Financial Poise
Equity Crowdfunding Diversification and Planning

Equity Crowdfunding for the New Angel Investor

Create Your 5-Year Crowdfinance Investment Plan

Your investment portfolio should spread risk among a number of different assets, from stocks and bonds to real estate or precious metals. With SEC exemptions for companies selling less than $1.07 million in securities, equity crowdfunding, or crowdfinance, has given the general public access to investments that they wouldn’t otherwise. Crowdfunding allows anyone, including non-accredited investors, to contribute smaller amounts (often as little as $100) of capital to an early-stage venture, making it an inexpensive (yet still relatively risky) way to further diversify an investment portfolio. But before you engage in equity crowdfunding as a way to diversify your investment portfolio, you should know your investment limits and what to expect over the course of three to five years.

Equity Crowdfunding Comes with Limits, Says the SEC

The first step of incorporating crowdfunding investments into your portfolio is to calculate the maximum amount of money that you can invest each year in Title III offerings.

Title III of the Jumpstart Our Business Startups (JOBS) Act of 2012 sets forth yearly investment limits based on investors’ income and net worth. Congress’s intent was to help prevent catastrophic losses being incurred by inexperienced investors in high-risk, private securities.

As of 2017, the Securities and Exchange Commission (SEC) has updated its rules (designated Regulation CF), which clarify those limits as follows:

Crowdfunding Investment Limits

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According to the chart provided by the SEC, if an individual (or couple) has an annual income or net worth less than $107,000, then that individual (or couple) can invest up to the greater of up to $2,200 or 5% of the lesser of their annual income or net worth. For an individual (or couple) with an annual income and net worth greater than $107,000, the investment can be up to the lesser of 10% of their annual income or net worth. However, the total must not exceed $107,000 in a 12-month period.

How to Diversify Your Crowdfinance Investments

Spread out your crowdfunding investments. Ideally, an investor should accept 10 to 15 deals over three to five years. Develop a securities crowdfunding budget for the coming 12 months. Be patient, and select offerings that are most likely to result in a strong ROI.

The first rule of investing is diversification. The benefits of equity crowdfunding 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. It may be further diversified into common and preferred shares, growth-oriented and dividend-paying securities and domestic and foreign stocks.

Similarly, your securities crowdfunding portfolio could be diversified in terms of:

  • Number of investments(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, etc.)

Which School of Thought Do You Follow?

There are two schools of thought on how you should diversify your angel portfolio: panoramic and non-panoramic.

Some angel investors try to diversify every which way, or in other words, in a “panoramic” way. That means investing in various industries, geographic regions, development stages and, perhaps, types of securities.

Other investors believe that you should focus your angel portfolio on industries that you understand and that are within 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, stages of development and types of securities.

In the world of securities 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 securities 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.

How Many Investments Should You Make?

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. 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, 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 to spread 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.

Create Your 3-5 Year Plan

As we explained above, 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.) Depending on how excited you are about the company’s growth prospects, you may invest more than the minimum amount in specific increments. 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 securities crowdfunding investments in the current year, and roughly how much you’ll have to invest each year over the next few years.

Assume 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 angel 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% of their original investment for that purpose.

How to Budget for the Next 12 Months

Start with a 3-5 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.

  1. Determine your allocation to alternative investments. In most cases, it is appropriate for a household to have 5% to 10% 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 securities crowdfunding. Then your allocation is $PA ÷ 100.
  2. 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 crowdfunding portfolio over Y years.
  3. 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 above.

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 regulation crowdfunding

Y = Years to build your 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.

Realistic Expectations: Risk and Return in Crowdfunding

Before you make a commitment to invest, be sure you have realistic expectations about ROI.

Angel investors who are members of angel groups enjoy average returns in the neighborhood of 25% per year, and some as high as 50% (with the highest returns being generated in the technology sector). They achieve impressive ROI 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. The government has raised the offering limits in the past, and it may once again, which would attract a better grade of equity offerings and more growth-stage companies.

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

Remember that there is a brutal downside to business startups and angel investing. Most startups fail, according to statistics, and even the smartest angel investors cannot predict who will be the winners. 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 crowdfunding investment opportunities.

[Editors’ Note: To learn more about this and related topics, you may want to attend the following webinars:

This is an updated version of an article originally published on October 16, 2019.]

©All Rights Reserved. September, 2021.  DailyDACTM, LLC d/b/a/ Financial PoiseTM

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About David M. Freedman

Dave Freedman has worked as a journalist since 1978, primarily in the fields of law and finance. He is a co-author of Equity Crowdfunding for Investors: A Guide to Risks, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms (Wiley & Sons, 2015). He currently analyzes turnaround stocks for Dave has also written extensively…

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