Over the last few years, investors have seen a huge spike in the availability of crowdfunded investments. In fact, in 2015, crowdfunding raised over $34 billion dollars according to the latest reports. There are all types of investments that anyone (seriously, you don't have to be an accredited investor) can invest money in.
The reason for this? In 2012, Congress passed the JOBS act, which made it easier for companies to raise money, with a specific provision around crowdfunding. This allows anyone (both accredited and non-accredited investors) to pool their money together to invest in a company.
As a result, we are seeing crowdfunding investments take over real estate, private equity, small business, and more.
This simple provision has allowed people to invest in all types of things, with the hope of one of these companies turning into the next Amazon, Google, or Uber.
But there's a big problem here that many people don't discuss - the risks. Investing in early stage companies is risky. According to the Small Business Administration, only 50% of businesses make it to year 5. And most investors in crowdfunded investments don't quite understand how their investment even works - how do they get paid, when do the get their money, etc.
All of these are risks, and as an investor, it's important that you do your due diligence. Here's our guide on how to do your due diligence on crowdfunded investments.
The Main Types Of Crowdfunded Investments
Over the last few years, a few primary types of crowdfunding investments have emerged:
Crowdfunded investments can be a great way for smaller investors to get access to great investments. And these investments have the potential to earn high rewards. However, these investments carry more risk, with many the risk being you lose all the money your invested.
With many of these investments, there are no way to sell them once you own them, and you have to wait for a liquidity event to get your money back. And if that never happens, well, your investment is essentially worthless.
As such, it's extremely important for investors to understand the risks of each of these main crowdfunded investments, as well as understanding the basics of how to do due diligence on these investments.
1. Equity Crowdfunding
Equity crowdfunding is when you invest in equity in a company - typically a startup. The most common way equity crowdfunding is done is through a convertible note.
A convertible note is a debt instrument that can convert to equity at a specific milestone or time. The way these companies can convert to equity is spelled out in the note agreement (which most platforms publish on their site).
You will usually see factors such as:
- Valuation Cap: This is the maximum amount that can be converted to equity.
- Interest Rate: The annual rate at which the loan accrues interest (although typically not paid out).
- Term Length: This is the amount of time the company has to pay back the loan or have a conversion event.
- Conversion Discount: This is the discount that you'll get on the equity on conversion. Basically, if the company offers a 10% discount, and the equity conversion is $1.00 - you get shares at $0.90.
While a convertible note is the most common form of equity crowdfunding, you may sometimes see any of the following:
- Direct Investment (You buy into the company and are on their capitalization table)
- Direct Equity/Share Purchase (You buy shares in a company - typically called a Series round)
- Debt Investment (You loan money to the company with an interest rate and repayment schedule)
- Revenue Share (You're buying a share of future revenue - similar to a royalty)
You can also invest in equity crowdfunded funds. These are funds that many platforms put together that make investments in individual companies, and you, as an investor, own the fund. Very similar to a mutual fund or ETF. This gives you more diversification across multiple investments, and also requires less work on your part.
Risks With Equity Crowdfunding Investments
The rewards can be easy to see: you invest in a company, and it grows and goes public, you become a shareholder, and you enjoy vast amounts of wealth. It's a great story in our minds, but it's not how it typically works.
As an equity crowdfunding investor, you need to really know and understand the risks of these investments. Here are a few of them.
- Potential For Loss: You could lose all of your money. If the business fails, you don't have much recourse. Remember our stat from above - the failure rate of small business is high.
- Lack of Liquidity: Once you invest, you can't typically get your money out until a liquidation event. This means your money could be tied up for years.
- Platform Risks: You have to understand why companies are going to these online crowdfunding platforms versus pitching to traditional VCs and Angel Investors. There may be some selection bias at play and you may not be getting the best companies to select from.
- Due Diligence Risks: You're relying on the platform or third-parties to do most of the due diligence for you, which presents additional risks. Also, incentives of the platform or third-parties may not align with your incentives.
How To Get Started With Equity Crowdfunding Investments
There are a lot of players in the equity crowdfunding space, and each of them has their own pros and cons. We would love to know your experiences with any of these companies in the comments below.
Here's our list of the major equity crowdfunding investment platforms:
One of the largest equity crowdfunding platforms currently online.
Wide array of deals available across industries.
In partnership with MicroVentures.
Invest in individual companies and funds.
Mainly consumer-facing companies
Offers rewards based crowdfunding and equity crowdfunding.
Offers investment clubs to invest with experts.
Focus on connecting investors with local business
Focus on accredited investors
Focuses on both small and large offerings
Highly curated offers
2. Real Estate Crowdfunding
Real estate crowdfunding is another area that has taken off over the last few years. Similar to equity crowdfunding, these real estate crowdfunding platforms give investors the opportunity to invest in real estate in multiple ways, for low minimums.
With real estate crowdfunding, there are three major ways to invest: direct equity, preferred equity, and debt.
Direct equity is just like in equity crowdfunding, you own equity in a property. You will typically receive shares equal to your investment in a newly formed entity managed by the Crowdfunding Sponsor to hold title directly to the Property.
Preferred Equity is a little more complicated. Preferred equity is typically offered as an investment in a real estate fund for a specific term. These funds will pay preferred equity holders a preferred return, typically monthly or annually. At the end of the term, the profits from the fund are paid out to equity holders, if any.
Sometimes the term is based on an exit - such as a sale or refinancing. Sometimes the payments are based on a waterfall of events.
The bottom line is that preferred equity deals are much more complicated, and you really need to understand the terms of the deal.
With both types of equity deals, it's important to remember that you're effectively becoming a partner with the sponsor. So you should know their background and track record. It's also important to really know what you're investing in.
Debt is what most people are familiar with in real estate, in the form of a mortgage. However, unlike a mortgage, most debt you'll be investing in with real estate crowdfunding will be short term loans - typically for rehabilitation, development, or bridge funding.
When lending to a sponsor, you should due your homework on the sponsor's track record, as well as understanding the Loan-to-Value (LTV) ratio (generally you want it around 65% to 75%) and how much money the sponsor is putting into the deal.
Risks Of Real Estate Crowdfunding
Real estate crowdfunding has some different risks compared to equity crowdfunding. Make sure that you know and understand these risks.
- Potential For Loss: With any investment, there is a potential for loss. Unlike equity crowdfunding, there is less risk with real estate that your investment will go to $0, since it is still backed by real property (unless you invest in an unsecured investment). However, there are plenty of ways to lose money - from vacancies, to incomplete rehabs, poor selling markets, inability to refinance, and more.
- Lack of Liquidity: Real estate investments are not liquid. Once you invest, you can't get your money back until there is a liquidity event - typically refinancing or sale.
- Platform Risk: With any online platform, there is a risk of fraud and lack of due diligence. Many investors rely on the platform to help assess this, but as an investor, you need to do your own homework.
- Due Diligence Risks: Since you're not able to walk the property, and really know what you're investing in, there is a risk here. Also, the platform's due diligence information might not be aligned incentive-wise with your needs as an investor.
How To Get Started With Real Estate Crowdfunding Investments
If real estate crowdfunding sounds interesting to you, there are a lot of ways to get started. We have used several of these platforms and have been happy with the results.
Some of these platforms require you to be an accredited investor, while others do not. Most allow free registration so you can at least see what they have to offer.
Closed to new investors
Invests in real estate through eREITs
Invest through real estate loan investments
Non-accredited investors can only invest in eREIT
Mostly single family homes.
Invest in real estate through loans
Mostly debt investments
Focus on commercial offerings
Focus on commercial offerings
3. Peer To Peer Lending
Peer to peer lending is the oldest crowdfunding investment. The main companies in the space, Prosper and Lending Club, both started in 2006. Unlike the real estate crowdfunding companies we mentioned above, these platforms allow loans for pretty much everything, and the amount of the loans are typically less than what you'll see in the real estate space.
Peer to peer crowdfunding loans are personal loans, that typically range anywhere from $1,000 to $40,000. These personal loans can be used for anything, from refinancing student loan debt, to doing home improvement projects.
On these platforms, instead of looking at a "deal" (like a company or property), you're looking at a person. You should evaluate these loans based on the individuals credit score and history, and what you think about their ability to repay.
Unlike the newer crowdfunding platforms, the personal credit industry is pretty standardized with great reporting and risk evaluation. As such, it's easier to do due diligence on borrower risk.
Risks Of Peer To Peer Lending
However, just because these platforms have been around doesn't mean there isn't risk. I've personally had loans on Proser default, and it's the cost of doing business on these platforms.
The main risk you need to know with peer to peer lending is:
- Default Risk: The biggest risk on these platforms is default risk, where the borrower simply defaults on the debt. Since these are all personal loans, there is nothing securing the debt (like there could be with real estate). However, these platforms have very low minimums (usually $25), so you can hedge default risk easier through diversification.
How To Get Started With Peer To Peer Lending
If you're looking to get started with peer to peer lending, here are the major platforms that allow you to get started.
Invest in $25 increments.
Minimum of $25, then any amount after.
Advertises a strong borrower portfolio.
4. Specialty Crowdfunding Investments
There are also several types of crowdfunded investment platforms that don't quite fit into a nice category, so we're calling them specialty crowdfunding platforms. In fact, most of these platforms don't advertise themselves as an investment. When you "invest" on these platforms, you're considered a sponsor or buyer - not an investor.
These include companies like Kickfurther, where you can invest in a company's inventory, or Kickstarter, where you can back a creative project in exchange for receiving the physical good.
However, we consider them crowdfunding because the same principles apply - people are pooling money together to fund "something", with the hope of getting that money/value back and more.
Each of these has their own risk/reward ratio, but we consider these investments to be the riskiest of all the crowdfunding options.
Risks of Specialty Crowdfunding Investments
These investments are typically much more risky than other crowdfunding investments. They are setup in ways that typically have no collateral or minimal collateral, and the reward sometimes doesn't equate the risk.
However, if you're a fan of the product/service, the reward could outweigh any potential risks.
The main risks to consider include:
- Potential For Loss: These are incredibly risky investments. Chances are you're either going to see a return or you're going to see $0. There isn't typically a backstop to save you from losing your entire commitment.
- Lack of Liquidity: There is no selling your commitment. That's why investors are called buyers or sponsors. You're putting money in, and it's almost not expected to see a return.
- Platform Risk: With these investments, you're taking a significant risk with the platform. For example, Kickfurther experienced several fraud instances that cost their users their commitments.
- Due Diligence Risks: It can be hard to do due diligence on the investments on these platforms because they are small startups or ideas. As such, you're depending a lot on the platform, which is highlighted in the platform risks.
Specialty Crowdfunding Platforms
Donate to products and services.
Donate to products and services.
Funding small business inventory.
Crowdfunding Investment Limits
If you're a non-accredited investor, there are limits to how much you can invest in crowdfunded investments in a 12 month period. If you're an accredited investor, there are no limits.
The limits are based on your net worth and income. Both of these rules apply - net worth and income. You qualify for both to meet that investment limit. It can be a little confusing.
Less Than $100,000/yr
The greater of $2,000 or 5% of Your Net Worth
Greater Than $100,000/yr
Up to 10% of your net worth, max limit $100,000
Less Than $100,000/yr
The greater of $2,000 or 5% of Your Income
Greater Than $100,000/yr
Up to 10% of your income, max limit $100,000
These limits are designed to protect you, as crowdfunded investments carry significant risk.
While you are prohibited one exceeding these dollar limits, there is no limit on how many companies you invest in. So, you could theoretically invest in 100 different $1,000 investments before you reach you limit.
How To Do Due Diligence On Crowdfunded Investments
If you were investing in a startup as a true angel investor, you would do a lot of due diligence before making any official investments. Here's a sample of a due diligence checklist for reference. The trouble is, with online crowdfunding platforms, you don't really know if you have the full picture.
Many platforms attempt to do a good job of vetting companies (as it is in their best interest), but at the end of the day, it's not their money on the line.
Given that many of these companies are unknown, here are some key tips to doing online due diligence for crowdfunded investments. Remember, these are things to look at beyond the basics of the deal structure. What you're thinking about here is:
- What is the opportunity? Does the company have a clear vision to execute on it?
- What is the risk? Is the company mitigating risk?
- What are the success factors currently in their favor?
- What potential challenges are they facing and will they face?
- What does the exit strategy look like to actually get my investment and gains paid?
- Analyze the competitors and market trends
- Validate what the management and ownership are telling you
How To Do Due Diligence On Companies
This is the absolute toughest part about online equity crowdfunding - including looking at deals on specialty platforms. How do you vet a company that you've likely never heard of before?
Remember, unlike becoming a partner or even a venture capital investor who's contributing a large investment, you're a small cog in the wheel. Your money is going in, but you get basically zero say in the firm. So, if you're not excited about the product or service now, it's not likely to change.
Here are our biggest tips for how to vet and complete due diligence before investing in any online equity crowdfunding deal.
Know The Platform Risks: Every platform has their pros and cons. Before moving forward with any of them, consider vetting the platform itself. Google it and see what others are saying. Have they been reviewed? Check out this sub-Reddit /r/Crowdfunding that has a lot of discussions around the various platforms and tools out there.
Understand The Deal: This is just a reminder that you need to know how the deal is structured. What type of investment is it (equity, debt, etc.)? How does that structure work for you getting paid? What does it mean for your rights if the company fails?
Focus On What You Know: Keep to your area of expertise. If you're not a tech or biotech expert, stay away from those companies. If you are familiar with online or consumer products, look for companies in those spaces. The bottom line is, you'll be more comfortable in your investment if you know about the industry the company is working in.
You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
See What Others Are Saying About The Company: Google it. Use Facebook search (just type the company name into the search bar, and also search for the URL). Use Twitter search (type the company name and URL). See if the posts are users engaging and interacting with the product, or is it mostly customer complaints? This is a key indicator of the market.
Check Their Website: This sounds silly, but go and look at it. Poke around. Is it completed or does it have unfinished sections? Do the links work? Does it look professional? Use a service like Whois to see who owns the website, when it was created, and if that matched the company/founders information. I've found that if you can't even create a professional website, why would I give you my money. The world is moving towards an online/mobile first society and you're not playing ball there.
Know The Exit Strategy: You're only going to get your money back on an exit - so what's the strategy to get there? Then, is it specific and realistic? You need to ask yourself if this company is shooting for the moon, or has a clearly laid out plan to hit it's goals over the next few years.
How Is The Company Selling Items? If the company already has sales, go and look for yourself. Many companies sell on Amazon - read reviews and see the sales rank in their category. Does the company have a purchase order(s) already? With who and what does that look like?
Assess The Founders: Google them and search them on LinkedIn. What have they done before? What experience do they bring to the table that will make this successful? How much are they invested personally in the company/product? Even better if you can see their credit score and committed capital.
Evaluate The Market: Who are the competitors? What's to stop someone from doing something similar? How are consumers interacting with the product. Also, always be leery of products in fashionable or trendy markets. Trends change fast, so it's an even riskier investment to go with a company in this space.
Know The Consumer: Why would someone buy the product? Are you a customer? Would you or your family be a customer and be proud of it? Consider using a service like UserTesting where you can pay people to evaluate a product/website online and give you live feedback.
Value Good Communication: Communication is key. How is the founder communicating with investors and the community. If you request information, do you get it promptly, or are you waiting days and days? If the crowdfunding website has a chat or message board, is the founder active responding to questions and concerns? If they aren't, it's probably best to stay away. And don't just go by frequency of replies - is the founder being respectful and helpful towards the investors/backers, or is it more hostile? I've seen both, and a hostile founder typically isn't a good sign.
How To Do Due Diligence For Real Estate Deals
Real estate is a little bit different from investing in a company. Here are our tips for vetting and doing due diligence before investing in any real estate crowdfunding deal.
Understand The Deal: Just like in equity crowdfunding, you need to understand the deal. Are you lending and investing via debt? Are you going in as an equity partner? What does that mean for you getting paid? What does that mean if the deal fails - for example, are you the 1st lien holder or 2nd lien holder?
Assess The Value Of The Asset: It is key for you to know what the property is worth. This allows you to assess the debt-to-equity ratio and more. Most platforms will give you a value, but you need to check it and be comfortable with it yourself. Go online to Zillow.com and enter the address. See what the "Zestimate" is. Now, this isn't guaranteed to be accurate, but it's worth noting. Also, see what the comparable sales are at the bottom of the page - what's the Price Per Square Foot and how does that compare to your property. Finally, go to Google street view and walk around the property and neighborhood. How does it look? Would you live there or are comfortable investing there?
Know The Market: This can be tough for real estate crowdfunding, because you're not likely to be near where the asset is you're looking at. However, you can still learn about the market for the property. Is it a single family home, commercial, or multi-family residential? Who is renting in those areas? What's the market look like (go online to Craigslist or PadMapper for that city)? How does your investment compare to the other similar rentals? What happens if a recession happens in the next 2-3 years? Do you still feel confident in your purchase? Also, never forget to look at the local crime map!
Assess The Sponsor: It's important to know who you're working with - whether you're lending them money, or joining them as a partner. Just like in equity crowdfunding, you should Google the sponsor and their company, and see what their LinkedIn profile says. Many of these sponsors are either licensed real estate professionals or contractors. That's great, because you can go onto their state website and validate their licenses and see if there have been any complaints.
Budget Review: Many real estate crowdfunding deals are for "flips" or renovations. Make sure you review the budget and see if it matches the work required. It can be hard to assess sometimes, but if the offer is calling out a new kitchen, roof, and pool, but the budget is only $10,000, you should be concerned.
Evaluate The Exit Strategy: Make sure you understand the exit strategy to get your investment back. Real estate is tough because once you're in, there are only a few scenarios to actually get your cash out - typically a sale or refinancing. Many plans highlight "refinancing in year X" as an approach to paying back borrowers. Ask yourself if that sounds reasonable, and are you comfortable if a recession occurs and the sponsor can't refinance?
Final Thoughts On Crowdfunding Investing
I truly believe that crowdfunding can be a great alternative investment for some people. It's a unique way to give access to people only looking to invest relatively small amounts into alternative assets, such as startups and real estate. These can also turn into great passive income streams.
However, those "some people" should be investors who are using this as a small portion of their overall portfolio. No investor should be over 20-30% in any of these assets (real estate or small business). There is high risk in these areas, with the potential for total loss. As such, it should only be done with money that can be lost.
But if you're ready to make the leap, and want to do your due diligence, this can be a fun and lucrative way to earn a higher return on your investment.
What are your thoughts? Have you used any of these platforms?