Monitor your equity crowdfunding investments and, every 12 months, perhaps adjust your allocation and budget for the coming year. Over the years, stay alert to opportunities for an exit (acquisition or IPO), later-round investing, redemption, liquidation, or sale of shares on secondary markets.
Your primary motive for investing in private securities via equity crowdfunding is either social or financial. If you have invested in one or more Title III offerings for social benefits, your main concerns are the company’s effectiveness in fulfilling its mission or achieving a particular social impact, and your satisfaction with being a member of the “team” (which may include both entrepreneurs and co-investors). You certainly do not wish to lose the money you invested, so you hope that the company will someday return your money in the form of dividends, a capital gain, and/or perks and benefits. But a spectacular return on investment, in the event of an IPO, for example, is not your primary concern or expectation. Nor should you have high expectations regarding the liquidity of your equity shares—that is, your ability to sell the shares at any time after the one-year holding period.
If your primary motive for investing is financial, on the other hand, ROI and liquidity are primary concerns. In previous steps we discussed upside exits such as acquisitions and IPOs, where—after holding an investment for a number of years—investors can measure annualized returns (e.g., 20 percent per year) and return multiples (e.g., 5x). With respect to liquidity, the deal terms may offer the possibility of conversion from preferred to common shares, or redemption of preferred shares where investors have a right or obligation to sell shares back to the issuer.
If one of your companies goes public, the return can be spectacular. Keep in mind, though, 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.
Still, you can earn a return on your investment through other exit strategies, including management buybacks, acquisitions, and resale on new kinds of 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.
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).
As you exit one or more investments, you should consider replacing it/them with further investments to maintain a fully diversified equity crowdfunding portfolio. Keep track of the amount you invest each year to make sure you do not (1) exceed the annual limit set by Title III, based on your income or net worth, or (2) exceed the percentage of your overall investment portfolio that is allocated to alternative assets like angel capital deals, which you calculated in Step 1.
If the company decides to raise more capital in subsequent rounds of equity crowdfunding, and you are not protected by an anti-dilution provision, you need to decide whether to invest more money in the company or let your equity percentage be diluted. If the company’s valuation has increased dramatically between rounds, then dilution is not necessarily going to lower the value of your shares, but it might still be a good investment opportunity. If the valuation has dropped between rounds and you anticipate a down round (where the share price is lower than the previous round), then your shares will be diluted in terms of both equity percentage and price, and you need to judge whether the company can bounce back or not. If you think it can bounce back, a down round might still be a good investment opportunity because of the lower share price.
Another scenario is that the company decides to raise capital not via equity crowdfunding but through a Regulation D angel deal, involving a small number of investors who each invest tens of thousands of dollars. If the offering is made under Rule 506(c), which allows general solicitation, it would be restricted to accredited investors only. This would be another magnitude of investing entirely. If the company skips a subsequent angel round and goes directly to venture capital, then you can no longer invest directly in the company; you would have to invest in the VC firm (if you are an accredited investor), which spreads your money over several portfolio companies. These scenarios might be too rich for your blood, but the good news is that the company you invested in is growing and might be on a fast track to an acquisition or IPO.
You will not know for several years, maybe as long as five to seven years, or even ten years, whether your equity crowdfunding portfolio is producing good returns on investment. Startups often need years just to break even and become cash-flow-positive, and then more time before they are acquisition targets.
Don’t be discouraged when some of your portfolio companies dissolve within the first few years of Title III investing, while it takes several years to produce a winner or two. Losses will probably happen before gains, as a general rule, but gains can be bigger than losses because the upside is unlimited while the downside is limited to the amount you invested.
Successful angel investors find that, over a period of decades, a very small percentage of the companies in their portfolio will account for most of their total returns. According to Robert Wiltbank’s 15-year study of accredited angel investors (Wiltbank is a professor of management at Willamette University, and a trustee of the Angel Resource Institute), just 7 percent of their investments accounted for three-quarters of their total returns. This is known as skewed returns in a portfolio. Likewise, Luis Villalobos, a successful angel investor and founder of Tech Coast Angels in California, reported that 6 percent of his investment portfolio accounted for 84 percent of his returns. This data suggests there are a lot of failures, but the idea is to overcome the losers with high-performing winners.
When (we should probably say “if,” but we are optimists) you do start to earn positive returns, you should compare your equity crowdfunding ROI with the returns on the rest of your investment portfolio, as well as the predominant market indexes such as the S&P 500. Your long-term goal is diversification of risk as well as absolute return. Remember that dollars are not the only cost of your investments—the time you spent selecting offerings and conducting due diligence should also be a consideration. If you spend a considerable amount of time managing your equity crowdfunding portfolio, then your returns must not only beat the benchmarks that you establish (whether they be your own portfolio or market indexes) but compensate for your time as well.
When you compare the return on Title III investments with returns on other investments, be sure to use annualized returns expressed as percentages, for an apples-to-apples comparison. Calculating annualized ROI is not simple, because of the time value of money—in other words, annual return rates compound. The easiest way to calculate annualized ROI is to use one of the many online “return rate calculators,” to derive a compound annual growth rate. Investopedia provides a simple one at http://www.investopedia.com/calculator/cagr.aspx.
Some angel investors also calculate a total return multiple, the formula for which is:
This is expressed as a number followed by “x.” This does not take into consideration the holding period of the investment (i.e., the time value of money) or the time spent by the investor.
Sophisticated angel investors use more complicated formulas to determine their returns annually, involving the “fair value” of all assets, including Title III equity. This is not really necessary for an asset that costs less than, say, $10,000.
If after 10 years (this is what “long-term” means) the returns on your equity crowdfunding portfolio and other alternative investments are not keeping pace with your mainstream investments (public stocks, corporate and municipal bonds, mutual funds, residential real estate, money market funds, etc.), then you need to reassess your overall portfolio strategy and/or your alternative investment strategy. That’s not to say you should quit equity crowdfunding investment necessarily, because the market is going to evolve—in terms of regulations, the kinds of issuers that participate, secondary (liquidity) markets, and platform technology—over the next decade.
If one of your equity crowdfunding companies goes public and you hit the jackpot, well, you might just graduate to larger venture capital and private equity deals. Or become a philanthropist.
If your motivation for making Title III investments is motivation is primarily social, each year you should review the operations and accomplishments of the companies you invested in and make sure their performance is consistent with their stated mission and business plan, especially before you make later-round investment in the same companies. You should still undertake the same long-term evaluation of financial returns on investment, however. The satisfaction of seeing your companies doing good can be compounded by seeing them and their investors do well. But if you are losing money on equity investments, then you might be more satisfied by simply making charitable donations, which are tax-deductible.
The Jumpstart Our Business Startups (JOBS) Act of 2012 imposes a one-year holding period (with exceptions) on securities issued via crowdfunding sites under Title III. During that first year, you may transfer (sell or donate) stock or LLC membership shares only (1) back to the issuer, (2) as part of an offering registered with the SEC, such as an IPO, (3) to an accredited investor, or (4) to a member of your immediate family upon divorce or death.
In its final rules under Title III, the SEC clarified that the one-year holding period (with noted exceptions) applies not only to the original purchaser of Title III securities but also to subsequent purchasers in secondary market transactions. Moreover, the preemption from blue-sky regulations (state securities laws) applies only to the original crowdfunding-based offer and transaction, not necessarily to the secondary transaction. Some states do not regulate secondary sales; others permit them to be made freely if they are “isolated.” Some permit resales freely to institutions. Until state laws are coordinated, the ability to create organized markets for secondary sales of Title III securities will be limited.
The main purpose of a holding period is to ensure that the first-level investors are not acting as “underwriters” who buy large blocks of securities solely to resell them in smaller portions at a markup.
In addition to Title III’s first-year restrictions on transfers of equity crowdfunding shares, as well as state law restrictions, the terms of your deal might contain further restrictions and/or obligations regarding transfers of those shares even after the one-year holding period. For example, you will be obligated to notify the issuer of your intention to transfer shares, including the name of the transferee (you are the transferor), the price per share (or other valuable consideration) if you are selling the shares, and the date of transfer. The company needs to know who its shareholders are. If the deal terms include a right of first refusal, you must give the issuer an opportunity to purchase the shares at the same price and on substantially the same terms by which you intend to sell them to a third party. Some deals (such as Series Seed) include terms that give other Series Seed investors the same right of first refusal, so the notification process can be more complicated.
It is also possible that a company would simply prohibit any private sale of shares for a specified period. For example, a company could include a provision in the organizational documents stating that no investor can sell his or her shares for 36 months after the offering date. These customized elements of offerings remind us of the importance of reviewing deal terms before you invest.
After the holding period, you may sell equity shares under Title III to any investor, either in a private transaction or on an established secondary market, if any such markets develop.
Now, if you really must sell, ask yourself: Who would buy my shares, and why? If the company is not growing, then the only reason another investor would want to buy in is if the deal were a bargain—in other words, the price is very low, perhaps less than you paid for the shares. If the company is truly profitable and growing, then investors should be interested in buying in at a reasonable price—but then you’re better off holding onto the shares and waiting for an upside exit, unless you desperately need cash.
Maybe the company experienced fast growth for a few years and now its growth has plateaued, but it’s not obvious whether the company will recover and resume its growth spurt, remain plateaued indefinitely as a stable “lifestyle” business, or slide into oblivion. You may believe the company will not grow significantly again, while other investors may still see strong potential in the company. This is one of those situations where, because the company has grown since the equity crowdfunding round, its valuation is higher and an optimistic investor might offer you a price for your shares that is significantly more than you paid. This is where your business experience can help you evaluate the company’s potential and make a smart decision about whether to sell your shares.
There could be other scenarios, not necessarily involving plateaus, where your forecast diverges from that of other investors—namely, you believe the share price will go no higher and they believe the opposite—creating an opportunity for you to sell at a decent price. This, after all, is what happens every day in the public stock exchanges: One investor buys and another sells, based on their disparate expectations of the same stock.
You might find yourself on the buying end of that scenario: Another investor wants to sell shares and you believe the share value will increase, so you are happy to buy those shares, preferably at a bargain price but maybe even at a “reasonable” price (where the valuation makes sense to you).
The question then is how you and those diverging investors can find each other. The answer is, the same way that you and the company you invested in found each other: via an online intermediary. The post-funding intermediary is known as a secondary market. Because these are the early days of equity crowdfunding, secondary markets for Title III equity crowdfunding shares are not well established, so the market mechanism—where buyers seek a low price and sellers seek a high price and the two parties meet somewhere in between to set a “fair” price—has not yet been fine-tuned. Title III secondary markets may be inefficient or even chaotic for some years to come. The only way these markets will evolve is for buyers and sellers to meet and set prices day after day, until the process becomes more efficient and prices more consistently fair. This is what we call free-market capitalism.
A good definition is provided by New York corporate and securities lawyer Mitchell Littman:
A secondary market transaction is “a negotiated private sale of securities of an issuer whose securities are not publicly traded. Some transactions are effected directly from seller to buyer, and in some instances one or both parties may be represented by a broker-dealer who earns commissions on the sale or purchase. Buyers and sellers may find one another through networking, their individual brokers, or intermediaries.”
In January 2016, PeerRealty, a Regulation D offering platform focusing on real estate deals, launched CFX Markets, the first secondary market for crowdfunding investments. CFX will list not only real estate securities sold via PeerRealty but also various kinds of Reg D securities sold via at least 22 other Reg D platforms including PropertyStake (real estate), EarlyShares (real estate), and CrowdFranchise (franchises).
It is possible that some equity crowdfunding portals and broker-dealer platforms themselves will have built-in peer-to-peer secondary markets that let their registered investors trade the shares that they purchased on-platform. The Netherlands-based equity crowdfunding platform Symbid already does this. Founded in 2011, Symbid allows non-accredited investors to participate with a minimum investment of €20 (and is the world’s first publicly listed crowdfunding platform).
Like the equity crowdfunding industry itself, the secondary market for Title III shares will evolve over the next several years.
In the process of investing on an equity crowdfunding site, especially if you collaborate with crowd members on due diligence, you probably made valuable connections with other investors. Keeping in touch with them, whether on- or off-platform, is a good way to exchange ideas about new investment opportunities. We expect that equity crowdfunding meet-up groups will form in cities across the country, open to all investors, just as angel investing groups have formed for accredited investors only.
As the equity crowdfunding industry matures, there will be educational conferences and networking events for investors, more books like this one, and maybe an equity crowdfunding channel on whatever medium replaces cable TV. You will be a member of an equity crowdfunding investor community.
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…
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