Close

Crowdfund Investing: An Exciting New Alternative for Individual Investors

by Louis C. Gerken and Thomas C. Gray

Indexing and thoughtful asset allocation are solid choices for most individual investors’ core holdings. But for those seeking exceptional gains on a long-term investment horizon, alternative investments like private equity—including venture capital—can offer an uncorrelated, value-based, and often highly lucrative, complement to the otherwise staid 60% stock/40% bond investment plan.

Historically, only high-net-worth individuals and institutional investors, including pension funds and university endowments, have been able to enjoy the 600+ basis points of annual incremental return that private equity and venture capital investments deliver long-term over traditional asset classes (exchanged-listed stocks and bonds). Meanwhile, an estimated $5 trillion in U.S. individual retirement and personal investing accounts has been restricted to those traditional asset classes. Now, Title III of the 2012 Jumpstart Our Business Startups (JOBS) Act is poised to change the game by allowing unaccredited investors to participate directly in equity-based crowdfund investing.

Crowdfunding, the pooling of capital from many individuals to financially back a cause, project or company, started mostly as a way for individuals to conveniently support social causes and artistic projects by donating online (commonly referred to as donation-based or reward-based crowdfunding). However, crowdfunding has evolved rapidly into what may well become a viable investment vehicle that connects investors in search of portfolio diversity and higher returns with entrepreneurs and small-to-mid-size enterprises (SMEs) in search of capital to develop their ideas and expand their businesses. Figure 1 shows the tremendous growth of crowdfunding in recent years, including the accelerating growth of crowdfunding capital raised with the hope of financial returns (commonly referred to as crowdfund investing).

Source: Massolution 2013 Crowdfunding Report.
Investment Typical Risk of Loss Likely 
Stage Investment Range of Capital Crowdfunding Stage?
Seed stage < $500,000 66.2%
Start-up stage < $2 million 53.0%
Expansion/2nd stage ~$10 million 33.7%  
Expansion/3rd stage ~$10 million 20.1%  
Bridge/pre-public stage Up to $100 million 20.9%  

Because equity-based crowdfund investing is still in its infancy, accurate and representative data regarding crowd-backed companies is not yet available. However, it’s a safe bet that their failure rate will be even higher than the 75% failure rate of companies identified by professional venture capital funds as worthwhile investments. No sugarcoating here: This is a risky and often unpredictable asset class with many moving parts. That said, huge returns are possible, and risk can be minimized by diversifying your portfolio of companies. Note that due to the fundraising limitations likely to be included in Title III, equity-based crowdfund opportunities are more than likely going to present in the early seed and start-up stages.

Tracking and Monetization

You’re confident you’ve unearthed a gem, you feel the term sheet is fair and you’ve put your money where your mouth is. Now it’s time to carefully track the progress of your investment and be ready to move if need be. Follow company news, read the quarterly investor reports and any other materials provided by the company, and reach out via the proper investor relations channels if questions arise.

Should the company decline or fail to prosper, a number of outcomes are possible. The worst case, of course, would be for the company to go belly up, in which case investors stand to lose most or all of their investment. A more common outcome is for a company to stall, grinding away tirelessly without gaining additional traction, or perhaps even losing some. Depending upon your rights as an investor, at this point you may be able to affect change in the company through a board or C-level executive shake-up. You may also be able to exercise warrants that allow you to either recoup some of your original capital or increase your stake in the company through a discount of the original valuation. More likely courses of action include selling your stake on the secondary market (likely for less than you bought it), sticking it out in hopes that the company is able to start moving in a positive direction, recapitalizing by selling your shares back to the company, or the company winding down and selling off all assets in order to pay investors back. All of these options may or may not be available to you, depending upon the term sheet agreement and your ability to galvanize the “crowd” of investors into unified action. A venture capital fund generally doesn’t have to contend with the latter concern, as it has more consolidated power and a more unified voice with which to affect change in a portfolio company.

Another common scenario is for a company to initiate another round of funding, hopefully at a higher valuation than when you invested. In some instances, a new round of financing could mean a dilution of your ownership stake. In other instances, part of the new round of funding could be used to buy out previous investors’ shares. Sometimes, the investor or company has a choice in how existing shares are handled during a new round of financing. Because there are many ways a new funding round can be handled, it’s critical that you understand the term sheet before committing your capital.

Ideally, though, the company will grow quickly and have a successful exit in the form of an initial public offering or acquisition by another company. In the rare case of an IPO, you will likely be the proud owner of liquid, publicly tradable shares of a company that is almost certainly exponentially more valuable than when you invested in it. In the more common case of an acquisition (according to a 2011 Ernst & Young report, 80% to 90% of all venture capital–backed exits are acquisitions), your shares will be paid out as set forth in the term sheet. In either case, you’ve likely made a great investment and will be rewarded accordingly. At the end of the day, these are the two outcomes most venture capital funds are aiming for.

Should you join the ranks of successful investors in early-stage companies, enjoy your substantial gains and reinvest wisely, taking care to stick to your overall investment strategy and asset class allocations, including additional venture capital or equity-based crowdfund investments.

Conclusion

We hope this article has provided you with a fundamental understanding of what crowdfund investing is, how Title III of the American JOBS Act is poised to impact individual investors, and how to participate in equity-based crowdfund investing once Title III takes effect.

Armed with the knowledge necessary to select the best crowdfunding platforms and employ a sound approach to evaluate investment opportunities, and with a little luck, you can diversify your personal investment portfolio and take advantage of the exceptional gains that savvy equity-based crowdfund investing can offer.

Louis C. Gerken is the founder of San Francisco Bay Area–based Gerken Capital Associates (GCA), an independent alternative asset fund manager and adviser, and author of “The Little Book of Venture Capital Investing: Empowering Economic Growth and Investment Portfolios” (John Wiley and Sons, 2014).
Thomas C. Gray is an analyst with Gerken Capital Associates .


Discussion

Stanley Rich from LA posted 4 months ago:

I plan to use crowd funding for my upcoming
musical comedy about taxpayers and the IRS. It's based on my true story of how I survived a fifteen year battle, won and made the IRS pay legal fees, and then turned it into a successful show for corporate events and fund raisers. Now, we are ready to put it into a live theater and then take it nationwide.

In this case, I believe the only way I can use crowd funding is to offer perks.

Legally, I do not think, I can offer a profit participation without it being considered a security.

I would appreciate any feedback.

Stan Rich
(310) 428-3341


Stanley Rich from LA posted 4 months ago:

I plan to use crowd funding for my upcoming
musical comedy about taxpayers and the IRS. It's based on my true story of how I survived a fifteen year battle, won and made the IRS pay legal fees, and then turned it into a successful show for corporate events and fund raisers. Now, we are ready to put it into a live theater and then take it nationwide.

In this case, I believe the only way I can use crowd funding is to offer perks.

Legally, I do not think, I can offer a profit participation without it being considered a security.

I would appreciate any feedback.

Stan Rich
(310) 428-3341


Michael D. Tilma from NC posted 4 months ago:

Thanks for the very informative article. As a younger investor (I'm 30) and an entrepreneur, I have a very high risk tolerance and intend to participate in crowdfund investing. Do you think perhaps you can follow this up with an article on the practical steps to tell a solid company from a dud, or even the pros/cons of convertible notes vs. SAFE agreements or other terms? It would be very helpful to get an experienced venture capitalist's perspective on these things.


Michael D. Tilma from NC posted 4 months ago:

Thanks for the very informative article. As a younger investor (I'm 30) and an entrepreneur, I have a very high risk tolerance and intend to participate in crowdfund investing. Do you think perhaps you can follow this up with an article on the practical steps to tell a solid company from a dud, or even the pros/cons of convertible notes vs. SAFE agreements or other terms? It would be very helpful to get an experienced venture capitalist's perspective on these things.


Ron Freund from CA posted 4 months ago:

This will open up many opportunities for SRI or "green" investors as well. One might add a question to the list of criteria for considering an investment: "Does it align with my values?"

Already, there are solar and microlending opportunities available to the small investor.

We are looking into those as well.


Kevin Cooke from IN posted 3 months ago:

Excellent timing as capital seeks growth. I am tracking an Educational rising star set to impact others. Sharing this succinct summary on crowd funding.
Thank you AAII team !

Kevin


You need to log in as a registered AAII user before commenting.
Create an account

Log In