By Jeff Brown for The Wall Street Journal
In the old days, an investor hoping to get in on the ground floor of the next Google orFacebook had a couple of options: have a friend or relative on the inside, or sign on with a big brokerage firm handling the startup company’s private placement—a sale of stock that hasn’t yet gone public.
Not anymore. Ordinary investors now can buy shares in startups that are just getting off the ground, sometimes for just a few dollars. If, that is, they are willing to take on a whole lot of risk.
It all started with the Jumpstart Our Business Startups Act in 2012. Since the act’s Title III took effect in May 2016, people no longer have to be well-to-do “accredited investors” to buy into startups.
Their stake can be as little as $10, or as much as they like, within Securities and Exchange Commission limits based on income. Investing is done through the soaring number of online “equity crowdfunding portals.” Ones that allow nonaccredited investors include Wefunder, SeedInvest and StartEngine. Well-known portals for accredited investors include EquityNet, Fundable, AngelList and Crowdfunder.
But along with hopes of 100-fold gains come big downsides. Many of these startups fly beneath the radar of big venture investors who vet fledgling firms. Often, they aren’t promising enough to go public the traditional way, and they lack a track record, proven product and thorough financial disclosures. And since their shares aren’t publicly traded, it may be impossible to cash out until an exit event like an IPO or buyout, and the firm may tank while you wait.
“Quite honestly, it’s as close to gambling as you can get. You are dealing with a level below penny stocks,” says Keith Hamilton, owner of Hamilton & Associates, a registered investment-advisory and wealth-management firm in La Jolla, Calif. When clients want to invest in startups of any kind, he says, “I tell them to call it their gambling account.”
The crowd gets bigger
This new method of buying into startups is the latest and hottest development in the broader field of crowdsourcing.
Money-lending sites like publicly traded LendingClub Corp. make loans from a pool of investor money and pass payments back to investors. Charitable sites like GoFundMe.com allow people to give to causes that may be too small for ordinary foundations, like helping an individual accident victim with living costs. Rewards portals such as Kickstarter and Indiegogo allow donors to contribute to specific projects such as an independent film, and offer perks like a prerelease showing.
Equity crowdfunding—where contributors get actual shares in businesses—began with portals like MicroVentures that largely served accredited investors—people with at least $1 million in net worth excluding the home, or incomes over $200,000. (MicroVentures now serves both accredited and nonaccredited investors.)
The 2015 Crowdfunding Industry Report by Crowdsourcing LLC’s Massolution.com, the latest industrywide data available, shows $16.2 billion raised through the various types of crowdfunding in 2014, up 167% from the year before. At the end of 2014 there were more than 1,250 crowdfunding portals world-wide, versus 850 in 2012.
“The floodgates have been opened!” the Massolution report says, and industry experts think growth has continued at a fast clip since that report was written. Many predict more money will be raised in coming years as the number of platforms grows, with new players occupying narrow niches such as fundraising for specific industries and a few big platforms taking an ever-larger share of the market. “International expansion will accelerate,” the report predicts.
For now, the lending, donation and rewards sites dominate crowdfunding. But the equity sector is only likely to grow, as more investors and entrepreneurs learn about it, saysJohn Rampton, an experienced startup investor in Palo Alto, Calif., who has invested in a startups through DreamFunded.
“In the future, a lot more startups will have a chance of being successful because of the funding they can get without [the help of] the institutional investor,” says Mr. Rampton,
The Massolution report found that in 2014, before Title III flung open the doors, the average equity campaign in North America aimed to raise $175,000. Portals charge investors a percentage of the funds raised—for example, 5% for DreamFunded, which welcomes investments as small as $10.
A nozzle idea
Currently, DreamFunded offers investments in startups like Aqua Blaster, a firm with a new hose nozzle for firefighting and pressure washing, and WorkCar, an Uber-like outfit planning to provide work vehicles. The portal supplies bios on startups’ management teams, a quick financial analysis and the firm’s business plan.
DreamFunded’s co-founder and CEO, Manny Fernandez, says the screening also entails interviews with management, credit checks, and criminal and terrorist background checks.
Though he thinks the industry will grow and provide valuable service to startups and small firms ignored by the venture-capital industry, he agrees the investor is more likely to lose money than to get rich.
‘If you want a safe, secure bet, this is not the way to go.’
—DreamFunded’s co-founder Manny Fernandez
“I think this is ideal for the person that knows the person that’s raising the money,” such as the owner of a local business, he says.
“I do not see it as a person thinking, ‘Hmm, I have a choice of putting my money in a CD or funding equity startups.’ If you want a safe, secure bet, this is not the way to go.”
Because the industry is so new and startup investments often don’t pay off for a decade or more, it’s too early to tell how well investors can do. Generally, the portals highlight their fundraising record, not investor returns.
But experts say it’s not to soon to see the risks. Marc Seward, principal of Enviso Capital, an investment-advisory firm in San Diego, says he wouldn’t put more than 15% of a client’s portfolio into alternative investments, with startups making up only a fraction of that, regardless of whether the investor uses equity crowdfunding or a more traditional way in.
Mr. Seward says he worries that portals’ seal of approval makes a startup look less dangerous than it is.
Though all these sites promote their due diligence, it’s not what you’d get with a listed stock that has met the listing standards of an exchange.
“I see this lack of due diligence as a tremendous weak link in the new crowdfunding equity space,” says Thomas White, co-director of the entrepreneur incubator at American University’s Kogod School of Business.
“I think a major red flag is that the company is looking to crowdfund for equity in the first place,” says John Torrens, professor of entrepreneurial practice at Syracuse University’s Martin J. Whitman School of Management, noting that “this would signal to me that more-sophisticated angels have looked at it and passed for some reason.”
Skeptics and insiders urge investors to study up before taking the plunge. Specifically:
• Read everything you can, especially on the management, and don’t just rely on the portal.
• See how managers are compensated. It’s a problem if they can boost their pay out of the money raised by the crowdfunding campaign, Mr. Seward says, noting that the better deals divide the first profits among investors before the managers get anything.
• Know whether your shares will have voting rights. While private placements through friends and family or brokerages often do include voting rights, crowdfunding deals generally do not, and in fact portals use this as a selling point to startups. Investors are wise to find out if they’ll have any voice or recourse if they’re dissatisfied with management.
Because of the risks, experts warn against dreams of riches. Be prepared to tie your money up for five to 10 years, and don’t bet the children’s college funds, Mr. Rampton advises, adding, “Nine out of 10 companies fail in the first five years.”
First appeared at WSJ