Step 2: Write a three- to five-year plan
Published on March 30, 2016
Spread out your crowdfunding investments, ideally 10 to 15 deals, over three to five years. Develop an equity crowdfunding budget for the coming 12 months. Be patient and select offerings that are most likely to result in strong ROI.
The first rule of investing is: diversify. The benefits of diversification—spreading the risk—apply not only to your overall investment portfolio (on a macro level), but to each asset class (on a micro level) as well.
At the macro level, a diversified investment portfolio might include stocks, bonds, mutual funds, real estate, hard assets like precious metals, liquid assets like money market funds, etc.
At the micro level, the stock portion of your portfolio might include, for example, companies in the manufacturing, retail, energy, technology, health care, banking, utilities, and other sectors; and perhaps it may be further diversified into common and preferred shares, growth-oriented and dividend-paying securities, domestic and foreign stocks.
Similarly, your equity crowdfunding portfolio could be diversified in terms of:
- Number of investments, eventually amounting to 10 to 15 deals or more
- Industry sectors
- Geographic regions
- Stages of development (e.g., seed, startup, early, growth, etc.)
- Types of securities (e.g., preferred stock, convertible debt)
There are two schools of thought on whether you should diversify your angel portfolio in a “panoramic” way, which means investing in various industries, geographic regions, development stages, and perhaps types of securities. Some angels try to diversify every which way.
Others believe that you should focus your angel portfolio on industries that you understand and geographies that let you conduct due diligence and monitor your investments without incurring outrageous travel expenses. According to this non-panoramic school of thought, you should diversify only in terms of the number of investments, and perhaps stages of development and types of securities.
In the world of equity crowdfunding, much due diligence and monitoring is done online, so travel might not be a concern. But we agree that an understanding of the issuer’s industry gives you an edge in selecting and evaluating equity crowdfunding offerings, and you need every edge you can get. You are already achieving broad portfolio diversification by investing in angel deals, so you don’t need to take diversification to a level where it creates more risk than it moderates. This approach is well articulated by David S. Rose in his book Angel Investing. Rose warns, however, that if you invest in two or more small companies in a particular industry, you should avoid investing in direct competitors. You don’t want one company to be using your invested money to fight against your interest in another company.
Some experienced angel investors set their sights on making at least five angel investments each year, with a goal of 20 to 25 deals in their portfolios at any given time. Because some of those investments will crash and perhaps one or more will result in profitable exits, those angels need to keep investing in deals each year to replenish their inventory of angel deals, at least until their overall portfolio allocation strategies change. Experience has shown that this level of activity can yield excellent returns, but it does require a long-term commitment, spreading out your angel investments over a period of several years, and in most cases a lot longer.
Inexperienced angel investors should not necessarily set 20 deals as their goal. A dozen equity crowdfunding deals, selected judiciously and accumulated over a period of three to five years, would probably constitute a full and proper angel investment portfolio for the majority of investors.
Diversify over 3 to 5 Years
As we explained in Step 1, the total amount of money that you can invest each year in equity crowdfunding deals (whether on one funding portal or a number of portals) is limited, depending on your income and net worth.
When an issuer lists its offering on a funding portal, the issuer sets a minimum investment amount. (The portal might set an absolute minimum across the entire platform, to which its issuers must conform.) You may invest more than the minimum amount, in specified increments, depending on how excited you are about the company’s growth prospects. Some smaller issuers with modest valuations will likely accept investments as low as $100, while some more established companies will set a minimum of $1,000 or more.
Based on your asset allocation strategy, assuming you will spread your angel investments out over a few years, you should calculate how much money you can devote to equity crowdfunding investments in the current year, and roughly how much you’ll have to invest each year over the next few years.
Figure you will make fairly small bets in the first year or two (or in your first few deals), while you are learning how to be a smart angel investor. After you become more skilled at reviewing offerings and judging suitability of investments, you might decide to increase the size of your bets.
Keep in mind that one or more of the companies that you invest in this year may need another round of equity financing in the next few years in order to expand. It is quite common for fast-growing companies to go through a series of equity funding rounds, typically named in sequence: the seed round (Series Seed), the crowdfunding round (Series CF), the Series A round, the Series B round, and so on. If you believe in your company and want to keep supporting it—especially if you want to avoid dilution of your equity percentage—you should reserve some cash for follow-on rounds. This reserved cash is known among angels VCs as “dry powder.” David Rose points out that issuers often provide incentives for its investors to participate in follow-on rounds, and sophisticated angels typically reserve 50 percent of their original investment for that purpose. (For a more thorough discuss of dilution and follow-on incentives, see the fundamentals of deal terms in Step 5.)
How to Budget for the Next 12 Months
Start with a three- to five-year plan. You will probably adjust and revise it from time to time, so don’t feel you are stuck with the first draft of your plan.
- Determine your allocation to alternative investments. In most cases, it is appropriate for a household to have 5 to 10 percent of its total investment portfolio in alternatives, including equity crowdfunding. Let’s say the total value of your investment portfolio today is $P, and you plan to allocate A% of your portfolio to equity crowdfunding. Then your allocation to equity crowdfunding is $PA ÷ 100.
- Develop a long-term plan. Most people will spread out their crowdfunding investments over three to five years. It is important to be patient and selective, looking for offerings that are most likely to result in strong ROI and/or social impact.Let’s say you plan to build your equity crowdfunding portfolio over Y years.
- Develop your first-year budget. For planning purposes, figure you will invest roughly equal amounts of capital each year in equity crowdfunding deals until you build your portfolio. The actual yearly amount can change depending on the quality of deal flow and other variables. Be sure this yearly investment amount falls within the limits permitted by Title III, which we outlined in Step 1.
You will invest roughly $PA ÷ 100Y in the first year, where:
P = Total portfolio value today in dollars
A = Percent of your portfolio allocated to equity crowdfunding
Y = Years to build your equity crowdfunding portfolio
Once you determine how much money you can allocate to equity crowdfunding investments over the next 12 months, you are ready to visit one or more funding portals and search for suitable investment opportunities.
Do not feel compelled to spend all of your first year’s allocation in the first year. It’s not a use-it-or-lose-it proposition. Be patient and look for investment opportunities that you believe in and feel comfortable with—you will be stuck with them for at least a year and more likely several years, as they are relatively illiquid securities. Keep in mind that as the new equity crowdfunding industry gains acceptance among entrepreneurs and broker-dealers, the deal flow will increase and the quality of deals will improve over the next five years or so.
Before you pull the trigger and make a commitment to invest, be sure you have realistic expectations about return on investment.
Angel investors who are members of angel groups enjoy 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. For a more thorough discussion of angel investors’ returns, see “Risks and Returns of Equity Crowdfunding.”
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. The government will, we predict, within a few years improve the law—raising both the offering limits and the investment limits, and lowering the cost of compliance for issuers—which will attract a better grade of equity offerings and more growth-stage companies.
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 Business School, 30 to 40 percent of startups wind up in liquidation, resulting in a total loss for investors. Among the sectors with the highest failure rates are information technology and retail; among the lowest failure rates are real estate, healthcare, and agriculture.
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.
If you are investing in startups mainly for social or ideological reasons, keep in mind that it is “practically impossible,” says David Rose, “to optimize for both financial return and social impact” on the same investment. If you are focusing on the social impact of your investment, forget about optimizing for ROI, and vice versa. You might participate in some deals purely for social motives and other deals purely for ROI.
Related articles and resources
“The Pro’s Guide to Diversification,” published 8/19/15 by Fidelity Investments https://www.fidelity.com/viewpoints/guide-to-diversification
About the authors
David M. Freedman and Matthew R. Nutting are coauthors of Equity Crowdfunding for Investors (Wiley & Sons, 2015).