For decades high-return investment in start-up companies has been off limits to regular investors. Rules by the Securities & Exchange Commission (SEC) didn’t even allow advertisement of these investments to the public as venture capital firms like Bain Capital got fat on the opportunity.
While Crowdfunding has not yet opened to everyone, new rules could soon be in place and understanding how to invest in this new financial growth engine will put you ahead of the pack.
Is Crowdfunding the Next Investment Revolution?
There’s nothing really new about equity crowdfunding. Private equity and venture capital firms have been pooling investor money to profit from small business growth for ages. Crowdfunding is just the natural evolution online and to the masses. Title II of the JOBS Act was passed a little over a year ago, allowing investors with more than $1 million in assets to bet on projects. Just a year after it passed, more than $200 million was raised and estimates for 2014 put the number at more than $500 million.
But crowdfunding could be set to go from evolutionary step to revolutionary force. Once rules are established by the SEC and Title III of the JOBS Act becomes law, anyone can invest in this new form of financing. Less than 5% of U.S. households qualify to invest under Title II. After Title III is passed, the available capital to small businesses jumps ten times!
Analyzing Start-Up Crowdfunding
Crowdfund investing is similar to your experience in the stock market in that you get a share ownership in the company for your investment, but the differences build up from there. To understand crowd fund investing, you need to understand the world of start-ups.
While share dilutions happen in stock investing, they are not nearly as common or as significant as in start-up investing. Established companies can usually raise money through debt or other credit. Debt is expensive for start-ups since they have little or no financial history so they raise money by selling ownership, multiple times. Why should you care? When a company issues more stock, those shares you held become a smaller slice of the whole pie. The idea is that with more money for growth, the bigger pie is more valuable but it doesn’t always work out that way.
Remember the movie, The Social Network, about the rise of Facebook? Co-founder Eduardo Saverin’s initial ownership of 30% would have been worth more than $30 billion at the IPO, except his position was diluted in 2004 to just 1%. Because of this, poor Eddy only made out with a few billion dollars.
A key to start-up investing is understanding at which stage of the company’s life you are investing and the possibility that more shares will be issued in the future.
- Seed financing is raised to develop the business plan and develop a product. This is obviously the riskiest stage for investors because so much is uncertain about the company’s product or chance of success.
- Start-up or Operational financing is the most commonly seen in crowdfunding. The owners have developed their plan and product, usually with money from family and friends, but need money to start production and marketing. Even with more certainty around the venture, most investments in this stage will never see a profit.
- Growth financing is needed when the company is operational but needs money to take it to the next level, maybe a geographical or tech expansion. These are good investments for beginning crowdfunders because the company provides more financial details which you can analyze.
- Mezzanine financing, or bridge financing, is short-term money needed to pay regulatory costs to go public on the exchanges or to seek another business recapitalization. Banks are quick to offer these loans because they are more certain and offer high yields. Don’t expect much of these to be crowdfunded but it is a point at which your ownership might be diluted.
Beyond dilution, understand that you may not be able to sell your crowdfunding investment for several years. Start-up companies need to focus on growing the business, not on continually raising money to cover investor exits.
Analyzing the financial statements of crowdfunding start-ups is similar to the analysis you do for established companies with publicly-traded shares. Robert has some great posts here on The College Investor that will guide you through basic financial statement analysis. Besides this basic analysis, there are some red flags to watch for in start-up investing.
- Management has a vested interest in estimating future sales in the best light possible. Be critical of the company’s growth assumptions in revenue and what share that revenue is of the total market. Is it likely that the company is going to come out of nowhere to take 5% or more of the market sales without competitors doing something about it?
- Expenses are another big source of manipulation on the income statement. Check out the percentage of sales for each expense line item for publicly-traded competitors. Expenses at start-ups; especially selling, general & administrative (SG&A) are going to be much higher as a percentage of sales compared to competitors. Be critical if management thinks it can run the company at relatively little expense or if expenses drop dramatically within the first few years.
- Depreciation expense will be a big factor for companies with a lot of property and equipment. Underestimating depreciation is an easy way to artificially boost earnings but the bill comes due when equipment needs replaced. Compare depreciation expenses as a percentage of long-term assets for the start-up against competitors.
- Expenses for professional fees are a big red flag for start-ups so be critical. Is management paying an exorbitant fee to a company run by a family member or another related party?
- Management perks and stock options is another expense to watch though you might have to dig further into the notes of the financial statements. Use of company assets and generous stock compensation is going to be common for companies with little cash flow but check to make sure it’s not excessive compared to competitors.
Investment in crowdfunding projects will take more time than most are used to with regular stocks but the returns can be well worth it. Dick Costolo made 400 times his $25,000 initial investment in Twitter when it went public November 2013 for a $10 million payday. Expect only a few of your crowdfunding investments to avoid total loss and a few of those to provide a return. Do your homework though and you could be looking at your own million dollar payday.
Joseph Hogue is the founder of Crowd101, an informational blog for investors and crowdfunding campaigns. He combines his experience in private equity and investment analysis with years spent coaching crowdfunding campaigns for a unique view from both sides of the table.