Crowdfunding is the new buzzword on both sides of the ocean. The new alternative in financing has become a huge opportunity for raising money to fund a social cause or business, but there is an extra advantage in the U.K. and in parts of Europe: investing.
Today we have, Joseph Hogue, founder of US based blog Crowd101. He will share his his experience in private equity and investment analysis from his years spent coaching crowdfunding campaigns and brings a unique view from both sides of the table. He is also a member of the Moneystepper Savings Challenge!
While investing in crowdfunding remains out of reach for most Americans because of special interests and the regulatory process, investors in other markets (such as the UK) have full access to the returns that venture capitalists have enjoyed for years.
Crowdfunding: The Alternative Financing that is Becoming Mainstream
It wasn’t but a few years ago that crowdfunding was a little known method of financing only used by tech startups. Things have changed quickly and early estimates for 2014 show that projects to the value of $10 billion have been funded globally, almost double its total 2013 pledges.
The industry started as a way for social causes and entrepreneurs to raise money. In a matter of moments, you can write out a crowdfunding campaign on one of the websites. The sites give you a platform for showcasing your business product or social cause to the world, and in return anyone can donate money to help you reach your funding goal.
More interesting to me has been the emergence of equity crowdfunding, where visitors are not asked to donate money but to take an ownership position in the company through investment. Previously only venture capitalists have had the opportunity to invest in start-ups and early-stage companies, and enjoy some pretty amazing returns.
According to Nesta, crowdfunding in the U.K. likely topped £1.6 billion last yea, showing 70% growth over the prior year. The equity crowdfunding market is still relatively small at £28 million but is growing rapidly. New disclosure rules put in place last year which required investors to declare that they had no more than 10% of their total wealth in one crowdfund investment did not slow growth as some had feared.
We’re just getting caught up here in the States with rules two-years overdue that will allow regular investors in the equity crowdfunding space. I cover investments and advice on crowdfunding campaigns on my blog, Crowd101, but the delayed rules definitely limit things.
Venture Investing: Few Scams but lots of Failed Investments
While the upside to crowdfunding investing can be very high, you need to understand the investment and the risks. Many new investors really don’t understand how ownership differs with normal stock investments, something I highlighted in a post on what you’re really getting with equity crowdfunding.
While investing in crowdfunding gives you an ownership stake just like stock investing, the difference comes in the type of companies. Most of these are extremely new companies, many of which have no sales and may not even have a developed product yet. Of every ten investments in start-up companies, venture capitalists expect maybe two or three to return some money after a five-year period.
Besides this risk of total failure, new companies usually need multiple rounds of financing to get started and operational. This means that your initial ownership stake may get diluted in the future.
The idea is that those few winners will post returns high enough to average out across the whole portfolio of investments. The media likes to highlight the failure rate and question whether the industry is rife with scams but it’s really just the normal failure rate in small businesses.
Due Diligence and Rational Expectations
If I haven’t completely turned you off with the two industry buzzwords above then you must be pretty committed to crowdfunding investment. That’s good because you will need that commitment to make your experience a success.
The biggest challenge to crowdfunding investment is the due diligence required into each investment, or the amount of homework you need to do. Publicly-traded stocks are scrutinized by tens of thousands and are more stable, mature companies. Much less is known about start-up companies so you’ll have to do a lot of the analysis yourself. Some crowdfunding sites may require companies to post their financial information but you may still have to dig around and determine how much the company is really worth. For other companies, you’ll have to visit the financial regulator’s website for financial documents.
Rational expectations, or simply understanding realistic returns for an investment, is a big part of crowdfunding. If the financial documents of start-up companies were to be wholly believed, the future would be lined with rainbows and the streets made of gold. You need to learn how to forecast sales and expenses for industries in which you invest. Unless you have a deep experience in start-up investing, follow the venture capital business model. Become an expert in forecasting one industry and have a group of friends that will do the same. You can then rely on each other to make better decisions across a group of industries.
Understand that crowdfunding investments can be locked up for three to five-years. Small companies cannot worry about having to constantly return money to shareholders so language is usually written into the investment for a period of a few years. Most crowdfund investments, those that return any money, return money through a sale of the company or a stock sale to the public.
Crowdfunding has reached the point where no amount of regulation will deter growth and it could be a great opportunity to diversify your portfolio of stocks and bonds. Investment in small companies carries additional risks but the payout on a few winners can make for very strong returns. Understanding these risks and how to find good investments is your first step into a whole new world of investment.
Jason Vitug says
I was able to start my company through crowdfunding raising over $78,000 in 30 days. I’ve been interested in equity fundraising but it seems like some ways away before laws change to allow us to do that here in the States. You are right it’s important when looking at these as investments to do the homework and lots of it.
Vawt says
I would like to invest in this at some point. While very risky, if I had some excess capital that I could do without for a couple of years I would try it.
Due diligence may be more difficult, but not impossible. Thanks for the info!
Joseph Hogue says
Thanks for the comment Vawt,
It will take a couple of years for crowdfunding investing to catch on but I believe it will be a common part of everyone’s portfolio within the decade. It is a great way to diversify returns from stocks and bonds and can offer some higher yields. The novelty and uncertainty around the industry is the only thing keeping it back.
Annie Logue says
I don’t like the math on crowdfunding as an investment. The shareholder services costs for the companies will be really high, and the risk-adjusted rates of return for the investors will be really low.
Joseph Hogue says
Annie,
There’s still stuff to work out for crowdfunding as an investment, fees for smaller issuers is a big one. Not sure that risk-adjusted returns will be as low as you think though. Venture capital returns are decent and compensate for the extra risk on a portfolio-wide basis.
Jeremy Norton says
Great roundup as usual, really enjoyed your article. Thanks for sharing your article on How to invest in the Crowdfunding Revolution. It’s very helpful and useful article. I will definitely share this to my friends.
Anastasiya says
Just like with all other high-risk investments, funding start-ups might be very rewarding. However, you need to be shrewd enough to separate the wheat from the chaff. It’s better to invest in the industries that are familiar to you.
jamesrod214 says
I have been wanting to invest in this equity crowdfunding revolution. All of my friends have been talking about it, and I wanted to know what it was all about. Like you say, it wasn’t too well known a few years ago. What made it so popular?
Sheldon Nesdale says
Indiegogo gives flexible crowd-funding service as an open and accessible option for campaigns worldwide.