Investing Basics: Investing in Equity Crowdfunding

Some of the phenomenal successes such as Facebook and Dropbox demonstrate the fantastic returns that can be achieved from early stage investing but a very small proportion of deals are responsible for delivering the vast majority of profitable returns – writes Christian Leeming.

If you are considering equity crowdfunding there are some essential guidelines that can help to mitigate what are undoubtedly considerable risks associated with this type of investment.

Build a Diverse Portfolio

Studies show how risky equity crowdfunding is and whilst every investor will think they’ve identified the next big thing at the outset, the reality is that most company start ups will fail; the best way to maximise the chances of investing in a winner is to build a portfolio of several early stage investments.

Facebook and Dropbox demonstrate the fantastic returns that can be achieved from early stage investing

Just as mutual funds have made it easy to add international exposure to a stock portfolio, equity crowdfunding delivers easy access to a new asset class – private companies.

Rather than putting all their eggs in one basket, investors can diversify their investments in small sums across a whole range of companies to spread their risk and minimize their potential losses; finding one prince can more than make up for a whole host of frogs.

finding one prince can more than make up for a whole host of frogs

If you build a large portfolio then you are certain to have a large number of failures, which will dilute the returns from your winners; however, you also reduce the impact of the companies which fail, and stand a better chance of achieving an overall profit.

Investments can also be diversified across different industry sectors (remember the Y2K dotcom crash) and across different stages – seed, early stage and expansion – so that your investments are likely to come to fruition at different times.

Equity crowdfunding platforms deliver information regarding the companies you may be considering and it is also possible to take the temperature of the bulletin boards which will indicate sentiment around a particular stock; in this most democratised environment the message is loud and clear – the opportunities the crowd likes get funded and those that it doesn’t, don’t.

As with any investment you should be comfortable with the level of risk you are exposed to and it would be wise to ensure that early stage investments make up only a small proportion of any diversified investment portfolio with the rest in safer, more liquid assets.
 

Take the Tax Relief

Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS) tax reliefs can make the decision to include eligible companies in your portfolio a little easier.

Depending upon your tax position, under EIS the cost of an investment in an qualifying company is immediately reduced by 30% and if the company fails, any losses can be set against income tax for the year; in this way the capital that is actually at risk is dramatically reduced.

If you pick a winner, as long as the company remains EIS eligible, any gain on disposal of your investment is tax free as long as you have held the investment for more than three years, thereby increasing your return.
 

Do Your Homework

It is wise to take time to fully understand each investment and if the numbers don’t tell a compelling and realistic story, then it may be time to find another company to invest in.

it’s better to invest in a world-class team with a half-baked idea than have it the opposite way round

If it’s important to invest in good management for a publicly traded company then it’s absolutely essential to identify leaders that are winners when investing in start ups.

The old adage has it that it’s better to invest in a world-class team with a half-baked idea than have it the opposite way round; taking a start-up from idea to exit can be a tortuous journey and it is important to have absolute faith in the team leading the business.

In order to be included on a platform a company will be required to deliver a summary pitch document that is likely to include the following information:

• Description of the business.
• Description of the market it operates in.
• Progress to date.
• Exit strategy – how it will deliver a return for investors.
• Intellectual property or patents that are owned.
• Details of the management team.
• High level financial summary.

A full business plan is usually also available with much more detail on the proposition and some platforms even allow would-be investors to interrogate a company’s management team about the proposition.

Investors can come together to consider the potential for a particular proposition and real crowdsourcing can demonstrate whether there is a market and whether customers are prepared to pay for a product or service.

One of the most difficult things for early stage companies is financial planning, but it should be possible for a potential investor to assess what the prospects for the company are and by comparing actual with forecast, get a feel for how in control the business is.
 

Anticipate Further Investments

Most companies that seek to raise money via equity crowdfunding will need to raise further funding in the future and if you want to protect your percentage holding from dilution, you will need to invest further funds; an investor may need to hold some funds in reserve to fund follow-on investments.

This may be planned and therefore explicit in the company’s business plan, but it can often be an unforeseen consequence of a business failing to perform according to plan.

If an existing investor does not participate in future funding rounds then their percentage ownership of the company will be reduced; this may not be a problem if the business is progressing well and subsequent funding is raised at a much higher valuation – although a holding may be diluted as a percentage, the value of the shares may still increase – owning 1% of a company worth £10million is better than owning 10% of a company worth £500k.
 

Be an Active Investor

Unless the investor has bought a seat on the board, there may be a limit to the day to day involvement they can have in the running of the company but it is wise to monitor an investment by keeping in touch with the company, and by understanding and exercising the right to vote on significant matters.

By definition it is impossible to completely ameliorate the risks associated with early stage investment but by adhering to these common sense guidelines it should be possible to enjoy what is undoubtedly a dynamic and potentially lucrative sector without the fear of impending financial doom – who knows, you may just spot the next Facebook.