everyone is prepared to walk through this door, though. Investors who have never bought into an angel deal, even those who consider themselves sophisticated when it comes to investing in publicly listed stocks and bonds, need to get familiar with a new universe of securities investing. Seed and early-stage investments include substantial risks as well as the possibility of exciting returns and benefits. You need to understand how angel investments can affect your overall portfolio in terms of diversification, asset allocation, liquidity, and long-term financial objectives.

Returns and Benefits

Keep in mind that an IPO—while conceivable—is probably the least likely exit for your angel investment. Only a fraction of 1 percent of angel investments end in IPOs, although some successful investor groups—such as the oldest angel group in the western United States, the Band of Angels in Menlo Park, California—achieve “IPO hit rates” of more than 3 percent of their portfolio companies.[1]

Still, you can earn a return on your investment through other exit strategies, including management buybacks, acquisitions, and resale of shares on secondary markets. We expect that the emergence of equity crowdfunding will spawn new, online secondary markets and/or public stock exchanges for crowdfunded equity—that is, Internet-based marketplaces where crowdfunding investors can sell their shares (after a mandatory one-year holding period). We will post news about secondary markets that launch in the future, as well as many other useful resources for crowdfunding investors, on our news blog.

Exit strategy is relevant only if the startup you invest in survives and grows. Many do not. Some of them simply fail to gain traction in the marketplace and wind up in dissolution or bankruptcy. Some of them stay small even if they succeed, in which case there may be no practical exit for angel investors (depending on the terms of the deal).

Social Benefits in the Title III World
With respect to financial benefits, we predict that equity crowdfunding will be similar to traditional angel investing over a period of several years. Assuming you diversify your angel portfolio with a number of investments, you will have a chance to achieve good overall returns. Your ultimate financial goal, to be realistic, should not be to earn triple-digit returns (if that happens, consider it a very pleasant surprise), but to beat the familiar market indexes such as the Dow and S&P. You may conceivably hit a grand-slam home run, but some or even most of your investments will probably be strikeouts.

The most successful angel investors have learned how to pick enough winners, and limit their losses from the losers, to earn a good overall return on their angel portfolios. Still, the most authoritative sources of data on angel investing indicate that, although in the aggregate angel investors may achieve good returns, the majority of individual angel investors actually lose money.[3]

You may wonder why, if most angel investors lose money, they keep making such investments. Some successful (or not so successful) entrepreneurs become angel investors because “it’s a way to stay in the startup world without having to work 80 hours a week,” explains Ian Sobieski, PhD, managing director of the Band of Angels, who also taught entrepreneurial finance at the University of California at Berkeley. “Many angels are retired CEOs or heads of industry who invest because they want to help startups grow and mentor younger executives. They are often motivated by the energy of a young company. But for most angels, the simplest answer is, it’s fun.” We have noticed also, having attended “demo days” events where entrepreneurs pitch their deals to angel investors in person, that it is highly social. Angel investors (and fabulous people in general) enjoy such elite hobnobbing.

With respect to strategic benefits, equity crowdfunding is a radically new environment, with nontraditional relations between founders and investors. Remember that it involves much larger numbers of smaller investors. In Title III deals, issuers cannot be selective about who they accept as investors based on their expertise or strategic value to the company. Even if you believe you bring consummate strategic value to the deal, you’ll be investing alongside hundreds or maybe thousands of other “small” investors, many of whom believe they too bring valuable expertise to the deal. So don’t assume that the strategic benefits of an equity crowdfunding deal will be as compelling as in a traditional angel deal.

Now for the good news. In place of those kinds of strategic benefits, equity crowdfunding investors will enjoy social benefits that are unique to this new financial ecosystem, the infrastructure of which has a strong social networking component. In addition to the social benefits of traditional angel investing (community development, job creation, supporting good people and ideas), the social benefits unique to equity crowdfunding include the opportunity to:

  • Connect and build relationships with entrepreneurs and fellow investors who share your passion for a particular product, brand, team of founders, community, or sector (such as games, movies, fashion, 3D printing, or sustainable energy, to name a few).
  • Collaborate with other investors to analyze an issuer’s business plan and financial projections, research and evaluate the competence of its executives, verify its claimed customer base, and estimate scalability (room for growth), to judge whether the company has a good chance for success.
  • Leverage the wisdom of the crowd to conduct due diligence—for example, ferret out evidence of fraud or incompetence, detect any misstatement or omission in disclosures, and (post-funding) monitor spending of proceeds from the investment round.

To some readers, especially Millennials and others who are accustomed to social networking and rewards-based crowdfunding, the social benefits of equity crowdfunding can be summed up in one word: fun.

Growth and Exits
Based on Shikhar Ghosh’s research at Harvard Business School, more than half of all startups will enjoy some measure of success, with satisfying financial rewards for founders. That does not mean they will provide good returns for investors. Some of them will chug along profitably, they will not require subsequent rounds of equity financing from venture capitalists, and for any number of reasons (e.g., they don’t penetrate the market widely enough) they will not become acquisition targets. A vast majority will never grow big enough to go public. So the mere fact that your portfolio company achieves profitability—while it may offer you income in the form of dividends—does not mean you will be able to sell or redeem your shares for a capital gain (at a higher price per share than you paid). If you need cash and must sell your shares, you may have to settle for a slight (or not so slight) loss. Or, if you really enjoy being an owner and/or believe strongly in the company’s long-term future, you may be able to buy up shares from other early investors who want to cash out.

If you are fortunate, your investment will result in an exit that yields a positive return, typically one of the following three types:

  • Buyback of shares by the company in the event of a subsequent venture capital funding round. This outcome depends partly on the terms of your investment in the company—some deals require or allow issuers to buy back shares, at a specified price (or based on a specified formula) that benefits early investors, before they accept future VC funding. The reason for a buyback is that VCs often want their portfolio company’s capitalization table “cleaned up” before they invest.
  • An acquisition by a competitor or larger company. According to Scott Shane’s research at Case Western Reserve University, around 1 percent of all angel investments result in an acquisition. Among angel groups (whose members must be accredited investors), the percentage is higher: The Band of Angels reports that 19 percent of its angel investments have resulted in acquisitions. There are many reasons that an established business might want to buy a startup outright even before it is profitable: as a shortcut to fast growth (e.g., to expand its sales territory or product line), to achieve vertical integration (e.g., a manufacturer acquiring a supplier or distributor), to achieve horizontal integration (e.g., buying out a competitor to gain its market share, also known as consolidation), for access to proprietary research, to acquire patents or other intellectual property, to bring in a brilliant founder or stellar management team (also known as an acqui-hire), to gobble up future competitors preemptively, and other motivations.
  • An IPO. Not all entrepreneurs dream of filing an initial public offering; some would rather stay midsize, or even get big but stay private, for various reasons. The two main reasons for wanting to go public are (1) to reward the founders and early investors by generating huge returns and making them rich, and (2) to make it easier to raise capital on regular basis in the vastly more efficient and liquid public markets. Even among the most sophisticated angel investors the IPO is rare, though. The Band of Angels reports that about 4 percent of its investments over 20 years have resulted in IPOs. Shane’s research indicates that roughly 0.2 percent of all the companies financed by angel investors eventually go public.

Return on Investment
Angel investors who are members of angel groups—accredited investors—historically have enjoyed average returns in the neighborhood of 25 percent per year, and some as high as 50 percent, with the highest returns being generated in the technology sector. They achieve impressive ROI numbers by gaining access to high-quality deal flow, assiduously conducting due diligence, and diversifying their angel portfolios with at least a dozen investments over a period of several years.

In the first year or two of equity crowdfunding, you probably can’t expect such high-quality deal flow. In fact, it is uncertain whether equity crowdfunding will ever attract the same quality of deals as angel investor groups do. As the industry gains acceptance among issuers and broker-dealers, however, high-quality issuers may gravitate more toward equity crowdfunding because of the efficiency with which they can reach large numbers of investors.

And you will become more successful as you learn the ins and outs of angel investing via equity crowdfunding. Meanwhile, you have a chance to earn decent returns, but don’t expect that your returns in the first few years will equal those of experienced angel investors.

Remember that there is a brutal downside to business startups and angel investing. According to research conducted by Shikhar Ghosh at Harvard, 30 to 40 percent of startups wind up in liquidation, resulting in a total loss for investors.[4]

Can the smartest angel investors consistently predict which startups will be winners? Definitely not. Consider the experience of Bessemer Venture Partners, one of the nation’s oldest venture capital funds. Bessemer may have invested in Staples, LinkedIn, and Skype when they were startups, but they took a pass on Apple, eBay, FedEx, Google, Intel, Intuit, PayPal, Compaq, and StrataCom (which was acquired by Cisco). Don’t expect that you will develop a sixth sense for which startups will succeed and which will flame out! Draw on your own entrepreneurial and financial experience when possible, and welcome input from the crowd (and other sources of news and insight) to develop a broader perspective on the equity crowdfunding investment opportunities.

Risk and Diversification

Why would anyone—anyone motivated primarily by financial returns, that is—invest in risky securities if they can (more easily and with greater liquidity) invest in less risky ones? Because taking such a risk gives investors an opportunity to earn commensurately higher returns.

Securities issued by small, private companies are generally riskier than securities of large, public companies. In return for investing x dollars in a small business, you should expect a chance to earn a return that is greater than investing x dollars in the public stock market. Where the risk is very much greater, you should hesitate to invest unless the possible return is very much greater as well. Issuers of private securities must be willing to reward their investors handsomely—first by offering sufficient equity percentages and second by working hard to make the business succeed—in return for taking a chance on them.

So the first principle of risk for investors is: Higher risk should be rewarded with the opportunity to earn a higher return.

Portfolio Diversification
The second principle of risk is: The riskiness of investing in private securities should not be judged in isolation. You should weigh the riskiness of an investment, or of a particular class of investments (in this case, startups and early-stage companies), in terms of how it affects the overall risk in your entire investment portfolio.

By adding diversification to your portfolio, private securities (which can appear risky in isolation) can potentially reduce overall portfolio risk when done judiciously.

Diversification is not putting all your eggs in one basket. Here is an example that will help clarify what diversification means in an investing context. Let’s say you have a 401(k) retirement fund, and you invest all your retirement savings in the stock of your employer. This is certainly an expression of loyalty, and you can be assured that working hard from 9:00 to 5:00 (or any other shift) helps your company earn profits, which in turn maximizes the value of your retirement fund. It seems like a very synergistic investment—you work hard for your company and your company rewards you with a salary and portfolio growth. But there is danger here: Your retirement portfolio is not diversified. If your company suffers a setback and its stock price plummets, your entire portfolio suffers. In the worst-case scenario, your company goes bust, your portfolio crashes, and you lose your job—total disaster. This actually happened to some Enron employees when the company declared bankruptcy in December 2001, as well as employees at many other companies over the years who failed to diversify their 401(k) plans.

In 1999 and 2000, investing in Enron seemed like a smart bet. But putting all their eggs in that basket resulted in financial catastrophe for Enron investors who failed to diversify their 401(k)s. As a result of Enron’s bankruptcy, Enron employees lost $1.2 billion in retirement funds and Enron retirees lost $2 billion in pension funds. (In that same year, Enron executives received bonuses totaling $55 million and cashed in $116 million in Enron stock.)

Diversification means investing in different asset classes (stocks, bonds, mutual funds, money markets, real estate, etc.), in different sectors of the economy (energy, utilities, healthcare, manufacturing, retail, natural resources, media, services, technology, etc.), maybe in global markets as well as U.S. markets. Even in the bond market you can diversify by allocating funds to corporate, municipal, and variously rated bonds that offer commensurate yields. Diversification assures you that if one sector of the economy suffers, your entire portfolio won’t be a disaster. If you were invested heavily in technology stocks in 1999, for example, the dot-com bust could have wiped you out; loading up in real estate investments in the lead-up to the 2008 recession would also have set you back decades in your financial performance.

Alternative Assets and Non-correlation
In addition to the asset classes mentioned in the preceding paragraph, accredited investors have had the privilege and the means to invest in alternative asset classes, further diversifying their risks. Alternatives include private equity, venture capital, angel capital, hedge funds, and tangible asset funds (which invest in farmland, machinery and equipment, natural resources, etc.).

Alternative assets offer investors a special kind of diversification, known as non-correlation. Alternatives typically do not rise and fall with the broader markets. When the country goes through a general economic downturn and most mainstream asset classes level off or fall in value, non-correlated alternatives will tend not to follow the mainstream, but can maintain their own momentum or otherwise move independently of macroeconomic pressures.

Venture capital, for example, has exhibited a lack of correlation with public stocks. Morningstar researchers found in 2002 that “the correlation coefficient between VC and public stocks is estimated to be 0.04 percent,” which is essentially zero.[8] In other words, share values of venture-backed startups and early-stage companies do not tend to drift upward and downward in response to macroeconomic forces that affect public stock values.

We could not find research on correlation measurement between angel capital and public securities. But because of the similarity of angel and venture capital stages and deal structures, the non-correlation characteristics should be similar as well—assuming sufficient diversification within the angel investment portfolio. In other words, angel investors likely have a similar experience as venture capital funds and hedge funds, in that they do better than the overall market during periods of decline and also do reasonably to very well when broader markets are in the black.

Before 2016, as a practical matter, only accredited investors could invest in most alternative asset classes. Thanks to the JOBS Act, now non-accredited investors can diversify into one alternative asset class, angel capital, via equity crowdfunding. So diversification into a non-correlated asset class is now possible for everyone.

Liquidity
When you invest in a public stock, your investment is relatively liquid. If you have an emergency need for cash, you can sell your stock a week after you buy it, and you can easily find a buyer for your shares in the appropriate public stock exchange. In many markets, except during the worst of economic conditions, you can buy real estate and flip it within a few months, making it not quite as liquid as public stocks. All kinds of capital assets (tangible or intangible property that has value) can be liquidated when necessary, though not always immediately. In equity crowdfunding, however, in most cases you must hold your investment for one year (with a few exceptions), making it relatively illiquid. Even after the one-year holding period, unlike public stocks, you may have a hard time finding a buyer for your shares, as the secondary markets for private securities are not well established.

Of course, if the company you invest in ultimately goes public (i.e., it grows big enough to be listed on a public stock exchange). your liquidity worries are over. That happens rarely, although the JOBS Act may improve those chances (thanks mainly to Title IV of the act). Another liquidity event is when a public company acquires the smaller entity and buys it in a stock-for-stock transaction, known as a merger. In that case, as a shareholder of the acquired company, you would end up inheriting public stock in exchange for shares held in the predecessor entity.

Liability
As an equity investor—part owner—in a company, you are entitled to share in its success, whatever those benefits might be (e.g., dividends and capital gains). What about its liabilities? If the company is a defendant in a civil lawsuit, for example, are you obligated to show up in court and pay your share of any judgments? The short answer is usually no, as long as (1) the entity is properly established in compliance with state and local laws; (2) the entity is one where investor assets are protected from business risks, such as a corporation or limited liability company; and (3) you don’t personally guarantee an obligation of the company. The terms of your equity investment will spell out the limits on investor liability.

Fraud
The most common fear expressed in connection with Title III is fraud. When the SEC issued its proposed rules for Title III in October 2013, Commissioner Aguilar warned that Title III crowdfunding “increases the risks of fraud, illiquidity, and self-dealing to relatively unsophisticated investors,” and especially certain “vulnerable” communities:

The use of crowdfunding to reach potentially vulnerable segments of society is a particular concern. Many of the SEC’s enforcement cases arise from ‘affinity frauds’ that exploit the trust and friendship that often exists among members of any ethnic, religious, or other community.

Supporters of crowdfunding acknowledge that some fraud will occur, as it does everywhere, including the public securities markets. But they point to the low instance of fraud in rewards-based crowdfunding in the United States, and especially in equity-based crowdfunding in Australia (since 2006) and the United Kingdom (since 2012), where unsophisticated investors may similarly participate. It is important to note that Australia and the United Kingdom have different securities regulations than the United States, and every country defines fraud a bit differently, so it is not an apples-to-apples comparison. But in general, equity crowdfunding has proceeded in those countries fairly successfully so far.

Of course, you can take steps to protect yourself against fraud in equity crowdfunding.

Conclusion
If the risks don’t scare you, and you want to consider investing via equity crowdfunding, please approach it with two simple guidelines, for starters:

  • Allocate no more than 5 to 10 percent of your investable capital to “alternative” private investments such as startup and early-stage equity offerings.
  • Because of the highly illiquid nature of angel investments in general, don’t invest more money than you can afford to lose access to for several years.

About the Authors
David M. Freedman, based in Chicago, has worked as a financial and legal journalist since 1978. Matthew R. Nutting is a corporate lawyer with the firm Coleman & Horowitt in Fresno, CA. Freedman and Nutting are coauthors of Equity Crowdfunding for Investors: A Guide to Risks, Regulations, Funding Portals, Due Diligence, and Deal Terms (Wiley & Sons, June 2015).


Footnotes

[1] Specifically, out of 269 companies in which the Band of Angels invested between 1994 and 2013, 10 have gone public, for an IPO hit rate of 3.7 percent. Data provided by Ian Sobieski, PhD (in aerospace), managing director, Band of Angels (www.bandangels.com), December 10, 2013.

[3] Most surveys and studies of angel investment returns use self-reported data from investor groups and individual angels, and thus are not necessarily reliable. It is likely that some investors and investment groups exaggerate their returns based on both practical and ego-related motives.

[4] Carmen Nobel, “Why Companies Fail—and How Their Founders Can Bounce Back,” Working Knowledge, Harvard Business School, March 7, 2011, http://hbswk.hbs.edu/pdf/item/6591.pdf.

[5] Statistic Brain, January 1, 2014 (citing Entrepreneur Weekly, Small Business Development Center of Bradley University, and University of Tennessee Research), www.statisticbrain.com/startup-failure-by-industry/.

[6] David S. Rose, Angel Investing, Wiley & Sons, 2014, p. 190.

[8] Peng Chen, Gary T. Baierl, and Paul D. Kaplan, “Venture Capital and Its Role in Strategic Asset Allocation,” The Journal of Portfolio Management, Winter 2002, pp. 83–89.