On Wednesday, the US Securities and Exchange Commission agreed on a proposal for groundbreaking rules that would allow almost anyone to buy shares of stock in start-up companies.
Experts say the general public should enter crowdfunding with caution.
*Figure out the track record of any angel investors you see
crowdfunding a company; you may want to consider following their lead if their
record is strong
*Build a portfolio of 20 companies to avoid losing everything in one
*Understand terms like “pre-money valuations” and “dilution”
* Look for companies with a business plan and three-year financial
The rules, if approved after a three-month comment period and review, will mean crowdfunding portals can open up to the general public. And, to concerned investor advocates, it also means a whole new set of investment pitfalls and potential frauds to watch out for.
But the United States isn’t the first country to tiptoe into start-up investing free-for-all, and Americans have much to learn from recent forays into crowdfunding abroad.
In the last few years in Europe, crowdfunding platforms — online funding portals that allow investors to electronically buy shares in start-ups seeking funding — have popped up in the United Kingdom, Scandinavia, Germany and elsewhere. In a way, they serve as a live laboratory for what happens when mom-and-pop investors are given entree to unproven start-ups — risky territory once inhabited only by wealthy investors. Investors in the UK, for instance, can now own equity shares in crowdfunded companies for as little as £10 ($16.20).
So far, the lesson for investors is clear: The road to crowdfunded wealth is lined with potholes.
The promise of equity crowdfunding is, of course, that you will be smart enough — or more likely, lucky enough —to invest in the next Google. There are other lures too, such as bragging rights of company ownership and perks like product discounts, said Lasse Makela, co-founder of Helsinki-based equity crowdfunding portal Invesdor. For instance, Helsinki brewery Bryggeri Helsinki, which raised 158,000 euros ($215,000), gives its 164 investors a 20% discount on its beers when they show their investor card.
Of course, there are pitfalls. The biggest: that you’ll lose everything. The first warning alarm from Europe sounded this summer. Fair trade soap maker Bubble & Balm went bust after raising £75,000 ($121,533) from 82 investors on Crowdcube, one of the UK’s largest equity crowdfunding players, in July 2011. Investors collectively got a 23% stake in the company in exchange for their money. “They lost that money,” said Darren Westlake, co-founder and CEO of Crowdcube.
Follow the angels?
Angel investors and venture capitalists in the US are typically the first people to invest in a start-up. That speculative bet can be lucrative if the company takes off, and a total bust if it doesn’t. (An angel investor is an individual who invests in a start-up with his or her own money. )
In Europe, though, there are far fewer angels, said Liam Collins, a policy advisor at NESTA, the UK charity focused on innovation. Essentially, that means “crowdfunding gives European start-ups the access to capital their need”, he said.
In the US, crowdfunded companies are usually ones that angels won’t touch. “Good entrepreneurs don’t want to deal with lots of shareholders,” said Daniel Isenberg, professor of entrepreneurship practice at Babson Executive Education.
Isenberg’s view: equity crowdfunding is fool’s gold for unwitting investors. The companies are so new they may lack products, revenues and even workers. For their part, would-be investors must be particularly diligent. That means wading through documents peppered with dense financial terms such as “pre-money valuations” and “dilution”. Without understanding those terms, they could be at risk for losing their investment.
“Crowdfunding has the characteristics of a lottery,” said Isenberg.
Shades of transparency
European equity crowdfunding platforms are openly addressing key issues like transparency for investors. Funding portals like Crowdcube do some due diligence for investors, since start-up financial data is typically scant. In the US, companies seeking funding must disclose their finances to investors, funding platforms and regulators.
“We look for business plans and three years of financial projections,” said Crowdcube’s Westlake. “And we do due diligence on the board of directors.”
Once listed on the portal, companies are further winnowed out by having 60 days to meet their funding goal. “If the goal isn’t reached, the funding doesn’t happen,” says Westlake. Only 20% of these companies successfully meet their goals, he adds. Crowdcube investors can also do their own due diligence by asking entrepreneurs questions online.
On other sites like technology-focused funding portal Innovestment in Germany, companies offer investors pitch videos, business plans and financial plans.
“You can even find out how much the CEO earns,” said Thomas Herzog, who handles business development, product and marketing at Innovestment.
But, in the end, many investors end up relying on the wisdom of the crowd to guide their investments, experts said. “Crowds aren’t wise,” said Isenberg. The legendary investor Warren Buffett, for instance, makes money by investing against the crowd, he added.
Hype can ramp up even before a company officially lists on a crowdfunding platform, explained Oliver Gadja, chairman of the European Crowdfunding Network, a non-profit that promotes crowdfunding as a viable funding source.
“They are fully-funded within five or six hours (of being available online),” he said. “I question whether investors have even read the business plan.”
The big unknowns
Italy is one of the first countries with legislated rules that govern crowdfunding company conduct and that establish liquidation rights for investors. Among them: investors’ profiles must match their tolerance for risk.
Liquidity rights — the ability to sell your shares to someone else — is an especially thorny issue that is likely to be an ongoing problem for investors. Private stocks can be notoriously difficult to dump. Invesdor, for instance, hopes to launch a private placement service where shares can be liquidated or sold to other investors, said Makela. “But,” he said, “you are locked in for now.”
Returns on an investment can also take a long time for any start-up investment — up to 10 to 15 years, said Isenberg, who is also an angel investor. “In some cases, you may need to hold the shares forever,” he added. This means that you should be prepared to have your money tied up for a very long time. You may even lose it all.
“For now, equity crowdfunding is still the wild West,” said Gadja.“There aren’t enough exits for investors.”