Financial Poise
Augmented Reality tech, as advertised on crowdfunding sites

The (Thorough) Art of Evaluating Crowdfunding Sites and Title III Offerings 

5 Steps of the Due Diligence Process

Once you have calculated the maximum you can invest in crowdfunded securities, you’re ready to begin the evaluation process of crowdfunding sites and Title III offerings, which are offerings from startups to non-accredited investors as allowed under Title III of the JOBS Act.

When you start looking for offerings to invest in, look first in the industries where you have knowledge or experience, or look for consumer products and services that you are familiar with. Later you can consider offerings in other industries for diversity. Make sure you understand the basics of private securities: stock, LLC shares and convertible debt.

You should not reasonably expect to achieve both social and financial objectives in the same investment—if it happens to work out that way, consider yourself lucky. Instead, most opportunities will be principally one or the other.

Portfolio diversification is about finding a mix of investments. You can hold a mix of social-impact and financial-return investments, but each investment should be optimized for one objective or the other.

If you are unsure about your motivation, the following list breaks the various kinds of financial motives that you might have.

Step 1: Determine Financial Motivations

Rapid Growth Potential

These offerings are more likely to result in a shorter-term exit (via acquisition or IPO) and larger—possibly spectacular—returns.However, they are also more likely to be crushed by competitors in the early stages, burn through seed capital, and need more rounds of financing, which may result in dilution of share value or the need to invest more capital in later rounds.

Examples of fast-growth potential sectors are technology and healthcare. If you do not understand the technology and/or the business model, then this is more akin to gambling where the odds are against you.

Long-Term Growth Potential

You represent “patient money” and look for established but still early-stage businesses that have solid growth strategies. Due diligence will be comprehensive, with special focus on whether the business can become self-sustaining (use retained earnings rather than external sources of capital) and identifying realistic exit strategies.

Long-term growth companies include commercial and agricultural real estate; service providers such as building contractors, healthcare, cleaning services, and auto repair; and franchisees.

Speculation in Boom-or-Bust Industries

This includes operations such as oil and gas exploration, small-scale mining of precious metals and pre-patent inventions (e.g., batteries, solar panels). A hit (or a desired patent) will result in potentially huge gains for investors, while a miss will often result in a total loss; there is rarely a middle ground. Such speculators, known as wildcatters in the oil and gas industry, must have a high tolerance for risk.

Strategic Investment

If you are a consultant or professional adviser, investing in a small business might help you reel it in as a prospective client. You might invest in a company because you want to get a job there. If you currently own or manage a business, you might sink money into startups that could become your company’s suppliers, strategic partners, sources of R&D, or even acquisition targets.

In Title III offerings, where there may be hundreds or thousands of investors in a deal, you would have to invest a noticeably large amount to gain the recognition you need from the issuer. This category may hit ethical or legal issues. In general, “vertical” investments—those related to you in the chain of goods or services—are fine, but “horizontal” investments, which are essentially competitors (whether direct or indirect) are likely to be barred by the issuer and may be illegal.

If you don’t identify with any of the above motives, you probably are more socially motivated than financially.

Step 2: Determine Your Target

We will proceed on the assumption that you are financially motivated. Before you pinpoint the kinds of offerings you will consider investing in, browse through the offerings on a few equity crowdfunding sites to get a feel for what kinds of companies appeal to you and why.

We suggest that you begin searching for suitable offerings in an industry where you have experience and knowledge, at least in the first year or two. As you gain confidence in your ability to select good deals, you might want to broaden your scope, for greater diversification to other industries where you feel you can study and become knowledgeable.

If you lack experience in angel investing and need direction aside from targeting an industry in which you have expertise, you can target offerings (if any such offerings are listed) using the following approaches for a slight dose of safety:

  • Target only companies with growing revenue.
  • Target companies that own hard assets like real estate or expensive manufacturing or mining equipment.
  • Target companies with headquarters nearby, so you can observe business operations as part of your due diligence.
  • Target startups whose founders are serial entrepreneurs, who were involved in growing successful companies in the past. (Past success as an entrepreneur is perhaps the best predictor of future success.)
  • Follow the lead of experienced, knowledgeable angel investors whom you know and trust. (Past success, even in institutional investing, is no guarantee of future success, however.)

Also, don’t be afraid to pull in the experience and investment skills of friends and colleagues—especially successful business executives and entrepreneurs, business lawyers and accountants—and from those you can network with online. Consider visiting chat rooms and discussion groups for crowdfunding investors, both on- and off-platform (including LinkedIn groups), before making investment decisions.

Follow the Smart Money

Experienced angel investors and venture capitalists, small incubators and accelerators, corporate entrepreneurship programs and even institutional investors will be cherry-picking some of the best deals on equity crowdfunding sites. Their participation in an offering is sometimes highly visible. While there is no guarantee that these sophisticated groups will do complete due diligence and apply the same variables that you would apply, this is a very intriguing investment type for those who want to invest but don’t have the time or experience to perform due diligence on their own.

Following “smart money” is one fairly prudent way to invest, although it is never a sure thing—even the most successful angel investors make bad investments most of the time. We don’t want to discourage you from following the smart money, as long as you understand the risks involved in leaving the analysis and due diligence to others.

Dissenting View: Don’t Confine Yourself to Familiar Industries

You have probably heard the axiom “Invest in what you know,” commonly attributed to Peter Lynch, an extraordinarily successful investor with Fidelity Investments’ Magellan Fund from 1977 to 1990. You have a better chance of earning a good return by investing in an industry where you have knowledge and experience—this is generally true whether you invest in public or private securities.

Traditionally, if an angel investor had no expertise in a particular field, he or she could join an angel group where other members had that expertise, so members of the group could collaborate on evaluating investment opportunities and, farther down the road, due diligence. But angel groups admit only accredited investors.

Equity crowdfunding makes collaboration possible among non-accredited angel investors. When you register on a funding portal, you have an opportunity to ask questions and share ideas with other investors—the crowd—before you decide whether to invest. So one of the most important things you should do when you join a discussion on a crowdfunding portal is check out the education and industry experience of the investors whose opinions you take into consideration.

Another reason why you, as an investor, do not need to feel confined to a familiar industry, Lynch’s advice notwithstanding: New research and review tools and services are emerging in the equity crowdfunding world that will help investors scrutinize and evaluate the offerings posted on funding portals. Pioneers in this field, such as Stratifund and Zacks CF Research, developed such tools and services for the equity crowdfunding market, because they anticipated a huge demand for them by investors who have never before considered buying private securities.

Get Good Advice from Informed Advisers

We would never discourage you from seeking advice from your professional financial adviser on how to plan your long-term investment strategy. Keep in mind, however, that advisers who are not thoroughly familiar with the risks, rewards and economics of Title III equity crowdfunding and associated crowdfunding sites will tend to reflexively warn you not to invest in Title III deals, because they are novel. Some of them will fear that you might hold them partly accountable for losses if they don’t dissuade you from making risky investments. Money managers and stockbrokers may also have an incentive to advise against Title III deals, because they do not earn commissions on crowdfunding transactions.

Step 3: Evaluate Offering Categories and Crowdfunding Platforms

First you should look for equity crowdfunding portals (and broker-dealer offering platforms, which we will explain below) which feature the kinds of offerings that you identified in the previous step.

We suggest that you begin searching for suitable offerings on three kinds of equity crowdfunding sites that feature Title III offerings:

  • Those that focus on the industries where you have expertise, or the locality or region that you want to support.
  • Those that have a broader focus, including your industry, but have a reputation for attracting high-quality offerings.
  • Those that aggregate offerings from multiple funding portals.

Note that some offering platforms will list not only Title III offerings but also Title II (Regulation D) offerings and Title IV (Regulation A+) offerings. Reg D is open to accredited investors only, while Reg A+ is open to all investors, including non-accredited. But Reg A+ is structured for later-stage private companies rather than seed-stage and startup companies.

Do not underestimate the importance of using reputable intermediaries, since some of them will effectively “prescreen” offerings to the extent legally permitted and you can rely on that prescreening to at least weed out the bottom layer of companies.

Portals and Broker-Dealers

Funding portals and broker-dealer platforms may look quite similar—in fact, you might not immediately be able to distinguish one from the other—but there are important distinctions between them that may affect your success in finding suitable investments. Usually a platform will reveal its broker-dealer status at the bottom of the homepage and/or on the “About” page of the site. If you are unsure about an intermediary’s status, you can contact the intermediary and ask whether it is a registered broker-dealer.

Funding portals, as defined in Title III of the JOBS Act, are crowdfunding sites  registered with the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) for the purpose of hosting equity crowdfunding activities: offering, disclosure, investor registration, communication, transaction and so on. Funding portals are a new type of intermediary created by Title III, while broker-dealers have been established market makers for many decades. A broker-dealer can be an individual or a company.

Broker-dealer platforms are authorized to do certain things that funding portals (which are not owned or operated by broker-dealers) are prohibited from doing, including the following:

  • Offer investment advice or recommendations to investors
  • Solicit purchases, sales, or offers to buy securities offered or displayed on its website or portal
  • Compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal
  • Hold, manage, possess, or otherwise handle investor funds or securities

Broker-dealers are subject to higher standards of due diligence than non-broker-dealer funding portals, with respect to how they select issuers and equity offerings to be listed on their platforms. We’re not suggesting that the due diligence conducted by all funding portals is less thorough than due diligence conducted by broker-dealer platforms, or that you can always rely on a broker-dealer’s due diligence efforts.It is possible that a particular funding portal’s due diligence is superior. In any case, investors should, whether alone or in collaboration with other investors or in consultation with a professional adviser, conduct their own due diligence in certain areas of an offering.

How can you tell funding portals and B-D platforms apart? They may be very similar in appearance, because they use the same kind of website architecture, design and navigation structure. You may not be able to distinguish between them readily, unless you read the “About Us” page and/or the fine print in the footer on the home page. If you are unable to determine whether a site is operating as a broker-dealer, you can (1) contact the platform’s staff and ask about their broker-dealer status or (2) visit FINRA’s BrokerCheck page  and conduct a search.

Curation Criteria

Both funding portals and B-D platforms may use objective and subjective criteria for accepting and rejecting issuers that apply to their portals. Objective criteria might include, for example, industry, geographic location, quantifiable performance metrics (such as revenue or key ratios), product testing results, patents issued, and market data). Subjective criteria would include the founder’s management style, credibility of claims regarding competitive advantages, soundness of business strategies, independence of one or more board members, and so forth.

Some portals use third-party services such as CrowdCheck, a Virginia-based due diligence and compliance service provider, to perform due diligence and/or conduct background checks on the owners and officers of issuers. If the platform claims to conduct its own due diligence in-house, make sure the principals have relevant experience in the securities or investment banking industry so that their due diligence is effective.

Other Considerations in Crowdfunding Site Selection

Revenue for platforms

Equity crowdfunding portals and B-D platforms may be independent enterprises or funding arms of larger enterprises. The latter includes portals owned by municipalities, chambers of commerce, “main street coalitions,” and civic organizations that want to inject capital into businesses in their areas, and universities that want to fund entrepreneurs who spin out of the academic environment.

Whether they are for-profit or not, equity crowdfunding platforms may earn revenue in the following ways:

  • A funding portal can charge an issuer a flat fee, usually on a monthly basis, for posting an offering on the platform. Or the portal can charge the issuer a “success fee,” a percentage of the capital raised on the platform. Portals should disclose to investors how they charge issuers (whether a monthly fee or a percentage of the funds raised), but they do not have to disclose the amounts of those fees. Typically, the success fee is in the 5 to 10% range—a higher percent for larger raises—although it can vary according to the type of startup as well (e.g., real estate ventures and startups with valuable hard assets may pay lower fees).
  • Broker-dealer platforms can charge the same kinds of fees and percentages as portals do, although the percentages might be slightly higher, because they typically provide consulting services to issuers. In addition, broker-dealers may compensate their employees and agents based on the amount raised by issuers.
  • Both kinds of platforms can charge issuers a flat fee for background checks and due diligence reports.

On most crowdfunding sites, investors do not pay registration fees. The only charges they might have to pay, aside from their actual investments, are transaction fees to third-party payment services such as PayPal, which can range from 1 to 3%.

Title III of the JOBS Act, and the SEC rules implementing the act (issued on October 30, 2015), establish the following additional requirements for equity crowdfunding intermediaries:

  • An intermediary may not pool investors’ funds into a centralized investing entity. In other words, each individual investor will invest directly in the company that offers shares.
  • Broker-dealers may, but non-broker-dealer portals may not, purchase a financial interest in an issuer that uses their platform. However, portals may accept equity in compensation for listing an offering on their platforms, as long as that equity has the same share price and deal terms as the equity offered to all investors using the portal.
  • Non-broker-dealer portals may not compensate any third parties (including promoters, finders, and lead generators) for identifying potential investors.
  • Equity crowdfunding portals may not (but broker-dealer platforms may) receive, manage, or hold investor funds. All intermediaries must use an independent escrow service for that purpose and release the funds to the issuer only when the offering is successfully funded. The money is returned to investors if a campaign is not fully funded.
  • Intermediaries must make reasonable efforts to ensure that issuers comply with offering limits (e.g., $1 million per year), ensure that the personal information collected from investors is kept private and secure, and make an effort to ensure (it is not yet clear how they will do this) that investors do not exceed their annual limits based on income and/or net worth.

Registering on Crowdfunding Sites

It is important that, before you become a registered investor on an equity crowdfunding site and enter your personal information, you should be sure the site is registered with FINRA as follows:

  • A broker-dealer, as mentioned earlier, should show up as registered on FINRA’s BrokerCheck page.
  • A funding portal should be registered with the SEC and FINRA.
  • The site should not show up on the SEC’s list of unregistered soliciting entities that have been the subject of investor complaints.

Before you register as an investor, look in the footer (bottom of the home page), the “About Us” page and the contact page, and make a note of the full corporate name under which the site does business, along with the names of its principals. If that information is not readily available, that’s probably a red flag. When you do find that information, check out the site by conducting an Internet search, looking for independent reviews or favorable mentions in the media.

Another way to tell if a site is reputable is if you see at least two or three offerings that have gained traction—meaning they have reached their funding goals or attracted substantial commitments from investors. If a site is too new to have attracted much in the way of commitments, check out the principals’ backgrounds and make sure at least one of them has experience in the securities or investment banking industry—then perform an Internet search to make sure their reputations are not questionable.

Application for Issuers

As an investor, you should become familiar with an equity crowdfunding site’s application process for issuers. On most sites, registered members can see the application that issuers must complete if they want to list their offerings. The application will give insight into the intermediary’s screening process. See the sidebar in this chapter for an example of a comprehensive application.

Before an issuer’s application is accepted, an equity crowdfunding site must conduct background checks on the issuer’s team: officers, directors, 20 percent equity holders, and “participants” in the offering. If any one of these team members is a “bad actor,” the offering is disqualified. The issuer may reapply after removing any bad actors from the team.

Step 4: Evaluating Deal Terms

When you find a Title III equity offering that seems attractive in terms of its industry, location, product or service, team profiles, business plan and financial projections, your next step is to review the term sheet, which sets forth the rights, obligations and restrictions that apply to both parties in the deal.

Offering terms vary from one kind of deal to another. Deal terms for a preferred stock offering are different from the terms for a convertible debt offering, for example. Terms for a seed-stage, pre-revenue startup may differ from terms for a growing, established company. There is no single standardized set of terms for all kinds of equity offerings, just as there is no single standard lease for all kinds of commercial real estate.

Securities: Straight Equity and Convertible Debt

One of the first terms you will see at the top of page one of a term sheet is the type of security being offered. The most common securities offered in equity crowdfunding are stock, LLC membership units and convertible debt. Stock and LLC shares are straight equity, while convertible debt is a hybrid of equity and debt. Straight equity is more common than convertible debt in angel investments today, although everything is subject to change, especially in this era of fintech and financial innovation.

So, we will start by explaining the most important deal terms that you (or your adviser) should know about for straight equity offerings. This includes economic terms, control terms, terms related to liquidity events, and other terms.

Deal Terms for Straight Equity

1. Economic Terms

When you invest in straight equity (e.g., preferred stock or LLC shares), the first terms that you will consider are the price per share (either a fixed dollar amount or a formula), minimum investment amount (and additional increments permitted), valuation of the company and the percentage of total equity offered per incremental amount invested.

Many offerings state a certain share price of stock or price per unit of LLC membership. The price alone is not very meaningful unless you also know the percentage of ownership that a share or unit represents. Issuers who are extra-thoughtful will give you both of these figures, but many do not. In any case, they must give you enough information—such as the company’s (proposed) valuation and the total number of existing shares or units—to calculate the percent of ownership that you get when you buy a share, using one or more of these formulas:

100 ÷ Total shares issued = Percent ownership of each share

Investment amount ÷ Company valuation = Percent ownership for the investment amount

To make these formulas meaningful, we need two definitions:

Total shares issued means all shares held by the issuer, granted to employees and directors, sold to investors and authorized for sale (and held in reserve as employee options) in the current round of financing.

Company valuation is the value on a specific date as proposed by the issuer or, in some cases, as estimated by a third-party valuation analyst hired by the issuer. For private companies, valuation is a highly subjective measure. In a private securities offering, valuation is usually stated in pre-money terms (that is, the value before the current round of financing), although it is sometimes stated in both pre- and post-money terms.

The issuer should reveal what approach, method or multiple it used to estimate its valuation, and the date on which the valuation was effective—as it can change from month to month. Angel capital valuations typically fall into the $500,000 to $10 million range, although outliers certainly come along.

How do you know if the price is fair? Of course, investors (buyers) want the price to be low, while issuers (sellers) want the price to be high, as in any free-market transaction. Some inexperienced, starry-eyed entrepreneurs assign their startups exaggerated valuations. You should try to judge whether the valuation seems reasonable, as the price is derived from the valuation, but not try to narrow it down too precisely. The key to success in angel investing is not necessarily buying in at bargain prices but buying shares of potentially great companies at fair prices.

2. Control Terms

As an equity crowdfunding investor, you will probably hold a hyper-minority share of the company in which you invest—that is, a tiny percent of the equity—among dozens, hundreds, or thousands of other investors in your funding class. One disadvantage of hyper-minority ownership is that you, as an individual (as opposed to your investment class as a whole) will have very little control over, or participation in, the governance and day-to-day management of the company.

Gaining even a small amount of control should not be one of your goals when you invest in equity crowdfunding deals. A lack of control should not, however, discourage you from investing in equity crowdfunding deals that let you achieve your social and/or financial goals.

Protective provisions. The terms of the deal should afford your Series CF class, collectively, a measure of control over a narrow set of actions that relate to the long-term value of your equity shares. This narrow area of control will be in the form of protective provisions, also known as veto rights. A typical set of protective provisions in an angel investment states that a supermajority (such as two-thirds) of the Series CF shares can veto any action, whether directly or through a subsequent round of financing or a merger, that:

  • Adversely alters the rights or preferences of the Series CF Preferred.
  • Increases the authorized number of shares of common or preferred stock.
  • Creates any new class or series of shares having rights or preferences senior to Series CF Preferred.
  • Results in any merger, corporate reorganization, sale of control, or any transaction in which all of the assets of the company are sold.
  • Results in the redemption or repurchase of any shares [other than pursuant to the company’s right of repurchase at a specified cost, if so provided by the terms].
  • Changes the authorized number of directors on the board.
  • Liquidates or dissolves the company.

Those are some of the more common protective provisions in angel deals, and there are others. Any given angel or VC deal may have several of those protective provisions, but rarely all, in the term sheet. In an equity crowdfunding deal, you might be satisfied with the first one, or maybe the first three, on that list.

3. Terms Relating to Liquidity Events and Future Financing

The most important factor that drives your return on investment is the consistent growth in profitability of the company in which you invest, or at least the potential for such growth, which in turn makes it a good acquisition target or IPO candidate. Along the way, however, several other factors can strangle your return on investment in large and small ways. Those factors include dilution of share value caused by the issuance of new shares for future financing rounds, the distribution of whatever proceeds might be available in the event of the dissolution of the company, and a sale of the company at a price that is lower than the Series CF valuation. Those are three examples of liquidity events that could result in a disappointing return, if not an actual loss, for investors.

To protect equity crowdfunding investors, who are often in the first round of equity financing outside of friends and family, from the potential constrictions of those adverse or “downside” kinds of liquidity events, the term sheet should include liquidation preferences.

Liquidation preferences. If you invest in 10 equity crowdfunding deals, chances are that you will experience a few liquidations. When a company calls it quits, whether voluntarily or otherwise, it must liquidate its assets in order to pay salaries and wages owed to employees first, repay its creditors and note holders second, and return money—if there is any left—to its investors third. Holders of preferred stock generally have priority over common stockholders.

Liquidation preferences spell out the amount of money, stated as a multiple of their original investment, that preferred shareholders receive in the event of a dissolution or sale. Only after preferred receives its full amount will common (including the founders) get any leftovers. To see how a typical liquidation preference is worded, see Chapter 11, “Deal Terms,” in Equity Crowdfunding for Investors, by Freedman and Nutting (Wiley & Sons, 2015).

In the case where the company is sold at a much higher valuation than in the Series CF deal (we’ll call this an “upside” acquisition)—the liquidation preferences may let preferred shareholders convert their shares to common stock in order to benefit from the capital gain that common shareholders enjoy. (Common stock prices rise and fall freely with market valuations, whereas preferred stock prices are protected—and restrained—from market volatility.)

So liquidation preferences can give early investors, as a reward for taking a big risk, the best of both worlds: the downside protection of preferred combined with the upside benefit of common.

Aside from liquidation preferences, other terms relating to liquidity events that might appear in your deal include: full participation, anti-dilution provisions, right to participate pro rata in future financing rounds, “pay to play,” and drag-along agreements. These are explained in Chapter 11 of Equity Crowdfunding for Investors (see reference above).

4. Other Deal Terms

The two deal terms in this group are no less important than the preceding ones; they just don’t fit neatly into any of the aforementioned categories.

Conversion rights

In addition to the conversion rights spelled out in the liquidation preferences, preferred shareholders may be granted the right to convert their shares to common stock, either (a) at any time of the investor’s choosing, (b) after a specific date, such as one year after the closing of the Series CF round, or (c) automatically upon the occurrence of a certain event such as an acquisition or IPO. You might wish to exercise this right if you want to vote more actively with the common shareholders, for example, or if you think it would be easier to sell common shares on the secondary markets. Once you convert to common, you can’t revert to preferred.

Whether conversion is at the investor’s discretion or only upon liquidation, this provision sets the conversion ratio—that is, the number of common shares the investor receives for each preferred share on conversion. The typical ratio is 1:1, unless it is adjusted according to an anti-dilution provision or a stock split (which is rare for startups).

Information rights

A typical term sheet in a Regulation D offering states that the company shall provide, at the very least, annual financial statements (reviewed or audited, depending on the amount raised) to each investor within a reasonable time. This provision may be unnecessary in equity crowdfunding deals because Title III requires issuers to do so anyway. Aside from Title III issuers, private companies are not obligated to share financial records with anyone unless compelled to do so by the terms of a securities offering, institutional debt financing arrangement, credit application, or certain legal or forensic proceedings.

Deal Terms for Convertible Debt

Convertible debt (a hybrid of debt and equity) is a completely different ballgame from straight equity.

The most important terms relate to the timing of when (under what circumstances) the debt can convert to equity, and how the conversion price per share will be determined—that is, the amount of equity you will get for every dollar you invested, if and when the conversion happens.

Step 5: Due Diligence

Due diligence is the research that an investor conducts into the issuer, and its associated industry and market, before buying its debt or equity securities. Any investor needs to either conduct due diligence before investing, or ensure that someone, such as an investment adviser or experienced angel investor, has done it reliably.

The crowdfunding intermediary is obligated to have a reasonable basis for believing the issuer has met the requirements to offer securities under Title III, codified as Section 4(a)(6) of the Securities Act. But you can’t always rely on the intermediary to conduct thorough due diligence. Some equity crowdfunding sites take additional steps, such as establishing an anti-fraud department or hiring a third party like CrowdCheck to conduct due diligence. This level of due diligence focuses mainly on compliance, rather than the potential return on investment.

Some platforms or issuers hire CrowdCheck to conduct due diligence, advise the company on how to get into compliance where needed, and issue a report, which the company can then post on the equity crowdfunding site (and only on that site) to share with prospective investors.

You can learn how to conduct due diligence yourself. You don’t have to be a securities lawyer or a financial wizard. We will help you get started below.

Legal, Financial and Business Due Diligence

Due diligence on an equity crowdfunding issuer can be divided into three buckets: legal, financial, and business due diligence. You do not have to approach due diligence in that order, as long as you (and the people with whom you collaborate) touch all three bases. At the very least you must make sure that someone you trust has looked into the issues in the list that follows, even if you aren’t reading the documents and disclosures yourself.

Legal due diligence includes  the following:

  • Look for any indications of fraudulent activity. Such activity includes false claims, intentional misstatements, material omissions, and guarantees that are too good to be true.
  • Make sure the offering complies with SEC regulations.
  • Check to see that the company is properly incorporated with bylaws drawn up, or organized as an LLC with operating agreement in good order, or otherwise organized as a legal entity under state law.
  • Make sure the company maintains minutes of meetings of the board of directors or managing members.
  • Check to see if the company has all necessary state and local registration and relevant permits and licenses to conduct its business.
  • The company should own its website domain and rights to the website content.
  • The company’s bank account should be wholly separate from its owners’ personal accounts.
  • Investigate whether the company is involved in litigation, and if so, what is its potential exposure to liability.
  • Look into any history of bankruptcy, unfulfilled tax obligations, or liens against property or other assets.
  • If the company claims that it owns intellectual property—patents, trademarks, and/or copyrights—check to see if it has current registrations or appropriate protection.

Financial due diligence includes the following:

  • Review the company’s financial statements, which owners and managers use to assess their company’s fiscal health, determine its ability to generate cash and cover short-term operating expenses and longer-term debt, and plan for the future. Pay particular attention to three metrics: net profit (or loss), total revenue, and profit margin.
  • Other financial considerations include: burn rate, revenue projections, previous capital raises, and others.
  • More details on how to research these items in Chapter 12 of Equity Crowdfunding for Investors.

Business due diligence includes the following:

  • Based on your own life, education and business experience, consider whether this a product or service that you would use, and how much you would pay for it.
  • If the company sells its product or services to consumers in your area, test it out. Buy the product, eat at the franchised restaurant, use the software. Is it just good, or is it exciting? Does it solve a common problem? Is it better than the competition? Is there or will there be a demand for it? Will the market ever be huge; if not, will margins (price minus cost to produce) be high enough for the company to thrive in a niche market? Will the novelty of the product require consumer education?
  • If the product is innovative (and if it is not patentable), how soon will competitors crop up like weeds and fight for market share? Will there be large competitors with virtually unlimited capital that can produce and market the product faster and cheaper? What are the barriers to entry? What is the company’s plan for preempting the competition or differentiating to protect market share?
  • Read profiles of the founders and management team (including directors, c-level officers, shareholders who own 20% or more of the company and key advisers).
  • Review the following, usually found in the issuer’s business plan: customer base, suppliers, marketing strategy, competitive advantages and exit strategy (acquisition, IPO, etc.).

After you have evaluated your financial or social goals, various crowdfunding sites, specific securities offered and their deal terms, then you can finally move on to the next step: committing to your purchase.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Crowdfunding from the Investor’s Perspective, Securities Crowdfunding for Intermediaries and Investing in Real Estate Through Equity Crowdfunding. This is an updated version of an article originally published on March 30, 2016.]

Like what you just read?

Then sign up to receive our weekly Financial Poise newsletter, our take on the most relevant and topical business, financial and legal issues affecting investors and small business owners.

Always Plain English. Always Objective. Always FREE.

About David M. Freedman

David M. Freedman has worked as a financial and legal journalist since 1978. He has served on the editorial staffs of business, trade and professional journals, most recently as senior editor of The Value Examiner (National Association of Certified Valuators and Analysts). He is coauthor of Equity Crowdfunding for Investors, published in June 2015 by…

Read Full Bio »   •   View all articles by David »

>